Full text of Financial Crisis Inquiry Commission : Documents Relating to the Financial Crisis of 2007-2009 : Financial Crisis Inquiry Report [Draft]

View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

TITLE PAGE HERE

TABLE OF CONTENTS HERE

LIST OF TABLES HERE

COMMISSIONER LIST HERE

STAFF LIST HERE

PREFACE HERE

FINDINGS AND CONCLUSIONS HERE

Preliminary Draft

Findings and Conclusions Regarding the Causes of and
Contributors to the Financial and Economic Crisis

Specific Findings



There were Dramatic Failures of Corporate Management and Governance

Management and Governance:
 Many systemically important financial institutions, including investment banks,
commercial banks, and the GSEs, acted recklessly, exposing their companies to
significant losses and, in most cases, failure or rescue by American taxpayers.
Risk Management:
 Failures included excessive leverage/inadequate capital, insufficient liquidity
including high reliance on “hot money”, highly risky activities, non-transparent off
balance sheet risks, and inadequate management systems and controls. These various
factors, as well as compensation practices (see below), were interconnected and must
be viewed in toto.
Compensation:
 Compensation structures and scale created incentives to increase annual revenues and
market share, without properly taking into account risks, long term performance, and
consequences of loss or failure.
Risky, Complex Securities:
 Major financial institutions put their companies and the financial system at risk
through their trading in the untested, complex non-prime mortgage related securities
that triggered the financial crisis (see below).
 Among other things, they supported/owned subprime lenders; securitized such
securities without proper due diligence and disclosure; created derivative instruments
(e.g. synthetic CDOs) that increased leverage and amplified exposure to mortgage
assets; and ended up retaining significant such assets on their balance sheets which,
in turn, led to substantial losses.
 At the investment banks, these activities were part of a larger shift from privately
held entities focused on investment banking to publicly traded corporations highly
focused on trading and principal investments.
Lack of Market Discipline and Regulation:






The failures in corporate risk management were particularly important in light of the
increased reliance on self –regulation (see below). Faith in the ability of financial
institutions and markets to regulate themselves turned out to be misplaced.
The lack of market discipline coupled with lack of effective supervision and
regulatory gaps was fatal.

There Were Significant Failures in Public Sector Leadership, Regulation, and Supervision

Failure to Use Substantial Powers:
 Policy makers and regulators failed to use their substantial, existing powers to
protect the financial system and the public. They had broad authority to constrain
risky financial products and financial institution risks and excess.
 Time and time again, the regulators were behind the curve as dangers mounted –
outrun and outmatched by Wall Street and market events.
 Notably, the Fed Reserve, along with other regulators, failed to curb the precipitous
decline in mortgage credit standards. As other examples, regulators failed to
constrain leverage, effectively oversee off balance sheet entities, and police short
term funding by institutions.
Regulatory Gaps and Arbitrage:
 Regulatory gaps – including regulatory arbitrage - resulted in a lack of transparency
in critical markets. Regulator shopping resulted in weakened supervision through
entities such as the OTS and the SEC’s CSE program.
 These gaps resulted from a failure to keep up with the evolving financial system or
deliberate decisions to deregulate or lessen regulatory requirements. In addition,
regulators failed to ask for needed authority in areas where they did not have it, but
where they identified risks.
Derivatives:
 The decision to ban regulation of OTC derivatives played a critical role in the crisis.
The lack of regulation resulted in a lack of transparency, excess speculation,
increased leverage, non-transparent counterparty risk, and an absence of business
conduct rules. In addition, it precluded state regulators (e.g. NY state insurance
regulator) from acting.
 Among other things, credit derivatives facilitated and extended the duration of
subprime securitization, helped fuel the housing bubble, increased the leverage of
financial institutions, and amplified exposure to the mortgage market.
 The lack of transparency of OTC derivatives and the substantial interconnections
between systemically important institutions resulting from those derivatives played a
key role in the panic of 2008.
Deregulation:
 The failures in regulation and supervision were in part due to a broadly accepted
philosophy – embodied in policy and practice and endorsed by the elected leadership
of both parties – that called for a greater reliance on self regulation of financial
markets and institutions.
 Even when regulators sought authority (CFTC, OFHEO), they were rebuffed.
 As noted above, the combination of weakened regulation and supervision and poor
corporate risk management proved devastating.
Power of the Financial Industry:





The financial industry exerted substantial power and pressure and undertook
extensive lobbying efforts to affect legislation and relax regulation, contributing
significantly to weakened oversight.

The Housing Boom and Bust Triggered the Financial Crisis

Declining Mortgage Standards Were Central:
 Dramatically and rapidly declining mortgage underwriting standards significantly
enlarged the housing bubble and bust.
 The explosion of poor quality, non- prime loans resulted in unprecedented
delinquency and foreclosure rates which triggered a wave of events that ultimately
resulted in the financial and economic crisis.
 Bank regulators were generally not worried about mortgage origination standards
since banks were selling loans into the secondary market (see mortgage regulation
below).
Failure of Mortgage Regulation:
 Regulators failed to halt worsening underwriting standards. While federal and state
regulators share in the culpability to varying degrees, prime responsibility rests with
the Federal Reserve that had the ability under HOEPA to regulate unfair and
deceptive lending and inappropriate subprime lending.
 The lack of any real effective regulation, coupled with incentives such as yield spread
premiums, led to a corruption of the mortgage sector, opening the door to predatory
lending, fraud, misrepresentation, and other inappropriate lending.
Non –Prime Mortgage Securitization:
 Non-prime mortgage securitization was essential to the origination of the burgeoning
numbers of subprime and Alt A loans.
 System incentives (“no skin in the game”) and the assumption that assets would be
moved along the chain/off the books contributed to the creation and sale of
increasingly poor quality mortgages.
 Mortgage securities were packaged and sold without appropriate due diligence and
disclosures to investors.
 As noted above, credit derivatives were an essential component of the subprime and
Alt A securitization process.
Credit Rating Agency Failures:
 The credit rating agencies were essential to non-prime mortgage securitization and,
thus the non-prime mortgage origination business. Their failure to assess the quality
of the securities which they rated was seminal to the crisis.
 But for the rating agencies, the subprime lending and securitization could not have
occurred on a significant scale.
GSEs:
 The GSEs contributed to, but were not a primary cause of the financial crisis. Their
scale mattered and they were dramatic failures, with a deeply flawed business model.
 They added significant demand for less-than-prime loans – but they followed, rather
than led the Wall Street firms. The delinquency rates on the subprime and Alt A
loans that they purchased were significantly lower than those purchased by Wall
Street firms.
 They dramatically increased their subprime and Alt participation in the 2005-2007
period primarily to regain market share, but also to a lesser extent to meet affordable
housing goals.
11



 They utilized their political power to successfully resist effective regulation.
Government Housing Policy:
 HUD’s affordable housing goals resulted in the GSEs buying more high risk
mortgages at the margin.
 There was no evidence in the Commission’s inquiry indicating that the Community
Reinvestment Act contributed to the crisis.
 The government’s aggressive promotion of homeownership provided cover for the
expansion of inappropriate subprime lending (n.b. - homeownership stopped
climbing in 2004 and much of the subprime lending activity was for refinancing, not
home purchase - let alone first time home purchase).
 Policy makers failed to ensure that their stated homeownership policy goals were
being carried out by sound and sustainable practices on the ground - even community
based groups advocating increased homeownership were sounding the alarm over
lending practices.

Excess Leverage, Risk, and Speculation Fueled the Crisis

Inadequate Capital:
 High leverage/inadequate capital made many financial institutions (e.g. GSEs,
investment banks) extraordinarily vulnerable to the downturn in the market. Leverage
or capital inadequacy at many institutions was even greater than reported when
taking into account “window dressing”, off balance sheet exposures (e.g. Citigroup)
and derivatives positions (e.g. AIG).
 When mortgage assets and derivatives began to plummet in value beginning in 2007,
many institutions came under enormous financial pressure given their thin capital
margins.
“Hot Money”:
 The financial system, particularly the “shadow banking” system, was extraordinary
dependent on “hot money” including short term (including overnight) commercial
paper and repo funding.
 When lenders began to have concerns about the health of certain financial
institutions, initially growing out of concerns re their exposure to troubled mortgage
related assets, they began to shorten the duration of lending or pull back from
lending. As concerns accelerated, liquidity shrank, and questions grew re the
financial condition of certain institutions (see transparency below), runs began at
institutions.
 Runs even affected some insured depository institutions (e.g. Indy Mac, Wachovia)
Risk and Speculation:
 The increase in risky, complex, and often non-transparent financial products and
activities contributed to the vulnerability of firms and the system as a whole. Trading
–including proprietary trading – replaced traditional investment banking as the
largest source of revenue at investment banks and a sizable source of revenues at
traditional banks.
 Dealing in derivatives had grown exponentially, particularly by systemically
important institutions. In the case of synthetic CDOs, these were almost infinitely
levered speculative instruments that amplified exposure to default prone mortgages
and mortgage securities.
 The combination of high leverage, reliance on “hot money” and risky and complex
financial products was an explosive mix.
12



Too Big to Fail:
 Many creditors of large systemically institutions did not exercise discipline when
extending credit to such institutions on the assumption that the government would
intervene to protect creditors in the event of the potential failure of such institutions.

Lack of Transparency and Interconnections Spurred Panic during the Crisis

Lack of Transparency:
 The lack of transparency about the financial condition of various systemically
important institutions and their counterparties exacerbated the panic and the financial
crisis of 2008. This lack of transparency was due to both decisions by firms re:
structuring and disclosure and lack of regulatory requirements re: disclosure.
 As firms scrambled to get a handle on their own exposures, counterparties and
regulators struggled to understand, among other things, the nature and extent of
mortgage related holdings, derivative positions, and the cash position of those firms.
The lack of knowledge and transparency resulted in panic.
Interconnections:
 The extensive interconnections between major financial institutions through a
variety of markets and instruments – including the repo market, interbank lending,
and OTC derivatives – and the scale and concentration of those exposures (e.g. Fed
analyses of Lehman and AIG) were seminal to the crisis. The interconnections –
coupled with the lack of transparency – caused panic.

Broad, Overarching Findings



The Crisis Was Avoidable

o
o

Public and Private Sector Leadership Failures:
 Financial institution leaders failed in the prudent management of their companies.
 Public leaders and regulators had extensive powers, yet failed to protect the financial
system, the economy, and the public from the crisis.
 If timely and appropriate actions had been taken, the crisis could have been avoided,
or at least significantly mitigated.
Warning Signs Ignored:
 Numerous warning signs were ignored in the years leading up to the crisis and even
after the housing market began to peak and decline in 2005 and 2006.
Excess Liquidity and Government Policy:
 Significant cash –including cash from abroad - seeking to invest in real estate assets
was a necessary pre-condition for the crisis.





The Fed and other regulators did not to take the actions necessary to constrain the
credit bubble.
 The Fed’s policies and pronouncements encouraged the growth of mortgage debt and
the housing bubble.
Complacency/Lack of Due Care:
 There was a complacency and lack of due care on the part of too many policy
makers, regulators, and others (e.g. economists, households) due to a “conventional
wisdom” that the business cycles had been mastered (the Great Moderation),
financial risk had been quantified and tamed, and financial crises could be handled
(the Greenspan Put).
 Policy makers and regulators did not understand or appreciate the growing risks to
the financial system.
Slow and Inconsistent Government Response:
 The government’s response to the crisis itself in 2006-2008 was flat footed at first
and then inconsistent, exacerbating the crisis.
 The inadequacy of the policy makers’ and regulators’ response to the crisis left the
nation in the fall of 2008 with only two stark choices: potential collapse of the
financial system or the infusion of trillions of taxpayer dollars.
 The inconsistent response worsened the crisis: policy makers saved Bear, placed
Fannie and Freddie in conservatorship, and then failed to save Lehman.

There was a Breakdown in Accountability, Responsibility, and Ethics

o
o

Tone at the Top:
 Primary responsibility for the breakdown rests with those in charge – tone at the top
mattered.
Ethical Responsibilities:
 Too many companies and individuals created and/or sold financial products without
regard to the quality of those products, the conflicts in their activities and the
consequences to the larger financial system and economy.
Broad Responsibility:
 As the speculative fever took hold, too many people participated in activities that
proved to be detrimental to their firms, their clients, their households, and the
ultimately the financial system and the economy.
 Too many households and companies took on more debt than they could afford.
Some households that took on debt were misled, steered into inappropriate debt, or
did not have the needed financial literacy.
Accountability and Critical Analysis:
 Faith in our financial system has been shaken. The economic consequences of the
crisis have been profound. Yet, there has been little acceptance of responsibility by
many financial industry and public sector leaders who were at the center of this crisis.
The lack of critical self examination – a prerequisite for change – has been striking.
 There have been few people held to account and little or no consequence for
inappropriate actions.



The crisis and risks remain with us

The Crisis Persists:
 The country remains in the grips of a severe economic crisis. Unemployment is high.
Foreclosures continue to climb, while many families are running into a brick wall as
they try to modify mortgages. Future economic security has been diminished for tens
of millions of Americans.
 While government actions taken in the fall of 2008 and early 2009 may have
stabilized financial markets and major financial institutions, they did not spare the
real economy from deep pain. The consequences of the financial crisis of 2007-2008
are likely to be felt for a generation.
The Future of Financial Reform Uncertain:
 The financial reform legislation of 2010 will be largely shaped by some 250 rule
making procedures and the outcome of those proceedings is very much up in the air.
In addition, no action has been taken on critical issues such as the future of Fannie
Mae and Freddie Mac.
 Real reform will require changes beyond legislation - in, among other things,
corporate governance, compensation incentives, and risk management as well as
standards of ethics and corporate responsibility.
The Risks of Future Crisis:
 There are fewer, bigger systemically important financial institutions now than were
before the crisis.
 While the banks have returned to profitability – largely through borrowing cheaply
and making money on the spread, there are still significant risks including a still
struggling housing sector, significant commercial real estate exposures, and the lack
of systemic reform.
 Very little real change has yet occurred.

Part A: “....”
Chapter Title here

In examining the worst financial meltdown since the Great Depression, the Financial Crisis
Inquiry Commission examined hundreds of thousands of documents and questioned hundreds of
individuals—financial executives, business leaders, policy makers, community leaders, people
from all walks of life—to find out how and why it happened.
In public hearings and interviews, many financial industry executives and top public officials
testified that they had been blindsided by the crisis, describing it as a dramatic and mystifying
turn of events. Even among those who worried that the housing bubble might burst, few—if
any—foresaw the magnitude of the crisis that would ensue.
Charles Prince, the former chairman and chief executive officer of Citigroup, called the collapse
in housing prices “wholly unanticipated.”1 Warren Buffett, chairman and chief executive officer
of Berkshire Hathaway Inc.—the largest single shareholder of Moody’s, which rated $4.7 trillion
in mortgage-backed securities from 2000 to 20072 - told the Commission that “very, very few
people could appreciate the bubble,” which he called a “mass delusion”3 that was shared by “300

FCIC hearing, April 8, 2010.

Preliminary Staff Report, Credit Ratings and the Financial Crisis, June 2, 2010, p. 22.

FCIC hearing testimony, June 2, 2010.

million Americans.”4 Lloyd C. Blankfein, chairman and chief executive officer of Goldman
Sachs Group, Inc., likened the financial crisis to a hurricane.5
Regulators echoed a similar refrain. Benjamin Bernanke, chairman of the Federal Reserve since
2006, told the Commission a “perfect storm” had occurred that regulators could not have
anticipated, but when asked about whether the Fed’s lack of aggressiveness in regulating the
mortgage market during the housing boom was a failure, Bernanke responded, “It was, indeed. I
think it was the most severe failure of the Fed in this particular episode.” Alan Greenspan, Fed
chairman during the two decades leading up to the crash, told the commission that it was beyond
the ability of regulators to ever foresee such a sharp decline. “History tells us regulators cannot
identify the timing of a crisis or anticipate exactly where it will be located or how large the losses
and spillovers will be.”6
In fact, there were warning signs. In the decade preceding the collapse, there were many signs
that house prices were inflated, that lending practices had spun out of control, that too many
homeowners were taking on mortgages and debt they could ill afford, and that risks to the
financial system were growing unchecked. Alarm bells were clanging inside financial
institutions, regulatory offices, consumer service organizations, state law enforcement agencies
and throughout corporate America, as well as in neighborhoods across the country. Many
knowledgeable executives saw trouble and managed to avoid the train crash. While countless
Americans reveled in the financial euphoria that seized the nation, many others were shouting
4

FCIC interview with Warren Buffett, May 26, 2010.

Blankfein testifying to FCIC, January 13, 2010, p. 36.

Alan Greenspan testimony to FCIC, April 7, 2010.

out to government officials in Washington and within state legislatures, pointing out what would
become a human disaster, not just an economic debacle.
“Everybody in the whole world knew that the mortgage bubble was there,” said Richard
Breeden, former Chairman of the Securities and Exchange Commission appointed by President
George H.W. Bush. “I mean, it wasn’t hidden. … You cannot look at any of this and say that the
regulators did their job. This was not some hidden problem. It wasn’t out on Mars or Pluto or
somewhere. It was right here…You can’t make trillions of dollars worth of mortgages and not
have people notice.”7
Paul A. McCulley, a managing director at PIMCO, one of the nation’s largest money
management firms, told the Commission that he and his colleagues began to get worried about
“serious signs of bubbles” in 2005, and sent out credit analysts to 20 cities to do what he called
“old-fashioned shoe leather research,” talking to real estate brokers, mortgage brokers and local
investors about the housing and mortgage markets. They witnessed what he called “the outright
degradation of underwriting standards,” McCulley told the Commission, and they shared what
they had learned when they got back home to the company’s Newport Beach headquarters. “And
when our group came back, they reported what they saw, and we adjusted our risk accordingly,”
McCulley told the Commission. The company “severely limited” its participation in risky
mortgage securities.
Veteran bankers, particularly those who remembered the savings and loan crisis, knew that ageold rules of prudent lending had been cast aside. Arnold Cattani, chairman of Bakersfield-based
Mission Bank, told the Commission that he grew uncomfortable with the “extreme speculation”
7

FCIC interview with Richard Breeden, Oct. 14, 2010.

he saw in the local homebuilding market, fueled by “voracious” Wall Street investment banks,
and opted out of certain kinds of investments by 2005, noting it had all “gone too far, too fast.”8
William Martin, vice chairman and chief executive officer of Service 1st Bank of Nevada, told
the FCIC that the desire for a “high and quick return” blinded people to fiscal realities.9
“You may recall Tommy Lee Jones in Men in Black, where he holds a device in the air, and with
a bright flash wipes clean the memories of everyone who has witnessed an alien event,” he told
the Commission.”10
Unlike so many other bubbles—tulip bulbs in Holland in the 1600s, South Sea stocks in the
1700s, internet stocks in the early 2000s—this one involved not just another commodity, but
rather a building block of community and social life and a cornerstone of the economy--the
family home. Homes are the foundation upon which much of our social, personal, governmental,
and economic structures rest. Children usually go to schools linked to their home addresses; local
governments decide how much money they can spend on roads, firehouses and public safety
based on how much property tax revenue they have; house prices are tied to consumer spending.
Downturns in the housing industry can cause ripple effects almost everywhere.
When the Federal Reserve cut interest rates early in the decade and mortgage rates fell, home
refinancing surged, climbing from $1.3 trillion in 2001 to $2.5 trillion in 2003, allowing people
to withdraw equity built up over previous decades and consume more, despite stagnant wages.
Then home sales volume started to increase, and prices nationwide climbed, rising 67 percent in

FCIC written and oral testimony, Arnold Cattani, Bakersfield, Calif., Sept. 6, 2010. Transcript page 37.

FCIC field hearing testimony, William Martin, Las Vegas, Nevada, Sept. 8, 2010.

eight years by one measure, hitting a national high of $227,100 in early 2006.11 Home prices in
many areas skyrocketed: Prices tripled in Sacramento, for example, in just five years,12 and shot
up by about the same percentage in Bakersfield, Cape Coral, Miami and Key West. Prices
doubled in about more than 200 metropolitan areas, including Las Vegas, Seattle, Washington
DC, Seneca Falls, Hilton Head, Boise, Phoenix, Poughkeepsie and Newark.13 Housing starts
nationwide climbed 58 percent, from 1.3 million in 1995 to more than 2 million in 2005, the
peak year.14 Encouraged by government policies, homeownership reached a record 69.2 percent
in the spring of 2004,15 although it wouldn’t rise an inch further even as the mortgage machine
kept churning for another three years. By refinancing their homes, Americans extracted $2.2
trillion in home equity between 2000 and 2007, including $334 billion in 2006 alone, more than
seven times the amount they took out in 1996.16 Real estate speculators and potential
homeowners stood in line outside new subdivisions for a chance to buy houses before the ground
had even been broken. Bigger was better, and even the structures themselves ballooned in size,

National Association of Realtors national home price data, existing homes sold, comparing second quarters of
1998 ($135,800) and second quarter 2006 ($227,100) the national peak in prices.
12

Sacramento Regional Chart Book, FCIC, prepared for Sacramento field hearing, Sept. 23, 2010.

CoreLogic Home Price Index for Urban Areas, All Areas Set to 100 index rate in January 2000, and compare to
peak of each market.

Privately-owned housing starts, 1-unit structures, Economic Research, Federal Reserve Bank of St. Louis, citing
US Department of Commerce, Census Bureau.

US Census Bureau. Residential Vacancies and Homeownership in the Third Quarter 2010, CB10-155, Nov. 2,
2010.

Kennedy-Greenspan Gross Equity Extraction 2008.

as the floor area of an average new home grew by 21 percent, to 2,479 square feet, in the decade
from the mid-90s to 2007.17
Money washed through the economy like water rushing through a broken dam. Low interest
rates and then foreign capital helped fuel the boom. Construction workers, landscape architects,
real estate agents, loan brokers and appraisers profited on Main Street, while investment bankers
and traders on Wall Street moved even higher on the American earnings pyramid and the shares
of the most aggressive financial service firms reached all-time highs.18 Homeowners pulled cash
out of their homes to erase mounting credit card debt, pay off medical bills, send their kids to
college, install designer kitchens with granite counters, take a vacation or launch new businesses.
Renters used new forms of loans to buy homes and to move to suburban subdivisions, erecting
swing sets in their backyards and enrolling their children in local schools.
In an interview with the Commission, Angelo Mozilo, the long-time Chairman and CEO of
Countrywide Financial—a lender brought down by its risky mortgages—said that a “gold rush”
mentality overtook the country during these years, and that he was swept up in it as well.
“Housing prices were rising so rapidly—at a rate that I’d never seen in my 55 years in the
business—that people, regular people, average people got caught up in the mania of buying a
house, and flipping it, making money. It was happening. They buy a house, make $50,000…and
talk at a cocktail party about it…Housing suddenly went from being part of the American dream

Characteristics of New Housing, US Census Bureau.

Weekly wage of New York investment banker, $16,849, compared to average privately-employed worker, of
$841 per week, according to Wages and Bonuses in Investment Banking, report by the US Bureau of Labor
Statistics, Summary 07/07, August 2007.

to house my family to settle down—it became a commodity. That was a change in the culture. It
was sudden, unexpected.”19
On the surface, it looked like prosperity. After all, the basic mechanisms making the real estate
machine hum—the mortgage lending instruments and the financing techniques that turned
mortgages into investments called securities, which kept cash flowing from Wall Street into the
U.S. housing market—were tools that had worked well for many years.
But underneath, something was going wrong. Like a science fiction movie where ordinary
household objects turn hostile, familiar market mechanisms were transformed. The time-tested
30-year fixed-rate mortgage, with the 20 percent down payment, went out of style. There was a
burgeoning global demand for residential mortgage-backed securities that offered seemingly
solid and secure returns. Investors around the world clamored to purchase securities built on
American real estate, seemingly one of the safest bets in the world.
Wall Street labored mightily to meet that demand. Bond salesmen earned multimillion dollar
bonuses packaging and selling new kinds of loans, offered by new kinds of lenders, into new
kinds of investment products that were deemed safe but possessed complex and hidden risks.
Federal officials praised the changes—these financial innovations, they said, had lowered
borrowing costs for consumers and moved risks away from the biggest and most systemically
important financial institutions. But the nation’s financial system had become vulnerable and
interconnected in ways that were not understood by either the captains of finance or the system’s
public stewards. In fact, several of the largest institutions had taken on what would prove to be
debilitating risks. Trillions of dollars had been wagered on the belief that housing prices would
19

Angelo Mozilo interview with FCIC, Sept. 24, 2010.

always rise and that borrowers would seldom default on mortgages, even as their debt grew.
Shaky loans had been bundled into investment products in ways that seemed to give investors the
best of both worlds—high yield, risk-free—but that instead, in many cases, would prove to be
high-risk and yield-free.
All this financial creativity was a lot like cheap sangria, said Michael Mayo, managing director
and financial services analyst at Calyon Securities. “A lot of cheap ingredients repackaged to
sell at a premium,” he told the Commission. “It might taste good for a while, but then you get
headaches later and you have no idea what’s really inside.”20
The securitization machine began to guzzle these once-rare mortgage products with their strangesounding names: alt-A, subprime, and “I-O” (interest-only), low-doc or no doc, ninja (no
income, no job, no assets) loans, 2-28s, 3-27s, liar loans, “piggy-back” second mortgages, payoption, or pick-a-pay. New variants on adjustable rate loans, called “exploding” ARMs, featured
low monthly costs at first, but payments could suddenly double or triple, if borrowers were
unable to refinance. Loans with negative amortization would eat away the borrower’s equity.
Soon there were more than 150 different kinds of mortgages available on the market,
confounding consumers who didn’t examine the fine print, baffling conscientious borrowers who
tried to puzzle out their implications, and opening the door for those who wanted in on the
action.
Many people chose poorly. Some people wanted to live beyond their means, and by 2005, nearly
one-quarter of all borrowers nationwide took out interest-only loans that allowed them to defer

FCIC, hearing 1, January 13, 2010, transcript page 114.

the payment of principal.21 Some borrowers opted for the nontraditional mortgages because that
was the only way they could afford to buy or refinance in high-cost areas, and in fact, more than
half of all the loans of this kind made in the country went to Californians, where homebuyers
used them to get a foothold in the sky-high West Coast housing market.22 Some speculators saw
the chance to snatch up investment properties and flip them for profit—and Florida became a
particular target for investors who used these loans to acquire real estate.23 Some were misled by
salespeople who came to their homes and persuaded them to sign loan documents on their
kitchen tables. Some borrowers naively trusted mortgage brokers who earned more money
placing them in risky loans than safe ones.24 As these new loans penetrated each region, home
prices rose there, as buyers were able to bid up the prices of houses even if they didn’t have
enough income to qualify for traditional loans.25
Some of these exotic loans had existed in the past, targeting high-income, financially secure
people as a cash-management tool. Some had been targeted to borrowers with impaired credit,
offering them the opportunity to build a payment history before they refinanced. But they began
to deluge the larger market in 2004 and 2005. The changed occurred “almost overnight,” Faith
Schwartz, a senior vice president of subprime lender Option One, told the Federal Reserve’s

Mortgage Bankers Association survey, press release from October 25, 2005

Subprime ARMs: Popular Loans, Poor Performance, by Yuliya Demyanyk and Yadav K. Gopalan, Federal
Reserve Bank of St. Louis, Spring 2007.

Testimony of Alex Acosta, dean of Florida International University, former US Attorney in Southern Florida; Ann
Fulmer, Vice President of Business Relations, Interthinx, Ellen Wilcox, special agent, Florida Department of Law
Enforcement, FCIC field hearing in Miami, Sept. 21, 2010.

FCIC interview with Julia Gordon and Michael Calhoun, Center for Responsible Lending, Sept. 16, 2010.

Restricted Federal Reserve document obtained by FCIC, Residential Mortgage Lenders Peer Group Survey:
Analysis and Implications for First Lien Guidance, Nov. 30, 2005, p. 34.

Consumer Advisory Council. “I would suggest most every lender in the country is in it, one way
or another.”26
At first not a lot of people really understood the potential hazards of these new loans. They were
new, they were different, and the consequences were uncertain.
It soon became apparent that what had looked like new-found wealth was a mirage based on
borrowed money. Overall mortgage indebtedness in the United States climbed from $5.3 trillion
in 2001 to $10.5 trillion in 2007.27 The mortgage debt of American households rose as much
from 2001 to 2007 as it had over the course of the country’s more than 200-year history. The
amount of mortgage debt per household rose from $91,700 in 2001 to $149,000 in 2007.28 With
a simple flourish of pen and paper, millions of Americans traded away decades of equity tucked
away in their homes.
Under the radar, the lending and the financial 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, with the growth of securitization, it wasn’t even clear who the lender was
anymore. The mortgages would be packaged, sliced, repackaged, insured, and sold as
incomprehensibly complicated debt securities to a collection of hungry investors. Now even the
worst loans could find a buyer.
More loan sales meant higher profits for everyone in the chain. Business boomed for
Christopher Cruise, a Maryland-based corporate educator who trained loan officers for
26

Transcript of the Consumer Advisory Council, Thursday, March 30, 2006. Faith Schwartz, senior vice president,
Government, Housing and Industry Relations, for Option One Mortgage Company, subsidiary of H & R Block.

Flow of Funds, Z1, Federal Reserve

Survey of Consumer Finances, Federal Reserve

companies that were expanding mortgage originations. He crisscrossed the country, coaching
about 10,000 loan originators a year in auditoriums and classrooms. His clients included many of
the largest lenders, including Countrywide, Ameriquest and Ditech. Most of their new hires were
young, with no mortgage experience, fresh out of school and previously “flipping burgers,” he
told the FCIC. With the right training, however, the best of them could earn more than $1 million
a year.29
“I was a sales and marketing trainer in terms of helping people to know how to sell these
products to, frankly in some cases, unsophisticated and unsuspecting borrowers,” he said.
He taught them the new playbook: “You had no incentive whatsoever to be concerned about the
quality of the loan, whether it was suitable for the borrower or whether the loan performed. In
fact, you were in a way encouraged not to worry about those macro issues,” he said. “…I knew
that the risk was being shunted off. I knew that we could be writing crap. But in the end it was
like a game of musical chairs. Volume might go down but we were not going to be hurt.”30
On Wall Street, where many of these loans were packaged into securities and sold to investors
across the globe, a new phrase was coined: IBGYBG, “I’ll be gone, you’ll be gone.”31 That
referred to deals that brought in big fees upfront while risking much larger losses a year or two in
the future. And, for a long time, IBGYBG worked at every level along the way.
Most home loans entered the pipeline soon after borrowers signed the documents and picked up
the keys. Loans were put into packages and sold off in bulk to securitization firms—including
29

FCIC interview with Christopher Cruise, Aug. 24, 2010..

FCIC interview with Christopher Cruise, Aug. 24, 2010.Date TK.

NY Times article.

investment banks such as Merrill Lynch, Bear Stearns and Lehman Brothers, and commercial
banks and thrifts like Citi, Wells Fargo and Washington Mutual. The firms would package the
loans into residential mortgage-backed securities (RMBS) that would mostly be stamped with
Triple A ratings by the credit rating agencies and then be sold to investors. In many cases, the
securities were sold off to be repackaged again, into newly formed collateralized debt obligations
(CDOs)—often comprised of the riskier portions of RMBS—which would then be sold to other
investors. Many of these securities would also receive the coveted Triple-A ratings that investors
believed attested to their quality and safety. Some investors would buy an invention from the
1990s called a credit default swap to protect against the securities defaulting. For every buyer of
a credit default swap, there was a seller, which now meant two investors made opposing bets,
and the layers of entanglement in the securities market would increase.
The instruments grew more and more complex; CDOs bought CDOs, creating CDOs squared.
When they ran out of real product, they started creating cheaper- to- produce synthetic CDOs –
not composed of real mortgage securities, but just bets on other mortgage products. Each new
permutation created an opportunity to extract more fees and trading profits. And each new layer
brought in more investors wagering on the mortgage market. 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 investors – or parts of bets being made by hundreds more. Timothy
Geithner, president of the New York Federal Reserve during the crisis, described the resulting
product as “cooked spaghetti” that became hard to “untangle.”32

Timothy Geithner testimony to FCIC, May 6, 2010, page 146.

Ralph Cioffi, spent several years creating CDOs for Bear Stearns and a couple of more years on
the repurchase or “repo” desk, where Bear Stearns borrowed money every night to finance its
broader securities portfolio. In September 2003, Cioffi created a hedge fund with a minimum
investment of $1 million. As was common, he used borrowed money—up to $10 borrowed for
every $1 from investors—to buy CDOs. Cioffi’s first fund was extremely successful, earning 17
percent for investors in 2004 and 9 percent in 2005 – after the annual management fee and the 20
percent slice of the profit for Cioffi and his Bear Stearns team [ck] – and growing to $9 billion
by the end of 2005. In the fall of 2006, he created another, more aggressive fund. This one
would shoot for leverage of 15 to 1. By the end of 2006, the two hedge funds had $18 billion
invested, half in securities issued by housing-focused CDOs. As a CDO manager, Cioffi also
managed another $18 billion of housing-focused CDOs for other investors. Because his CDOs
and hedge funds bought securities from investment banks like Lehman Brothers and Goldman
Sachs, Cioffi became “a very popular fellow” on Wall Street, a Bear Stearns colleague told the
Commission.33
Cioffi’s investors and other like them wanted high-yielding mortgage-backed securities. That, in
turn, required high-yielding mortgages. An advertising barrage bombarded potential borrowers,
urging them to buy or refinance homes. Direct-mail solicitations flooded people’s mailboxes.34
Dancing figures, depicting happy homeowners, boogied on computer monitors. Telephones
began ringing off the hook with calls from loan officers offering the latest loan products: 1
33

FCIC interview with Tom Marano--quote being confirmed.

FCIC interview with James Ryan, chief marketing officer at CitiFinancial and John Schachtel, executive vice
president of CitiFinancial, Feb. 3, 2010; Letter from Federal Trade Commission Chairman Robert Pitofsky to
Dolores S. Smith, director, division of consumer and community affairs, Federal Reserve, about complaint filed by
the FTC against First Alliance Mortgage Co., citing use of direct mail solicitations to target homeowners for
deceptive loans, Feb. 20, 2001; Joint Report on Recommendations to Curb Predatory Home Mortgage Lending, US
Department of the Treasury and US Department of Housing and Urban Development, June 20, 2000.

percent loan! (But only for the first year.) No money down! (Leaving no equity if home prices
fell.) No income documentation needed! (Soon dubbed by the industry itself as “liar” loans.)
Borrowers answered the call, many believing that with ever-rising prices, housing was the
investment that couldn’t lose.
In Washington, four intermingled issues came into play that made it difficult to acknowledge the
looming threats. First, boosting home ownership had broad political support – from Presidents
Clinton and Bush and successive Congresses, even though in reality the homeownership rate had
peaked and was ticking down after the spring home-buying season in 2004. Second, the real
estate boom was generating a lot of cash on Wall Street and creating a lot of jobs in the housing
industry even at a time when other sectors of the economy were dreary. Third, many top
officials and regulators were reluctant to challenge the profitable and powerful financial industry.
And finally, policy makers believed that even if the housing market tanked, the broader financial
system and economy would hold up.
As the transformation of the mortgage market began to take shape in the late 1990s, consumer
advocates and front-line local government officials were among the first to spot the changes, as
homeowners surged into their offices seeking help in dealing with mortgages they could not
afford to pay. They began raising the issue with the Federal Reserve and other banking
regulators.35 Bob Gnaizda, general counsel and policy director of the Greenlining Institute, a
California-based non-profit housing group, told the Commission he began meeting with
Greenspan at least once a year starting in 1999, each time highlighting to him the growth of

FCIC hearing, April 7, 2010.

predatory lending practices and discussing with him the social and economic problems they were
creating.36
One of the first places to see the bad lending practices envelop an entire market was Cleveland,
Ohio. From 1989 to 1999, home prices in Cleveland rose 66 percent, climbing from a median of
$75,200 to $125,100,37 while home prices nationally rose about 49 percent in those same years,
though the city’s unemployment rate, ranging from 5.8 percent in 1990 to 4.2 percent in 1999,
tracked the US pattern pretty closely.38 James Rokakis, long-time treasurer of Cuyahoga County,
where Cleveland is located, told the Commission that the region’s housing market was juiced by
“flipping on mega-steroids” with rings of real estate agents, appraisers and loan originators
earning fees on each transaction and feeding the securitized loans to Wall Street. City officials
began to hear reports that these activities were being propelled by new kinds of nontraditional
loans that enabled investors to buy properties with little or no money down and gave
homeowners the ability to refinance their houses, regardless of whether they could afford to
repay the loans. Foreclosures shot up in Cuyahoga County from 3,500 a year in 1995 to more
than 7,000 a year in 2000. Rokakis and other public officials watched as families who had lived
in modest residences for years lost their homes. After they were gone, many homes were

FCIC interview with Bob Gnaizda, general counsel and policy director, retired, of the Greenlining Institute,
March 25, 2010.

National Association Realtors median home prices, existing homes, Cleveland and U.S.

Bureau of Labor Statistics. National annual figure as reported by Economic Research, Federal Reserve Bank of St.
Louis, citing BLS data, Cleveland data from Bureau of Labor Statistics, Local Area Unemployment Statistics, series
ID LAUMT39174603, Cleveland-Elyria-Mentor, Ohio Metropolitan Statistical Area.

ultimately abandoned, vandalized and then stripped bare, as scavengers ripped out the copper
pipes and aluminum siding to sell for scrap.39
“Securitization was one of the most brilliant financial innovations of the 20th Century,” Rokakis
told the Commission. “It freed up a lot of capital. If it had been done responsibly, it would have
been a wondrous thing because nothing is more stable, there’s nothing safer, than the American
mortgage market. It worked for years. But then people realized they could scam it.”40
Officials in Cleveland and other Ohio cities reached out to the federal government for help. They
asked the Federal Reserve, the one entity with the authority to regulate risky lending practices by
all mortgage lenders, to use power it had been granted in 1994 under the Home Ownership and
Equity Protection Act (HOEPA) to issue new mortgage lending rules. In March 2001, Fed
Governor Ned Gramlich, an advocate for expanding access to credit but only with safeguards in
place, attended a conference on the topic in Cleveland. He spoke about the Fed’s power under
HOEPA, declared some of the lending practices to be “clearly illegal,” and said they could be
“combated with legal enforcement measures.”41
Looking back, Rokakis told the Commission, “I naively believed they’d go back and tell Mr.
Greenspan and presto, we’d have some new rules…I thought it would result in action being
taken. It was kind of quaint.”42

FCIC interviews with James Rokakis, Cuyahoga County Treasurer, Nov. 8, 2010; FCIC interview with Alyssa
Katz, author of Our Lot: How Real Estate Came to Own Us, Bloomsbury: NY, 2009, chapter “Into Oblivion:
Cleveland, Ohio, 2006,” p. 78-101.

FCIC interview with Rokakis.

Remarks by Governor Edward M. Gramlich, at Cleveland State University, March 23, 2001, Federal Reserve
Board website.

FCIC interview with Rokakis

In 2000, at the same time Cleveland was looking for help from the federal government, other
cities around the country were doing the same. John Taylor, president of the National
Community Reinvestment Coalition, with the support of community leaders from Las Vegas,
Detroit, Maryland, Delaware, Chicago, Vermont, North Carolina, New Jersey and Dayton, went
to the Office of Thrift Supervision, which regulates savings and loan institutions, asking the
agency to crack down on what they called “exploitative” practices they believed were putting
both borrowers and lenders at risk.43
The California Reinvestment Coalition, a non-profit housing group based in Northern California,
also begged regulators to act, CRC officials told the Commission. The non-profit group had
reviewed the loans of 125 borrowers and discovered that borrowers with good credit were being
placed into high-cost loans when they qualified for better mortgages and that many borrowers
had been misled about the terms of their loans.44
There were government reports, too. The Department of Housing and Urban Development and
the Treasury Department issued a joint report on predatory lending in June 2000 that made a
number of recommendations for reducing the risks to borrowers.45 In December 2001, the
Federal Reserve Board used the HOEPA law to amend some regulations, including establishing
new rules that limited high-interest lending and prevented multiple refinancings over a short

Letter from John Taylor, chairman and chief executive officer, National Community Reinvestment Coalition, to
Office of Thrift Supervision, July 3, 2000, provided to FCIC; FCIC interviews with Taylor, Josh Silver.

Kevin Stein interview with FCIC, Details TK

Joint Report on Recommendations to Curb Predatory Home Mortgage Lending, US Department of the Treasury
and US Department of Housing and Urban Development, June 20, 2000.

period of time, if they were not in the borrower’s best interest.46 FDIC Chairman Sheila Bair,
then an assistant treasury secretary in the administration of President George W. Bush,
characterized the action as addressing only a “narrow range of predatory lending issues,”47
particularly high-interest rate loans that carried hefty upfront fees,48 and that it ultimately
covered only 1 percent of loans.49 In 2002, Gramlich noted again the “increasing reports of
abusive, unethical and in some cases, illegal, lending practices.”50
Bair told the Commission that this was when “really poorly underwritten loans, the payment
shock loans” were beginning to proliferate, placing “pressure” on traditional banks to follow
suit.51 She said she and Gramlich considered seeking rules to rein in the growth of these kinds of
loans, but Gramlich told her he thought the Fed, despite its broad powers in this area, would not
support the effort. Instead, they sought voluntary rules, but that effort fell by the wayside as well.
With minimal government restrictions, the number of nontraditional loans surged and lending
standards declined. The companies issuing these loans made profits that attracted envious eyes.
New lenders entered the field. Investors clamored for mortgage-related securities and borrowers
wanted mortgages. The volume of subprime and nontraditional lending rose sharply. In 2000,

Federal Reserve Board press release:
http://www.federalreserve.gov/boarddocs/press/boardacts/2001/20011212/default.htm

Statement of Sheila C. Bair, chairman, Federal Deposit Insurance Corp., to the FCIC, Jan. 12, 2010.

Amendments to Regulation Z (Truth in Lending) under the Home Ownership and Equity Protection Act, Federal
Reserve, Dec. 12, 2010. Became effective Oct. 1, 2002.

FCIC discussion during testimony of Alan Greenspan, April 7, 2010.

Remarks by Governor Edward M. Gramlich, at the Housing Bureau for Seniors Conference, Ann Arbor,
Michigan, January 18, 2002. http://www.federalreserve.gov/boarddpcs/speeches/2002/20020118/default.htm.

Statement of Sheila C. Bair, chairman Federal Deposit Insurance Corp., to FCIC, Jan. 12, 2010.

the top 25 non-prime lenders originated $138 billion in loans. Their volume rose to $213 billion
in 2002, and then $332 billion in 2003.52
California, with its high housing costs, was a particular hotbed for this kind of lending. In 2001,
about 24.5 percent of all loans made in the state were riskier, non-traditional loans, rising to 31.3
percent in 2002 and 34.5 percent in 2003.53 In those years, “subprime and option ARM loans
saturated California communities,” Kevin Stein, associate director of the California
Reinvestment Coalition, testified to the Commission. “We estimated at that time that the average
subprime borrower in California was paying over $600 more per month on their mortgage
payment as a result of having received the subprime loan…”54
Gail Burks, chairwoman of Nevada Fair Housing, Inc., a Las Vegas-based housing clinic, told
the Commission she took her concerns directly to Greenspan at this time, describing to him in
person what she called the “metamorphosis” in the lending industry. She told him that in addition
to bad lending practices, she was also witnessing a growing sloppiness in the preparation of the
loan documents, she said. Many lenders were employing very young loan officers, including
many with no previous mortgage industry experience. They were preparing documents hastily
and incorrectly, making careless mistakes that caused paperwork nightmares for borrowers.55
Lisa Madigan, the attorney general in Illinois, also spotted the emergence of a troubling trend.
She joined state attorneys general in Minnesota, California, Washington and Massachusetts in
pursuing allegations about First Alliance Mortgage Company, a California-based mortgage
52

Inside B & C Lending; 2009 Mortgage Market Statistical Annual, Top Subprime Mortgage Originators.

Inside B & C Lending; Market Statistical Annual, Subprime Originations by State, 2001-2003.

Stein testimony to FCIC at Sacramento field hearing, Sept. 23, 2010.

FCIC interview with Gail Burks.

lender. Consumers complained they had been deceived into taking loans with hefty fees. The
company was then packaging the loans and selling them as securities to Lehman Brothers,
Madigan said. The case was settled in 2002 with a $50 million settlement for borrowers. First
Alliance went out of business. But, other firms stepped into the void.
State officials from around the country joined together again in 2003 to investigate another fastgrowing lender, California-based Ameriquest.56 It became the nation’s largest subprime lender,
originating $17 billion in subprime loans in 2002, mostly refinances that let borrowers take cash
out of their homes, but with hefty fees that ate away at borrowers’ equity.57 Madigan told the
FCIC, “Our multistate investigation of Ameriquest revealed that the company engaged in the
kinds of fraudulent practices that other predatory lenders subsequently emulated on a wide scale:
inflating home appraisals; increasing the interest rates on borrowers’ loans or switching their
loans from fixed to adjustable interest rates at closing; and promising borrowers that they could
refinance their costly loans into loans with better terms in just a few months or a year, even when
borrowers had no equity to absorb another refinance.”58
Ed Parker, former head of Ameriquest’s Mortgage Fraud Investigations department, told the
Commission he detected fraud at the company within one month of starting his job there in
January 2003. He told company officials about his findings, but was told to be reactive, not
proactive. He heard other departments were complaining he “looked too much” into the loans. In

“The Monster: How a Gang of Predatory Lenders and Wall Street Bankers Fleeced America—and Spawned a
Global Crisis,” by Michael W. Hudson, Times Books: New York City, 2010, p. 173.

Inside B&C Lending, The 2009 Mortgage Market Statistical Annual – Volume I.

Testimony of Illinois Attorney General Lisa Madigan to the FCIC, Jan. 14, 2010, Washington, DC.

November 2005, he was downgraded from “manager” to “supervisor,” and was laid off in May
2006.59
In late 2003, Prentiss Cox, a former Minnesota assistant attorney general, asked Ameriquest to
produce information about its loans. He received about 10 boxes of 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 “antiques dealers,” – in his view, a blatant misrepresentation of
employment. In another loan file, a disabled borrower in his 80s who used a walker was
described in the loan application as being employed in “light construction,” he told the FCIC.
“It didn’t take Sherlock Holmes to figure out this was bogus,” Cox told the Commission.60
In trying to figure out why Ameriquest would make such obviously fraudulent loans, a friend
suggested that he “look upstream.” Cox suddenly realized the lenders were simply generating
product to ship to Wall Street to sell to investors. “I got it,” Cox recalled. “The lending pattern
had changed.”
Ultimately, 49 states and the District of Columbia joined in the lawsuit against Ameriquest, on
behalf of 240,000 borrowers. The result was a $325 million settlement.61 But during the years the
investigation was underway, between 2002 and 2005, Ameriquest originated $180.4 billion in
loans, which then flowed to Wall Street for securitization.

FCIC interview of Ed Parker, May 26, 2010.

FCIC interview with Prentiss Cox, former assistant attorney general for Minnesota, Oct. 15, 2010.

Mortgage Lender Settles Lawsuit; Ameriquest Will Pay $325 Million, by Kirstin Downey, Washington Post, Jan.
24, 2006, page D1.

Although the federal government played no role in the Ameriquest investigation, some federal
officials said they followed the case. At the Department of Housing and Urban Development,
“we began to get rumors” that “Ameriquest” as well as other firms, were “running wild, taking
applications over the internet, not verifying peoples’ income or their ability to have a job,”
recalled Alphonso Jackson, housing and urban development secretary from 2004 to 2008, in an
interview with the Commission. “Everybody was making a great deal of money… and there
wasn’t a great deal of oversight going on.” Although he was the nation’s top housing official at
the time, he placed the blame on Congress.62
Cox, the former Minnesota prosecutor and Madigan, Illinois attorney general, told the
Commission that one of the biggest single obstacles to effective state regulation of unfair
lending came from the federal government, particularly the Office of the Comptroller of the
Currency, which regulated nationally chartered banks including Bank of America, Citibank and
Wachovia. Along with the Office of Thrift Supervision, which regulated nationally chartered
thrifts, the OCC had issued rules preempting states from enforcing rules against national banks
and thrifts.63 Cox recalled that in 2001, Julie Williams, chief counsel of the Comptroller of the
Currency, had delivered what he called a stern “lecture” to the states’ attorneys general, in a
meeting in Washington, warning them that the OCC would sue them if they persisted in
attempting to regulate the consumer practices of nationally regulated institutions.64
Former OCC comptrollers John D. Hawke Jr. and John Dugan told the Commission they were
defending the agency’s constitutional obligation to block state efforts to impinge on federally
62

FCIC interview with Alphonso Jackson, Oct. 6, 2010.

Office of Thrift Supervision lawsuits and actions 1996, 2001, 2002. Details TK

Cox interview with FCIC.

created entities. They said there were more lending problems among state-chartered lenders, so
the states should have been focusing their efforts on their own problems rather than looking to
involve themselves in an arena where they had no jurisdiction, that is, federally-chartered
institutions. Madigan told the Commission that national banks funded 21 of the 25 largest
subprime loan issuers operating with state charters, and that those banks were the end-market for
abusive loans originated by the state-chartered firms. 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 consumers from the coming crisis.”65
Many states nevertheless pushed ahead with their own lending regulations, as did some cities. In
2003, Charlotte, N.C.-based Wachovia Bank told state regulators that it would not abide by state
laws because it was a national bank and fell under the supervision of the OCC. Michigan
protested Wachovia’s announcement, and Wachovia sued Michigan. The OCC, the American
Bankers Association and the Mortgage Bankers Association entered the fray on Wachovia’s side;
the other 49 states, Puerto Rico and the District of Columbia aligned themselves with Michigan.
The legal battle lasted four years. The Supreme Court ruled five to three in Wachovia’s favor on
April 17, 2007, leaving the OCC its sole regulator. Speaking of the federal government, Cox
said, “Not only were they negligent, they were aggressive in trying to stop enforcement
actions…Those guys should have been on our side.”66
Non-prime lending surged to $540 billion in 2004 and then $665 billion in 2005, and its impact
began to be felt in more and more places. Many of those loans were funneled into the pipeline by
mortgage brokers, who served as the conduit between borrowers and the lenders who financed
65

Written testimony of Illinois Attorney General Lisa Madigan to the FCIC, Jan. 14, 2010.

Cox interview with FCIC.

the mortgages, preparing the paperwork for loans and earning fees from lenders for doing it.
More than 200,000 new mortgage brokers entered the field during the boom, and some were less
than honorable in their dealings with borrowers.67 At least 10,500 people with criminal records
became mortgage [brokers] in Florida, for example, including 4,065 who had previously been
convicted of fraud, bank robbery, racketeering and extortion, according to an investigative report
in 2008. J. Thomas Cardwell, commissioner of the Florida Office of Financial Regulation told
the Commission that “lax lending standards” and a “lack of accountability” created significant
problems. [cite]
Mark S. Savitt, past president of the National Association of Mortgage Brokers, told the
Commission that while most mortgage brokers looked out for borrowers’ best interests and
steered them away from risky loans, approximately 50,000 of the newcomers to the field
nationwide were willing to do whatever it took to maximize the number of loans they made, and
could earn more money putting people in bad loans than good ones. In addition, he told the
Commission, some loan-origination firms, such as Ameriquest, were “absolutely” corrupt.68
In Bakersfield, California, where home starts doubled and home values tripled between 2001 and
2006, real estate appraiser Gary Crabtree initially felt pride that his birthplace, 110 miles north of
Los Angeles, “had finally been discovered” by other Californians. The city, a farming and oilindustry center in the San Joaquin Valley, was drawing national recognition for the pace of
development. Wide-open farm fields were ploughed under and divided into thousands of
building lots. Home prices jumped 26 percent in Bakersfield in 2002, 17 percent in 2003, and 35

FCIC interview with Mark Savitt, Nov. 17, 2010.

percent more in 2004. The median price for a house climbed from $100,000 in 2001 to almost
$300,000 in 2006.69
Crabtree, an appraiser for 48 years, started to think in 2003 and 2004 that things were not making
sense. People were paying inflated prices for their homes, and they didn’t seem to have enough
income to pay for what they had bought. Within a few years, the buyers fell behind on the
payments. When he passed some of these same houses, he saw they were vacant. For-sale signs
appeared on the front lawns. And when he passed again, he saw that the yards were untended and
the grass was turning brown. Next the houses went into foreclosure, and that’s when he noticed
that the empty houses were being vandalized, which pulled down values for the new suburban
subdivisions.”
The Cleveland phenomenon had come to Bakersfield, a place far from the rust belt. Crabtree
watched as foreclosures spread like an infectious disease through the community. Houses fell
into disrepair and neighborhoods disintegrated.
Crabtree started to study the market to try to understand what was happening, and worked at the
effort in earnest in 2005 and 2006. He ended up identifying what he believed were 214
fraudulent transactions in Bakersfield that were allowing insiders to siphon cash off each
property transfer. The transactions involved many of the nation’s largest lenders. One house, for
example, was listed for sale for $565,000, and sold for $605,000 with 100 percent financing,
though the real estate agent told Crabtree it actually sold for $535,000. Crabtree realized the gap
between the sales price and loan amount allowed these insiders to pocket $70,000. The terms of

Bakersfield Regional Chart Book, FCIC background briefing, Bakersfield field hearing, Sept. 7, 2010.

the loan required the buyer to occupy the house, but it was never occupied. Then the house went
into foreclosure, and sold in a distress sale for $322,000.70
Crabtree began calling lenders to tell them what he had found, but to his shock, they did not
seem to care. He finally reached one quality assurance officer at Fremont Investment & Loan,
the nation’s eighth-largest subprime lender.
“Don’t put your nose where it doesn’t belong,” he was told.71
Crabtree took his story to state law enforcement officials, and to the Federal Bureau of
Investigation. “I was screaming at the top of my lungs,” he said. Crabtree grew infuriated at the
slow pace of enforcement and response by prosecutors to a problem that was wreaking economic
havoc in Bakersfield.72
At the Washington headquarters of the FBI, Chris Swecker, an assistant director, was also trying
to get people to pay attention to mortgage fraud. "It has the potential to be an epidemic," he said
at a news conference in Washington in 2004. "We think we can prevent a problem that could
have as much impact as the S&L crisis."73
Swecker called another news conference in December 2005 to say the same thing, this time
adding that mortgage fraud was a “pervasive problem” that was “on the rise.” He was joined by
officials from HUD, the U.S. Postal Service and the Internal Revenue Service. The officials told

Written statement of Gary T. Crabtree to FCIC, Sept. 7, 2010.

Fremont Investment & Loan was ordered etc and etc here

Gary Crabtree interview with FCIC, Aug. XX, 2010.

CNN news report, Sept. 17, 2004: http://www.cnn.com/2004/LAW/09/17/mortgage.fraud/

reporters that real estate and banking executives were not doing enough to root out mortgage
fraud and that lenders needed to do more to “police their own organizations.”74
Meanwhile, the number of cases of reported mortgage fraud continued to swell. Suspicious
activity reports, also known as SARs, are reports filed by banks to the Financial Crimes
Enforcement Network, a bureau within the Treasury Department.75 In November 2006, the
network published an analysis that found that mortgage fraud reports had increased 20-fold
between 1996 and 2005. The FinCen analysis noted the figures likely represented a substantial
underreporting, because two-thirds of all the loans being created were originated by mortgage
brokers who were not subject to any federal standard or oversight.76 In addition, many lenders
who were required to do so did not submit reports.77
“The claim that no one could have foreseen the crisis is false,” said William K. Black, an expert
on white collar crime and former staff director of the National Commission on Financial
Institution Reform, Recovery and Enforcement, created by Congress in 1990, as the savings and
loan crisis unfolded78
Former Attorney General Alberto Gonzalez, who served from February 2005 to 2007, told the
Commission he could not remember the press conferences or news reports about mortgage fraud.
Both Gonzalez and former Attorney General Michael Mukasey, who served in 2007 and 2008,

FCIC Investigative Findings on Mortgage Fraud, p. 10.

Mortgage Loan Update, An Industry Assessment based Upon Suspicious Activity Report Analysis, Financial
Crimes Enforcement Network, Regulatory Policy and Programs Division.

FCIC interview with Frances San Pedro, Sept. 20, 2010; FinCEN response to FCIC interrogatories, Oct.
14-15, 2010.

Written testimony of William Black to FCIC, Miami field hearing, Sept. 21, 2010.

told the FCIC that mortgage fraud had never been communicated to them as a top priority.
“National security was an overriding” concern, Mukasey said. [ck] 79
To community activists and local officials, however, the lending practices were a matter of
national economic concern. Ruhi Maker, a lawyer who worked on foreclosure cases at the
Empire Justice Center in Rochester, New York, told Fed governors Bernanke, Susan Bies and
Roger Ferguson in October 2004 that she suspected that some investment banks—here she
specified “Bear Stearns and Lehman Brothers”—were producing such bad loans that it raised
questions about whether the firms would survive.
“We repeatedly see false appraisals and false income,” she told the Fed officials, who were
gathered at the public hearing period of a Consumer Advisory Council meeting. She urged the
Fed to prod the Securities and Exchange Commission to examine the quality of due diligence by
the firms, because otherwise, she said, serious questions could arise about whether they could be
forced to buy back bad loans they had made or securitized.80
Maker told the board that she feared an “enormous economic impact” could result from the
confluence of financial events: flat or declining incomes, a housing bubble and fraudulent loans
with overstated values.
In an interview with the FCIC, Maker said Fed officials seemed impervious to what the
consumer advocates were saying. The Fed governors politely listened and said little, she said.

FCIC interview with Michael Mukasey, DATE TK.

Transcript of the Federal Reserve Consumer Advisory Council Meeting, Oct. 28, 2004.

“They had their economic models, and their economic models did not see this coming,” she said.
“We kept getting back, ‘This is all anecdotal.’”81
Soon nontraditional mortgages were crowding other kinds of products out of the market in many
parts of the country. In 2005, about 23 percent of mortgage borrowers nationwide took out
interest-only loans, up from fewer than 2 percent in 2000, with the trend far more pronounced on
the west and east coasts.82
Home prices rose quickly in states where nontraditional loans flowed in.[ck data] With their
easy credit terms, these loans allowed borrowers 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 followed soon after. By 2005, in thirteen states, at least one in ten of every
mortgage outstanding was now a risky, nontraditional loan, up from a miniscule amount years
earlier. These states included Arizona, California, Florida, Hawaii, Indiana, Louisiana, Michigan,
Mississippi, Nevada, Ohio, Rhode Island, Tennessee and Texas. In a number of other states, the
change was less marked. Nontraditional loans penetrated much more slowly, for example, into
Montana, North Dakota, South Dakota and Vermont. In those states, home price hikes were
lower, but so were foreclosure rates.83
As home prices shot up in much of the country, many observers began speculating about whether
the country was witnessing a housing bubble. On June 16th, The Economist magazine’s cover
story posited that the day of reckoning was at hand, with the headline, “House Prices: After the

81
82
83

FCIC interview with Ruhi Maker, Oct. 25, 2010.
Many Buyers Opt for Risky Mortgages, Page A1, May 28, 2005, The Washington Post.
CoreLogic statistics provided to FCIC.

Fall.” The illustration depicted a brick plummeting out of the sky. “It is not going to be pretty,”
the story said. “How the current housing boom ends could decide the course of the entire world
economy over the next few years.”84
In June 2005, Fed Chairman Greenspan acknowledged the issue, telling the Joint Economic
Committee of the U.S. Congress that “the apparent froth in housing markets may have spilled
over into the mortgage markets.” For years, he had warned that Fannie Mae and Freddie Mac,
subsidized by investors’ beliefs that these institutions had the backing of the U.S. government,
were growing so large, with so little oversight, as to create systemic risks for the financial
system.85 Still, he reassured legislators that the U.S. economy was on a “reasonably firm
footing” and that the financial system would be resilient if the housing market turned sour.
“The dramatic increase in the prevalence of interest-only loans, as well as the introduction of
other relatively exotic forms of adjustable rate mortgages, are developments of particular
concern,” he said. “To be sure, these financing vehicles have their appropriate uses. But to the
extent that some households may be employing these instruments to purchase a home that would
otherwise be unaffordable, their use is beginning to add to the pressures in the marketplace.
…Although we certainly cannot rule out home price declines, especially in some local markets,
these declines, were they to occur, likely would not have substantial macroeconomic
implications. Nationwide banking and widespread securitization of mortgages makes it less

The Economist, June 16, 2005.

http://www.federalreserve.gov/boarddocs/testimony/2005/20050406/default.htm

likely that financial intermediation would be impaired than was the case in prior episodes of
regional house price corrections.”86
Indeed, Greenspan would not be the only one who would think that a housing downturn would
leave the broader financial system largely unscathed. As late as June 2007, after housing prices
had been declining for a year, Bernanke testified to Congress that the problems in the housing
market were “likely to be contained,” meaning he didn’t expect spillovers to the broader
economy. 87
Some were less sanguine. For example, consumer lawyer Sheila Canavan, of Moab, Utah, told
the Fed’s consumer advisory council in October 2005 that 61 percent of recently originated
loans in California were interest-only, more than twice the national average. “That’s insanity,”
she told the Fed governors. “That means we’re facing something down the road that we haven’t
faced before and we are going to be looking at a safety and soundness crisis.”88
On another front, while many academics were publishing studies that showed that rising house
prices were perfectly rational, and were expressing few worries about the stability of the
financial system, some raised pointed alarms. For example, in August 2005, Yale professor
Robert Shiller, who along with Karl Case developed the Case-Shiller Index, charted home prices,

Testimony of Chairman Alan Greenspan, The economic outlook, Before the Joint Economic Committee, U.S.
Congress, June 9, 2005, transcript, Federal Reserve Board website.

Ben Bernanke, “The economic outlook,” testimony before the Joint Economic Committee, U.S. Congress, March
17, 2007, http://www.federalreserve.gov/newsevents/testimony/bernanke20070328a.htm (checked)

Transcript of the Consumer Advisory Council Meeting, Federal Reserve, Oct. 25, 2005. P. 52.

illustrating how precipitously prices had climbed and how distorted the market appeared in
historical terms. Shiller warned that the housing bubble would likely burst.89
That same month, a conclave of economists gathered at Jackson Lake Lodge in Wyoming, in a
conference center nestled amid the Grand Teton National Park. It was a “who’s who of central
bankers,” recalled Raghuram Rajan, then chief economist of the International Monetary Fund,
who was on leave from the University of Chicago business school. Greenspan was there, so was
Bernanke. Jean-Claude Trichet, president of the European Central Bank and Mervyn King,
governor of the Bank of England, were among the other dignitaries.90
Rajan presented a paper with a provocative title: “Has Financial Development Made the World
Riskier?” Rajan posited that executives were being over-compensated for short-term gains but let
off the hook for losses—the IBGYBG syndrome. Rajan added that investment strategies such as
credit-default swaps could have disastrous consequences if the system became unstable, and that
regulatory institutions might not be able to control the outcome.91
He recalled to the FCIC that he was treated with scorn. Lawrence Summers, president of Harvard
University and former U.S.Treasury Secretary, called Rajan a “Luddite,” a historical reference to
a social movement that opposed technological change. “…I felt like an early Christian who had
wandered into a convention of half-starved lions,” Rajan wrote later.92

http://www.nytimes.com/2005/08/21/business/yourmoney/21real.html?pagewanted=1&_r=1

FCIC interview with Raghuram Rajan, Nov. 22, 2010.

Fault Lines, by Raghuram G. Rajan, Princeton University Press, New Jersey, 2010, p. 3.

Susan Wachter, a professor of real estate finance at the University of Pennsylvania’s Wharton
School, prepared a research paper in 2005 that suggested the United States could have a real
estate crisis similar to Asia’s in the 1990s. When she discussed her work at the Jackson Hole
gathering two years later, it received a chilly reception, she told the Commission. “It was
universally panned,” she said, and an economist from the Mortgage Bankers Association called it
“absurd.”93
In 2005, news reports were beginning to highlight signs that the real estate market was
weakening. Home sales began to drop, Fitch Ratings reported signs that mortgage delinquencies
were rising. That year, hedge-fund director Mark Slipsch of Orix Credit Corp. told participants
at the American Securitization Forum, a securities trade group, that investors had become “over
optimistic” about the market. “I see a lot of irrationality,” he said. He said he was unnerved
because people were saying, “It’s different this time”—a common rationale before previous
collapses.
Some real estate appraisers had also been expressing concerns about the problem for years.
From 2000 to 2007, a coalition of appraisal organizations circulated and delivered to Washington
officials a public petition signed by 11,000 appraisers, each providing their names and addresses,
charged that lenders were pressuring appraisers to place artificially high prices on properties. The
petition stated that lenders were “blacklisting honest appraisers” and instead assigning business
only to appraisers who would hit the price targets. “The powers that be cannot claim ignorance,”
appraiser Dennis Black of Port Charlotte, Florida, told the Commission in testimony.94

FCIC interview with Susan Wachter, Oct. 6, 2010.

Dennis Black written testimony to FCIC, Miami field hearing, Sept. 21, 2010.

Appraiser Karen Mann of Discovery Bay, California, another industry veteran, told the
Commission that lenders had opened subsidiaries to perform appraisals, allowing them to extract
extra fees from “unknowing” consumers and making it easier to inflate home values. She said the
steep hike in home prices and the unmerited and inflated appraisals she was seeing in Northern
California convinced her that the housing industry was headed for a cataclysmic downturn. In
2005, she shut down her office, laid off some of her staff and began working out of her home to
cut her overhead expenses and wait out the coming storm.95
Despite all the signs that the housing market was slowing, Wall Street just kept going and going,
ordering up loans, packaging them into securities, taking profits, earning bonuses. By the third
quarter of 2006, home prices were falling and mortgage delinquencies were rising, which spelled
trouble for mortgage-backed securities. But, from [September] 2006 on, investment banks
created and sold some $1.2 trillion in mortgage-backed securities and an additional $346 billion
in CDOs.
Not everyone on Wall Street kept applauding, however. Some executives were urging caution.
At Lehman Brothers, for example, Michael Gelband, head of fixed income, and chief risk officer
Madelyn Antoncic warned against taking on too much risk in the face of growing pressure to
compete aggressively against other investment banks. Antoncic, who held the position from 2004
to 2007, was shunted aside: “At the senior level, they were trying to push so hard that the wheels
started to come off,” she told the Commission. She was reassigned to a policy position working

Karen Mann testimony to FCIC, Sacramento field hearing, Sept. 23, 2010.

with government regulators.96 Gelband left; Lehman officials blamed Gelband’s departure on
“philosophical differences.”97
At Citigroup, meanwhile, Richard Bowen, a veteran banker in the consumer lending group, got a
promotion in 2005 when he was named business chief underwriter, overseeing the loan quality
of, in peak years, $90 billion a year in mortgages purchased by CitiFinancial. These mortgages
were packaged into securities and resold to Fannie Mae, Freddie Mac and other investors. About
a year into the job, Bowen discovered that as much as 60 percent of the loans that Citi were
buying where what he called “defective.” They did not meet Citigroup’s loan guidelines, a
dangerous proposition for the company, because if the borrowers were to default on their loans,
the investors could force Citi to buy them back. Bowen told the Commission he tried to alert top
managers at the firm by “email, weekly reports, committee presentations and discussions,” and
although he said they expressed concern, it “never translated into any action.” Instead, he said,
“there was a considerable push to build volumes, to increase market share…”98
Moreover, Bowen told the commission, Citi instead began loosening its own standards during
these years rather than tightening them, specifically by beginning to purchase stated-income,
“liar” loans. “So we joined the other lemmings headed for the cliff,” he told the Commission.99
He finally took his warnings to the highest spot he could reach—Robert Rubin, [Chairman of the
Executive Committee of the Board of Directors] and former US Treasury Secretary in the
Clinton Administration [ck title at time], and three other bank officials. He sent a memo to Rubin
96

FCIC interview with Madelyn Antoncic, former chief risk officer, Lehman Brothers, July 14, 2010.

FCIC Investigative Findings on Lehman Brothers, pages 29 and 30. – ck source

FCIC interview with Richard Bowen, INFO TK

FCIC interview with Richard Bowen, date TK.

and the others, with the words “URGENT—READ IMMEDIATELY” in the subject lines, and
shared his concerns. He told top managers that Citi faced billions of dollars in losses if investors
were to demand that Citi repurchase the defective loans.
Rubin told the Commission in a public hearing in April 2010 that Citibank handled the Bowen
matter promptly and solved the problem. “I do recollect this and that either I or somebody else,
and I truly do not remember who, but either I or somebody else 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.” Citigroup attorney Brad Karp said the bank undertook an investigation in response to
Bowen’s claims and that the system of underwriting reviews was [revised].100 [check]
Bowen told the Commission he suffered retaliation for pointing out the problems—that he went
from supervising 200 people to supervising only two, that his bonus was reduced and that he was
downgraded on his performance review.101
Some industry veterans took their concerns directly to government officials. J. Kyle Bass, a
Dallas-based hedge fund manager and a former Bear Stearns executive, testified to the FCIC that
he told the Federal Reserve in [date] that he believed the housing securitization market was on a
shaky foundation. “Their answer at the time was, and this was also the thought that was—that
was homogeneous throughout Wall Street’s analysts—was home prices always track income
growth and jobs growth. And they showed me income growth on one chart and jobs growth on
another, and said, “We don’t see what you’re talking about because incomes are still growing

100

Brad Karp to FCIC, Nov. 1, 2010.

101

FCIC interview with Richard Bowen, Feb. 27, 2010, p. 104-106.

and jobs are still growing.” And I said, well, you obviously don’t realize where the dog is and
where the tail is, and what’s moving what.”102
Even those who had profited through the growth of non-traditional lending practices said they
became disturbed by what was happening. Herb Sandler, co-founder of mortgage lender Golden
West, which was heavily-loaded with Option ARM loans, wrote to officials at the Federal
Reserve, the FDIC, 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
churned through securitization and transformed into a AAA-rated asset, and when a multi-billion
dollar industry is all too eager to facilitate this alchemy.”103
Similarly, Lewis Ranieri, a mortgage finance veteran who helped pioneer the development of the
Wall Street mortgage securitization machine in the 1980s, said he didn’t like what he called “the
madness” that had descended on the real estate market. Ranieri told the Commission.“I was not
the only guy. I’m not telling you I was John the Baptist. There were enough of us, analysts and
others, wandering around going ‘look at this stuff,’ that it would be hard to miss it.”104 Ranieri’s
own Houston-based Franklin Bank Corporation would itself collapse under the weight of the
financial crisis in November 2008.
Other industry veterans inside the business also acknowledged that the rules of the game were
being changed. “Poison,”105 was the word famously used by Countrywide’s Mozilo, to describe
102

J. Kyle Bass, testifying to FCIC, Jan. 13, 2010.

103

http://www.goldenwestworld.com/wp-content/uploads/world-savings-basel-anpr-1-18-061.pdf

104

FCIC interview with Lewis Ranieri, July 30, 2010.

105

4/13/06 Mozilo email to Sieracki, BAC-FCIC-E-00006734227-28, FCIC Investigative Report on Countrywide, p.
31.

one of the loan products his firm was introducing. “In all my years in the business I have never
seen a more toxic [product],” he wrote in an internal email.106 Others at the bank argued that they
were offering products “pervasively offered in the marketplace by virtually every relevant
competitor of ours.”107 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. “They
all went broke.”108
In late 2005, regulators decided to take a look at the changing mortgage market. Sabeth
Siddique, assistant director for credit risk at the Federal Reserve Board, was directed to
investigate how broadly loan patterns were changing. He took the questions directly to the
[largest] banks in 2005 and asked them how many of which kinds of loans they were making.
Siddique found the information “very alarming,” he told the Commission.
First, the growth of nontraditional loans was not isolated to state-chartered institutions in farflung states, as federal regulators [ck] had publicly stated. In fact, they comprised 59 percent of
originations at Countrywide, 58 percent for Wells Fargo; 51 percent for National City; 31
percent at Washington Mutual, 26.5 percent at CitiFinancial, 18.3 percent at Bank of America.
Moreover, the banks expected that their originations of nontraditional loans would rise by 17
percent that year, to $608.5 billion.109 The review of bank underwriting practices also noted
“slowly deteriorating quality of loans due to loosening underwriting standards.”110
106

4/17/06 Mozilo email to Sambol and Kurland, BAC-FCIC-E-0000673435

107

4/17/06 Sambol email to Mozilo (cc Kurland, McMurray and Bartlett) BAC-FCIC-E-0000673436, FCIC report
on Countrywide, p. 32.
108

4/17/06 Mozilo email to Sambol (cc Kurland, McMurray and Bartlett) BAC-FCIC-E-0000673436, FCIC
investigative report on Countrywide, p. 32.
109

Confidential Federal Reserve document obtained by FCIC, produced Nov. 1, 2005.

The bank practices analysis found that two-thirds of the nontraditional loans the banks had made
in 2003 had been stated-income, minimal documentation variety known as “liar’s loans,” which
had a particularly great likelihood of going sour.
The reaction to Siddique’s briefing was mixed. Federal Reserve Governor Bies recalled the
response by the Fed governors and regional board directors as divided from the beginning.
“Some people on the board and regional presidents…just wanted to come to a different answer.
So they did ignore it, or the full thrust of it,” she told the Commission.111
The OCC was also pondering the situation. Former Comptroller of the Currency Dugan told the
Commission that the push had come from below, from bank examiners who had become
concerned about what they were seeing in the field. The agency began considering issuing
“guidance,” a kind of nonbinding official warning to banks that non-traditional loans could
jeopardize safety and soundness and would invite scrutiny by bank examiners.112 Siddique said
the OCC led the effort, which became a multi-agency initiative.113
Bies said deliberations over the potential guidance also stirred debate within the Fed because
some critics feared it would stifle the financial innovation that was bringing record profits to
Wall Street and the banks, and that it would make homes less affordable. Moreover, all the
agencies—the Fed, the OTS, the FDIC and the National Credit Union Administration--would

110

Fed report, p. 5.

111

FCIC interview with Susan Bies, Oct. 11, 2010.

112

Regulators May Warn About New Mortgages: Guidance Would Address the Use of High-Risk Loans,” by
Kirstin Downey, June 17, 2005, The Washington Post.
113

FCIC interview with Siddique, date TK.

need to work together on it, or it would unfairly prevent one group of lenders from doing loans
that other lenders were doing. The American Bankers Association and Mortgage Bankers
Association opposed it as regulatory overreach.
“…The bankers pushed back,” Bies told the Commission. “The members of Congress pushed
back. Some of our internal people at the Fed pushed back…”114
The Mortgage Insurance Companies of America, which represents mortgage insurance
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,” they told regulators
in a letter in 2006. “…The most recent market trends show alarming signs of undue risk-taking
that puts both lenders and consumers at risk.”115
William A. Simpson, the group’s vice president, pointedly referred to past real estate downturns
in congressional testimony about a month later. “We take a conservative position on risk because
of our first loss position,” Simpson told the Senate Subcommittee on Housing, Transportation
and Community Development and the Senate Subcommittee on Economic Policy. “However, we
also have a historical perspective. We were there when the mortgage markets turned sharply
down during the mid-1980s especially in the oil patch and the early 1990s in California and the
Northeast.”116

114

FCIC interview with Susan Bies, Oct. 11, 2010.

115

Insurers Want Action on Risky Mortgages; Firms Want More Loan Restrictions, by Kirstin Downey, Washington
Post, page D1, August 19,2006.

116

MICA Testimony on Non-Traditional Mortgages, Sept. 20, 2006. Statement of William A. Sampson, Mortgage
Insurance Companies of America before the Subcommittee on Housing and Transportation and the Subcommittee
on Economic Policy. MICA website.

Within the Fed, the debate grew heated and emotional, Siddique recalled. “It got very personal,”
he told the Commission. The ideological and interagency turf war lasted more than a year, while
the number of nontraditional loans kept growing and growing.117
Consumer advocates kept up the heat. In a Fed Consumer Advisory Council meeting in March
2006, Fed governors Bernanke, Mark Olson and Kevin Warsh were specifically and publicly
warned of dangers that non-traditional loans posed to the economy. Stella Adams, executive
director of the North Carolina Fair Housing Center, raised concerns that non-traditional lending,
“may precipitate a downward spiral that starts on the coast and then creates panic in the east that
could have implications on our total economy as well.” 118
At the next meeting of the Fed Consumer Advisory Council, held in June 2006, which was
attended by Bernanke, Bies, Olson and Warsh, several consumer advocates told Fed governors
that alarming incidents were now erupting all over the country. Edward Sivak, director of policy
and evaluation at the Enterprise Corp. of the Delta, in Jackson, Mississippi, said that mortgage
brokers had told him that property values were being inflated to maximize profit for real estate
appraisers and loan originators. Alan White, supervising attorney at Community Legal Services
in Philadelphia, reported a “huge surge in foreclosures,” and said that up to half of borrowers he
was seeing with troubled loans had been overcharged and given high-interest rate mortgages
when their credit had qualified them for lower-cost loans. Hattie B. Dorsey, president and chief
executive officer of Atlanta Neighborhood Development, said she worried that houses were
being flipped back and forth so much that it would lead to neighborhood “decay.” Carolyn Carter

117

FCIC interview with Siddique, DATE TK.

118

Transcript of Consumer Advisory Council meeting, Federal Reserve, March 26, 2006.

of the National Consumer Law Center in Massachusetts urged the Fed to use its regulatory
authority to “prohibit abuses in the mortgage market.”
The balance was tipping. Before he left his post as Fed Chairman in January 2006, Greenspan
had indicated he was willing to accept the guidance. Ferguson acted as Greenspan’s lieutenant,
shepherding support in the Fed board and among the regional Fed presidents. Bies supported it,
and Bernanke did as well. [cite and ck]
More than a year after the OCC initially proposed the guidance, it was issued as an interagency
warning that affected banks, thrifts and credit unions nationwide. It was released in September
2006. Dozens of states moved swiftly to duplicate the rules, directing their versions of the
guidance to tens of thousands of state-chartered lenders and mortgage brokers.
In July 2008, long after the risky, nontraditional mortgage market had died out and the Wall
Street mortgage securitization machine had ground to a halt, the Federal Reserve finally adopted
new rules under HOEPA to curb the abuses about which consumer groups had raised red flags
for years – including a requirement that borrowers have the ability to repay loans made to them.
By this time, however, the damage had been done. The total value of mortgage-backed securities
issued between 2001 and 2006 [update to 2007] reached $13.4 trillion, according to the
Securities Industry and Financial Markets Association. That created a mountain of problematic
securities, debt, and derivatives that were resting on real estate assets that were far less secure
than they were thought to have been.
By the end of 2007, most subprime lenders had failed or been acquired, including New Century
Financial, Ameriquest, and American Home Mortgage. In January 2008, Bank of America
announced it would acquire the ailing lender Countrywide. Then, what became clear was that
57

risk—rather than being diversified across the financial system as had been thought—was
concentrated at the largest financial firms. Bear Stearns, laden with risky mortgage assets and
dependent on fickle short-term credits, was bought by JP Morgan with government assistance in
the spring. Before the summer was over Fannie Mae and Freddie Mac would be put into
conservatorship. Then, in September, Lehman Brothers failed and the remaining investment
banks, Merrill Lynch, Goldman Sachs, and Morgan Stanley, struggled as they lost the market’s
confidence. AIG, with its massive credit default swap portfolio and exposure to the subprime
mortgage market, was rescued by the government. Finally, many commercial banks and thrifts,
with their own exposures to declining mortgage assets and their own exposures to short-term
credit markets, teetered. IndyMac had already failed over the summer; Washington Mutual
became the largest bank failure in U.S. history. In October, Wachovia was acquired by Wells
Fargo. Citigroup and Bank of America fought to stay afloat. Before it was over, taxpayers had
committed trillions of dollars though more than two dozen extraordinary programs to stabilize
the financial system and to prop up the nation’s largest financial institutions.
The crisis that befell the country in 2008 had been years in the making. In sworn testimony to the
Commission, former Fed Chairman Greenspan defended his record and said most of his
judgments had been correct. “I was right 70 percent of the time but I was wrong 30 percent of the
time,” he told the Commission. Yet, the consequences of what went wrong in the run up to the
crisis would be enormous.
The economic impact of the crisis has been devastating. And the human devastation is
continuing. The officially reported unemployment rate hovered at almost 10 percent in
[November], but the underemployment rate, which includes those who have given up looking for
work and part-time workers who would prefer to work full time, is over 17 percent And, the

share of unemployed workers who have been out of work for over six months was just above 40
percent. Of large metropolitan areas, the Las Vegas, Nevada and Riverside-San Bernardino,
California areas have the highest unemployment with rates of about 15 percent.
The loans were as lethal as many had predicted, and it has been estimated that ultimately 13
million [ck cite] households in the United States may lose their homes to foreclosure. As of xx,
foreclosure rates were highest in Florida and Nevada; in Florida, nearly 14% of loans were in
foreclosure, and Nevada was not far behind. By xx, nearly one-quarter of American
homeowners owed more on their mortgages than their home was worth. In Nevada, the
percentage was nearly 70%. Households have lost $12 trillion in wealth since 2006.
As Mark Zandi, chief economist of Moody’s Economy.com, testified to the commission, “The
financial crisis has dealt a very serious blow to the U.S. economy. The immediate impact was the
Great Recession: the longest, broadest and most severe downturn since the Great Depression of
the 1930s…The longer-term fallout from the economic crisis is also very substantial…It will
take years for employment to regain its pre-crisis level.”
Looking back on the years before the crisis, economist Dean Baker said, “So much of this was
absolute public knowledge in the sense that we knew the number of loans being issued with zero
down. Now, do we think we have that many more people—who are capable of taking on almost
zero down who we think are going to be capable to pay that off—than was true 10, 15, 20 years
ago? What’d changed in the world? There were a lot of things that didn’t require any
investigation at all; it was entirely in the data.”119
Warren Peterson, a home builder in Bakersfield, felt that he could pinpoint to the day when the
world changed. Peterson built semi-custom homes in an upscale neighborhood, and each
119

FCIC interview with economist Dean Baker, co-founder of the Center for Economic and Policy Research.

Monday morning, he would arrive at the office to a bevy of real estate agents, sales contracts in
hand, vying to be the ones chosen to purchase the new homes he was building. He was at the
sales office one Saturday in November 2005, and he noticed that not a single purchaser had
entered the building.
He called a friend, also in the homebuilding business, who said he had noticed the same thing,
and asked him what he thought about it.
“It’s over,” his friend told Peterson.

Part I: Setting the Stage for the Crisis

Introduction
The financial crisis of 2007 and 2008 was not a single event, but a series of crises that rippled
through the financial system and, ultimately, the economy. Distress in one area of the financial
markets led to failures in other areas by way of interconnections and vulnerabilities that bankers
and government officials had missed or dismissed. When subprime and other risky mortgages issued during a housing bubble that many experts failed to take seriously - began to default at
unexpected rates, a once-obscure market for complex investment securities backed by those
mortgages abruptly failed. When the contagion spread to new fronts, investors panicked – and
the danger inherent in the whole system became all-too manifest. Financial markets teetered on
the edge and brand-name financial institutions were left bankrupt or dependent on the taxpayers
for survival.

Federal Reserve Chairman Ben Bernanke insisted through mid-2007 that the subprime mortgage
crisis would be contained. He now acknowledges that he missed the systemic
risks. “[P]rospective subprime losses were clearly not large enough on their own to account for
the magnitude of the crisis,” Bernanke told the FCIC. “Rather, the system’s vulnerabilities,
together with gaps in the government’s crisis-response toolkit, were the principal explanations of
why the crisis was so severe and had such devastating effects on the broader economy.”

This section of our report explores the origins of risks as they burrowed into the financial system
over the past decades. It is a fascinating story with profound consequences – a complex history
that could yield its own report. Instead, we focus on four key developments which helped lay the
foundation for the crisis that shook our financial markets and economy. Big books have been
written about each of them; we stick to the essentials for understanding our examination, which
is the recent crisis.

First, we explain the phenomenal growth of the shadow banking system—the investment banks,
most prominently, but other financial institutions, too—which freely operated in the capital
markets that were beyond the reach of the regulatory apparatus that had been put in place in the
wake of the Crash of 1929 and the Great Depression. This new system threatened the oncedominant traditional commercial banks, who took their grievances to their regulators and to
Congress, who slowly but steadily removed longstanding restrictions and helped banks break out
of the traditional mold and join the feverish capital markets. The result was two parallel financial
systems of enormous scale. This new competition not only benefited Wall Street but also seemed
to help all Americans, lowering the costs of their mortgages and boosting the returns on their
401(k)’s. Shadow banks and commercial banks were codependent competitors. Their new
activities were very profitable—and, it turned out, very risky.

Second, we look at the evolution of financial regulation. To the Federal Reserve and other
regulators, the new dual system that granted greater license to market participants appeared to
provide a safer and more dynamic alternative to the era of traditional banking. More and more,
62

regulators looked to financial institutions to police themselves – “deregulation” was the label.
Former Fed Chairman Alan Greenspan put it this way: financial “modernization…would permit
banking organizations to compete more effectively in their national markets.”120 From the Fed’s
view, if problems emerged in the shadow banking system, the large commercial banks – which
were believed to be well-run, well-capitalized, and well-regulated despite their loosened
restraints – could provide vital support. And if problems outstripped the market’s ability to right
itself, the Fed took on the responsibility. It did so again and again in the decades leading up to
the recent crisis. And, understandably much of the country came to assume that the Fed could
always and would always save the day again.

Third, we follow the profound changes in the mortgage industry, from the sleepy days when
local lenders took full responsibility for making and servicing thirty-year loans to a new era in
which the idea was to sell the loans off as soon as possible to be packaged and sold to investors
around the world. New mortgage products proliferated; new borrowers, too. Inevitably, this
became a market in which the participants –mortgage brokers, lenders, and Wall Street firms had more of a stake in the quantity of mortgages signed up and sold, and less in their quality. We
trace the history of Fannie Mae and Freddie Mac, privately-owned corporations established by
Congress that became dominant forces in providing financing to support the mortgage market
while also seeking maximum returns for investors.

120

H.R. 10, the Financial Services Competitiveness Act of 1997: Testimony of Fed chairman Alan Greenspan
before the House Committee on Banking and Financial Services (May 22, 1997), available at
http://www.federalreserve.gov/boarddocs/testimony/1997/19970522.htm.

Fourth, we introduce some of the most arcane subjects in our report: securitization, structured
finance, and derivatives—words that entered the national vocabulary as the financial markets
unraveled through 2007 and 2008. Simply and most pertinently put, structured finance was the
mechanism by which subprime and other mortgages, many of dubious value, were turned into
complex investments often accorded AAA ratings by credit rating agencies with their own
conflicting motivations. This entire market depended on finely honed computer models which
turned out to be divorced from reality—and on ever-rising housing prices. When that bubble
burst, the complexity bubble also burst: the securities almost no one understood, backed by
mortgages no lender would have signed twenty years earlier, were the first dominos to fall in the
financial sector.

A basic understanding of these four developments will bring the reader up to speed to where
matters stood with the financial system in the year 2000, at the dawn of a decade of promise and
peril.

Part I, Chapter 1. The Shadow Banking System

Contents
Chapter 1. The Shadow Banking System............................................................................................... 65
Commercial paper and repos: “A lot of pressure on their regulators” ................................................... 68

In the traditional system of borrowing and lending that had been in place in the United States for
most of the twentieth century, banks and S&Ls accepted deposits from retail and corporate
customers and loaned that money to people who wanted to buy homes or operate businesses.
Prior to the Depression, these institutions had historically been subject to “runs”. In those
episodes, reports or mere rumors that a bank was in trouble spurred depositors to demand their
cash. If enough depositors made such demands at the same time, a bank might not have the funds
on hand to meet those demands, even if it had the necessary assets on its books. Such events
happened not just during the Great Depression, but also in the decades earlier. Since the Civil
War, U.S. banks experienced depositor runs in 1873, 1884, 1890, 1893, 1896, and 1907.121
Then, in 1913, the Federal Reserve was created to bring stability to financial markets, in part by
acting as the lender of last resort to the banks.
This change was not enough to prevent panic in financial markets in the 1920s and 1930s. To
prevent a recurrence of such a crisis , the Glass-Steagall Act of 1933 established the Federal
Deposit Insurance Corporation, insuring bank deposits up to $2,500 -- the vast majority of
deposits in that era - a number that would eventually rise to $100,000 in 1980. With this
121

Prior to the end of the Civil War, banks issued notes instead of deposits. Runs on that system occurred in 1814,
1819, 1837, 1839, 1857, and 1861. See Charles Calomiris and Gary Gorton, “The Origins of Banking Panics:
Models, Facts, and Bank Regulation,” in Calomiris, Bank Deregulation in Historical Perspective (New York:
Cambridge University Press, 2000), 99.

safeguard in place, depositors didn’t need to worry about being the first in line at a troubled
bank’s door when it opened for business. And, if banks were short of funds, they could borrow
from the Federal Reserve, even when they could borrow from no one else. As lender of last
resort, the Federal Reserve would make sure that a bank would not fail simply due to a lack of
liquidity.
At the same time, to discourage banks from taking excessive risks now that deposits were
federally insured, Congress had put in place new restrictions on the activities banks could
undertake, limited the number of institutions that could operate in a single area, prohibited them
from operating across state lines, and in some cases prevented them from opening branches.
Restrictions on activities, more regulation, and less competition, policymakers thought, would
discourage risky behavior and help to prevent failures.122 Congress also gave the Federal Reserve
the authority to cap the interest rates that banks and thrifts – also known as savings and loans, or
S&Ls —were allowed to pay depositors. Again, the idea of this Regulation Q was to restrict
overly zealous competition for deposits that could get an institution in trouble.
The system was stable as long as interest rates remained relatively steady, which was the case for
the first two decades after World War II. In the 1970s, however, inflation increased sharply,
which caused interest rates to increase sharply. The rate that banks paid other banks for overnight
loans had rarely breached 5% in the preceding decades; in [197xx], it pushed 20%. Meanwhile,
thanks to the Fed’s Regulation Q, banks and thrifts were stuck with offering [roughly 5%] 123 on
122

See R. Alton Gilbert, “Requiem for Regulation Q: What It Did and Why It Passed Away,” Federal Reserve Bank
of St. Louis Review (Feb. 1986): 22-37.
123

The 19 percent figure is the fed funds rate from March 28 (just before DIDMCA went into effect), and I got it
from the FRB St. Louis’s database. The five percent figure I eyeballed from an article by R. Alton Gilbert,
“Requiem for Regulation Q: What It Did and Why It Passed Away,” Federal Reserve Bank of St. Louis Review 68
(Feb. 1986): 23-37 at .

their deposits.124 This was almost [XXX%] below the rate paid on a one-year Treasury bill.
Clearly, this was an untenable bind for the depository institutions, which could not compete on
the most basic level of the interest rate offered on a deposit.
Compete with whom? With firms such as Merrill Lynch, Fidelity, and Vanguard, who had seen
their opening and persuaded consumers and businesses to abandon traditional banking and thrift
services in order to obtain higher returns. These firms, happy to find new business lines,
particularly after the SEC abolished fixed commissions on retail and institutional trades in
1975,125created money-market mutual funds (MMMFs) that took the depositors’ money and
invested it in short-term, safe securities, such as government bonds and highly-rated corporate
debt, which paid a higher interest rate than the banks and thrifts were allowed to offer. The new
financial products were functionally similar to bank accounts, although they were set up with a
mechanism that sold shares that customers could redeem on a daily basis at a stable value never
less than one dollar for every dollar originally invested.126 In 1977, Merrill Lynch introduced a
product even more similar to the standard bank account: With its “cash management accounts,”
customers could write checks.127 The other MMMF sponsors quickly followed suit.
These funds were different from bank and thrift deposits in one important respect: they were not
protected by the FDIC’s deposit insurance. Nevertheless, consumers were enticed by the higher
124

The Federal Reserve and FDIC did allow banks to pay higher rates on some types of deposits, such as certificates
of deposit worth $100,000 or more.
125

cite

126

Financial Crisis Inquiry Commission, Preliminary Staff Report, “Shadow Banking and the Financial Crisis”
(May 4, 2010), at 18-25 [hereinafter FCIC PSR on Shadow Banking], available at
http://www.fcic.gov/reports/pdfs/2010-0505-Shadow-Banking.pdf.
127

Donald Regan, who was then Merrill’s chairman, later said that “I wanted to get into banking, and CMA was the
way to do it.” Quoted in Eric J. Weiner, What Goes Up (New York: Little Brown, 2005), at 176.

interest rates and by the stature of the sponsors. Merrill Lynch, for one, was a brand-name
American institution. It and the other established sponsors implicitly promised that the full $1 net
asset value (NAV) of a share in the fund would be maintained. They would not allow their funds
to “break the buck,” as the phrase goes. Even without the FDIC insurance, therefore, these funds
were widely considered as safe as a bank or thrift deposit. Business boomed; a key player in the
shadow banking industry was born. Total assets held in the lightly-regulated money-market
mutual funds grew rapidly, from $3 billion in 1977 to more than $740 billion in 1995 and $1.8
trillion by 2000.128

Commercial paper and repos: “A lot of pressure on their regulators”
In order to maintain their competitive edge over the insured depository firms, the new money
market funds needed safe, high-quality assets in which to invest, and they quickly developed an
appetite for two booming markets that will figure prominently in our story: the “commercial
paper” and “repo” markets. These were the conduits through which Merrill Lynch, Morgan
Stanley, and other Wall Street securities firms were able to broker and provide, for a fee of
course, short-term financing to large, established corporations. Commercial paper was simply
short-term unsecured corporate debt – meaning that it was backed by the corporation’s promise
to pay, rather than any specific collateral. These loans were of less than nine months in duration
– sometimes as short as two weeks and then eventually as short as just one day – and they were
usually “rolled over” by the lenders when they came due, and then rolled over again, and then
again. Because only financially stable corporations could attract such financing, it was
considered a very safe investment; companies such as General Electric and IBM, investors
believed, would always be good for their interest payments and for repayment if the paper wasn’t
128

Wilmarth (2002), at 239-40.

rolled over. Investors bought and sold this commercial paper like bonds. Corporations had been
issuing such “paper” to raise money since the beginning of the century, but it became much more
popular in the 1970s.
The newly popular market had suffered an early crisis that amply demonstrated that these capital
markets, like bank deposits had been before the introduction of backstops such as deposit
insurance, could be vulnerable to investor runs. Yet, the outcome of that crisis had actually
strengthened the market. In 1970, when the Penn Central Railway Company, the sixth largest
industrial corporation at the time, filed for bankruptcy, it had $200 million in short-term,
unsecured commercial paper outstanding, on which it defaulted.129 The holders of that paper—
the lenders—now worried about this market in general and refused to roll over their loans to
other corporate borrowers. The commercial paper market virtually shut down. In response, the
Federal Reserve supported the commercial banks with almost $600 million in emergency loans
and by cutting interest rates. These measures allowed the banks, in turn, to lend funds to
corporate borrowers to pay off their commercial paper. From that time, it became standard
practice for the issuers of commercial paper—the borrowers—to set up standby lines of credit
with major banks so that they would have the funds to pay off their debts if the market
experienced another shock. This strategy and the Fed’s use of the traditional banking system to
support the market reassured commercial paper investors that their money was safe.
Given this very liquid market through which they could borrow at rates lower than the banks
could offer, corporations did not hesitate to turn their backs on the banks and instead issue their
129

Frederic S. Mishkin, “Asymmetric Information and Financial Crises: A Historical Perspective,” in R. Glenn
Hubbard, ed., Financial Markets and Financial Crises (Univ. of Chicago Press, 1991), at 69, 99. Andrew F.
Brimmer, “Distinguished Lecture on Economics in Government: Central Banking and Systemic Risks in Capital
Markets,” Vol. 3, Journal of Economic Perspectives, Spring 1999, at 3, and 6.

own commercial paper in order to obtain short-term financing. In the 1960s, outstanding
commercial paper showed a more than seven-fold increase. Then, in the 1970s, it increased
almost four-fold again. And among the best customers for this commercial paper were the
money-market mutual funds—created, in some cases, by Wall Street firms that also brokered the
paper for the corporations. It was deemed a win-win-win deal: the mutual funds could earn a
solid rate of return, the stable companies could borrow at lower rates, and Wall Street could earn
fees on putting the deals together. Corporations could also use the same Wall Street securities
firms for less expensive medium-term loans (from nine months to several years). By the year
2000, the total amount of outstanding commercial paper and medium-term notes in the domestic
U.S. market had risen from less than $125 billion in 1980 to $1.6 trillion.130
The second major shadow banking market that grew significantly in the 1970s was the repo
market. “Repo” is short for “repurchase agreement.” Like commercial paper, these transactions
have a long history, but they grew rapidly in the 1970s.131 As the U.S. debt also grew during
that decade, the Treasury issued hundreds of billions of dollars of securities that were purchased
by institutions such as financial corporations and local and state government agencies. Rather
than hold them on their balance sheets and earn relatively low Treasury returns, these institutions
would sell them to conservative investors in return for cash, which they could then invest in
higher-interest securities or use for other purchases. These institutions would agree to buy back,
130

Securities Industry Association, 2002 Securities Industry Fact Book, at 14 (2002); Arthur E. Wilmarth, Jr., “The
Transformation of the U.S. Financial Services Industry, 1975-2000: Competition, Consolidation, and Increased
Risks,” 2002 University of Illinois Law Review 215, 231.
131

In 1969, the Fed amended its Regulation D to allow banks to borrow in the repo market against government and
agency securities without posting reserves against them at the Fed. In 1974, the Treasury shifted the bulk of its
deposits from accounts at commercial banks to accounts at the Fed. This freed up billions of dollars of government
and agency securities for use as collateral in the repo market. Marcia L. Stigum and Anthony Crescenzi, Stigum’s
money market, Fourth Edition, 2007, page 536.

or repurchase, the securities in the future –often within one day. Repos provided these financial
firms and government agencies with a low cost and convenient way to borrow. Lenders took
comfort in the fact that the lending was collateralized, generally demanding only a small margin
or “haircut” so that the loans would be for nearly the full value of the collateral. Similar to
commercial paper, repo would be “rolled over” many times over—that is, if the investors were
willing. These sources of very short-term financing would get the nickname “hot money”.
The repo market, too, had vulnerabilities, but it, too, had emerged from an early crisis stronger
than ever. In 1982, two securities firms that were major borrowers in this market failed, creating
large losses for lenders, some of whom were commercial banks. Again, the Federal Reserve
announced that it would act as a lender of last resort to support a shadow banking market. The
Fed lent to commercial banks through their normal emergency lending programs to meet credit
demands created by the disruptions and loosened the terms on which it lent Treasuries to
securities firms.132 ,133 Participants in the repo market and the Fed subsequently persuaded
Congress to provide special protection for repos in bankruptcy, which allowed repo lenders to
seize collateral rather than be caught up in bankruptcy proceedings. And, in the wake of this
incident, most repo participants switched to a three-party arrangement that used a large bank as
an intermediary to act as a go-between between the borrower and the lender, essentially
escrowing the collateral and the funds.134 As we will see, this mechanism would have profound

132

Kenneth Garbade, “The Evolution of Repo Contracting Conventions in the 1980s,” Federal Reserve Bank of New
York Economic Policy Review 12 (May 2006): 27-42, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=918498.

133

To implement monetary policy, the Federal Reserve Bank of New York sets interest rates by borrowing and
lending Treasuries in the repo market from securities firms, many of which are units of commercial banks.

134

Ibid.

consequences in 2007 and 2008. In the 1980s, however, these new procedures stabilized the
market.
The new parallel banking system – with commercial paper and repo providing cheaper financing
for corporations and money market funds providing more profitable investment opportunities for
consumers and institutional investors – had a crucial catch: this popularity came at the direct
expense of the banks and the thrifts. Some regulators viewed the impact of this parallel banking
system on the commercial banking system with growing alarm. According to Alan Blinder, Vice
Chairman of Federal Reserve from 1994 to 1996:
We were concerned as bank regulators with the eroding competitive position of banks,
which of course would threaten ultimately their safety and soundness, due to the
competition they were getting from variety of nonbanks—and these were mainly Wall
Street firms, that were taking deposits from them, and getting into the loan business to
some extent. So, yeah, it was a concern; you could see a downward trend in the share of
banking assets to financial assets….135

As shown in the figure below, in the 1980s and the 1990s, the shadow banking system was
threatening to overtake the traditional banking sector, something that occurred for a time in the
2000s.

135

Alan Blinder interview.

The link ed image cannot be display ed. The file may hav e been mov ed, renamed, or deleted. Verify that the link points to the correct file and location.

Banks and thrifts argued that their problems competing with the shadowing banking institutions
stemmed from the regulations issued by the Federal Reserve and the Office of the Comptroller of
the Currency, pursuant to the Glass-Steagall Act of 1933. As noted, that landmark Depressionera legislation was prompted by the theory that bank runs and financial crisis had resulted from
too much risk-taking, which had in part stemmed from unbridled competition. Congress had
restricted the activities of banks and thrifts and toughened their regulation. These restrictions
included strict limitations on commercial banks’ involvement in the securities markets, in part
meant to put an end to the practices of the 1920s when banks sold highly speculative securities to
their depositors.136 In 1956, regulators had permitted the commercial banks and S&Ls to
amalgamate into bank holding companies and engage in some securities activities, but they had
to implement protections against transactions that might endanger any depository institution
under the umbrella. A bank holding company was allowed to establish subsidiaries that
136

Commercial banks became heavily involved in the securities markets during the 1920s, and many observers
argued that banks helped to promote the speculative boom that burst in 1929 and led to the Great Depression. 145
Cong. Rec. S13871-74 (daily ed. Nov. 4, 1999) (remarks of Sen. Wellstone); id. S13896-97 (remarks of Sen.
Dorgan); id. 145 Cong. Rec. H11530-31, H11542 (daily ed. Nov. 4, 1999) (remarks of Rep. Dingell).

underwrote or dealt in “bank-ineligible” securities as long as the subsidiaries were “not
principally engaged” –in fact only minimally engaged - in these activities. Strict “firewalls”
restricted the bank’s ability to lend to its securities subsidiaries.
Bank supervisors also monitored banks’ leverage – the amount of borrowing relative to their
assets – inasmuch as excessive leverage endangered a bank’s safety and soundness. In 1981,
bank supervisors put in place the first formal minimum capital standards.137 Relative to these
regulated institutions, Wall Street firms enjoyed the advantage of greater leverage in their
investments, unhindered by capital requirements or oversight of their safety and soundness. In
essence, leverage—employed by virtually all financial institutions and indeed a necessary
element of banking—is the use of borrowed money to conduct their business and amplify their
returns. To understand how it works, consider the following back-of-the-envelope example. If
an investor, such as an investment bank, uses $100 of its own money to purchase a security that
increases in value by 10%, the firm earns $10. However, if it borrows an additional $900 and
therefore invests ten times as much ($1,000), the same 10% increase in value yields a profit of
$100, ten times the return on its out-of-pocket investment (minus the cost of the loan). If the
investment goes sour, on the other hand, leverage magnifies the loss to the same degree. A
decline of 10% costs the unleveraged investor $10, leaving it with $90, but it wipes out the
leveraged investor’s $100 (with the cost of the loan on top of that). An investor borrowing that
much money is said to have a leverage ratio of 10:1, with the numbers representing the total
money invested relative to the value of its own assets that the investor has committed to the deal.

137

R. Alton Gilbert, Courtenay C. Stone, and Michael E. Trebing, “The New Bank Capital Adequacy Standards,”
May 1985, Federal Reserve Bank of St. Louis.

In contrast, the main participants in the shadow banking industry – the money market funds and
the securities firms that sponsored them – were not subject to the same safety-and-soundness
supervision as were banks and thrifts. The funds in this parallel banking industry came not from
insured depositors but principally from investors (in the case of money market funds) or
commercial paper and repo markets (in the case of securities firms). They were therefore
regulated by the Securities and Exchange Commission (SEC). But the mission of the SEC,
created in 1934, was to supervise the securities markets in order to protect stock and bond
investors against misrepresentations and fraud. It was charged with ensuring that issuers of
securities provide disclosures sufficient to enable investors to make informed decisions, and it
required firms that bought, sold, and brokered transactions in such securities to comply with a
variety of restrictions, such as keeping their customers’ funds in separate accounts and
maintaining proper records. Historically, the SEC did not focus on the safety and soundness of
individual firms. Deposit insurance did not cover any of the money-market mutual funds, for
example, so the government was not on the hook. There was little concern about a “run” on any
of these funds or institutions. In theory, the investors had knowingly put their money at risk. If a
given investment lost value, it lost value. If a firm failed, it failed.
As a result, money market funds faced no capital or leverage standards whatsoever. “There was
no capital requirement and there was no regulation,” former Federal Reserve Chairman Paul
Volcker told the Commission. “It was kind of a free ride.”138 The funds did have to abide by
regulations restricting the type of securities in which they could invest, the duration of those

138

Audio of FCIC interview of Paul Volcker, ca. 0:23:30.

securities, and the diversification of their portfolios.139 In combination, these requirements were
supposed to ensure that the investors’ money would not lose value and would be available for
redemption when their investors wanted it—important reassurance, but not the same as FDIC
insurance. The only protection against losses was provided by the implicit guarantee of sponsors
like Merrill Lynch that had reputations to protect.
Quite simply, on an increasing number of fronts, the traditional world of the Main Street banks
and thrifts were ill-equipped to keep up with the new parallel world of the Wall Street firms. The
new shadow banks had few constraints on how they raised and invested money, bolstering their
profitability. The iconic old institutions suffered a competitive disadvantage for raising funds
and for lending, and they therefore were in danger of losing their dominant position as
intermediaries between depositors and borrowers. The bind was labeled “disintermediation,” and
many critics of the system concluded that policy makers, going all the way back to the
Depression, had trapped the depository institutions into this unprofitable straitjacket not only by
capping the interest rates they could pay depositors and later imposing capital requirements, but
also by preventing the institutions from competing against the securities firms (and their money
market mutual funds). Moreover, critics broadly argued that the regulatory constraints imposed
on industries across the economy discouraged competition and restricted innovation. The
financial sector was cited as a prime example of the problems the critics decried.
As Federal Reserve Chairman Greenspan would describe the argument years later, “Those of us
who support market capitalism in its more-competitive forms might argue that unfettered

139

Under Rule 2a-7 of the Investment Company Act of 1940, money market funds cannot buy debts that mature In
more than 13 months, and they must keep the average maturity of their debts within 60 days or less. (This average
is weighted according to the amounts of money invested in each security.)

markets create a degree of wealth that fosters a more civilized existence. I have always found
that insight compelling.”140
The banks and the S&Ls went to Congress for redress of their grievances. In 1980, the
Depository Institutions Deregulation and Monetary Control Act repealed the limits on the
interest rates that the depository institutions could offer their customers. This legislation did
relieve the banks and thrifts of an important regulatory constraint, but it could not restore their
competitive advantage. Depositors wanted a higher rate of return, which the banks and thrifts
were now free to pay, but the interest they earned was largely fixed and could not fully match
their new costs. While their deposit base increased, they now faced an interest rate squeeze. In
1979, the advantage in interest earned from the safest investments (one-year Treasury notes)
versus interest paid on deposits was almost 5.5%; by 1994, it was only 2.6%. Thus the
institutions lost almost 3 percentage points of the funding advantage they had enjoyed when the
rates they could pay out were capped.141 This had not been the idea at all. The 1980 legislation
wasn’t to blame, but had it not solved all the competitive pressures facing the banks and thrifts.
That legislation was followed in 1982 by the Garn-St. Germain Act, which significantly
broadened the types of loans and investments that thrifts could make. The act also gave banks
and thrifts needed relief in the mortgage market. They had tended to rely on 30-year, fixed-rate
mortgages as the mainstays of their business. But the interest from these previously-issued
mortgages on the books could compete as the inflation surge of the mid 1970’s and early 1980’s
had eroded the value of the dollars they had loaned. Another grievance, another piece of
140

“International Financial Risk Management.” Remarks by Fed Chairman Alan Greenspan before the Council on
Foreign Relations, Nov. 19, 2002, available at
http://www.federalreserve.gov/boarddocs/speeches/2002/20021119/default.htm.
141

Id. at 239-41.

legislation. In the 1982 act, Congress acted to permit banks and thrifts to issue interest-only,
balloon-payment, and adjustable-rate mortgages (“ARMs”), even where state laws forbade
them.142 For consumers, interest-only and balloon-mortgages had the advantage of making
homeownership more affordable, but only in the short term. ARMs would lower borrowers’
rates when interest rates decreased, but had the disadvantage of raising their rates when interest
rates rose. For the banks, ARMs had the advantage of an interest rate that would float in
relationship to the rates they were paying to attract money from depositors. The floating
mortgage would protect the banks and S&Ls from yet another squeeze on their funding, but they
transferred the risk of interest rate movements to borrowers. Two decades later, the
consequences of this shift would be profound.
Still, traditional financial institutions continued to chafe against the regulations still in place. The
playing field wasn’t level, a fact of life that “put a lot of pressure on institutions to get higher rate
performing assets,” as former SEC Chairman Richard Breeden told the FCIC. “[A]nd they put a
lot of pressure on their regulators to allow this to happen.”143
Beginning in 1986, the Federal Reserve accommodated a series of requests from the banks to
undertake activities previously forbidden to them under the dictates of the Glass-Steagall Act and
subsequent modifications. They permitted subsidiaries of bank holding companies to engage in
‘bank-ineligible” activities, including selling or holding certain kinds of securities, as long as
such activities did not exceed 5% of the total assets or total revenue of any subsidiary. Over time,
however, the Fed relaxed these restrictions. By 1997, “bank-ineligible securities” could comprise

142

Garn-St Germain Depository Institutions Act of 1982, available at FDIC Law, Regulations, Related Acts,
Codified to 12 U.S.C. 226 note, available at http://www.fdic.gov/regulations/laws/rules/8000-4100.html
143

Transcript of FCIC interview with Richard Breeden, 5.

as much as 25% of the total assets or revenues while the Fed also weakened or eliminated
various other firewalls between traditional banking and securities activities.144
Meanwhile, the Office of the Comptroller of the Currency (OCC), the regulator of banks with
national charters, was expanding the scope of permissible activities for those banks to include
any activity that was “functionally equivalent to, or a logical outgrowth of, recognized bank
functions.”145 Among the previously prohibited but now authorized activities was the brokering
and trading of bets and hedges on the prices of certain assets, known as derivatives. We discuss
this subject in depth below, but note here that between 1983 and 1994, the OCC permitted banks
to deal in derivatives related to debt securities (1983), interest and currency exchange rates
(1988), stock indices (1988), precious metals such as gold and silver (1991), and stocks
(1994).146 The OCC’s permissive orders blurred the boundaries between the banks and the
securities firms because derivatives could reproduce the same risk-and-reward elements of
conventional securities.
Greenspan and many other regulators and officeholders supported and encouraged this policy
direction. They argued that financial institutions, operating under strong incentives to protect the
interests of their shareholders, would exercise self-regulation through improved risk
management. Likewise, financial markets would exert strong and effective discipline over

144

Thereafter, banks were only required to lend on collateral and set terms based upon what the market was offering.
They also could not lend more than 10 percent of their capital to one subsidiary or more than 20 percent to all
subsidiaries.
145

Julie L. Williams and Mark P. Jacobsen, ”The Business of Banking: Looking to the Future,” Business Lawyer 50
(May 1995), 783.
146

Saule T. Omarova, “The Quiet Metamorphosis: How Derivatives Changed the ‘Business of Banking’,” 63
University of Miami Law Review 1041 (2009), available at http://ssrn.com/abstract=1491767. See especially OCC
Interpretive Letter No. 892 (Sept. 13, 2000), www.occ.gov/static/interpretations-and-precedents/sep00/int892.pdf.

financial institutions through the activities of market analysts and investors. Greenspan proposed
that the urgent question regarding government regulation was whether it strengthened or
weakened private regulation. Speaking some years later, he would frame the issue this way:
financial “modernization” was needed to “remove outdated restrictions that serve no useful
purpose, that decrease economic efficiency, and that . . . limit choices and options for the
consumer of financial services.” Removing the barriers “would permit banking organizations to
compete more effectively in their natural markets. The result would be a more efficient financial
system providing better services to the public.”147
Over the course of the 1980s, banks and thrifts sought out loans that would generate higher
interest payments. They loaned money to oil-and-gas producers, they financed leveraged
buyouts of corporations, and they funded developers of residential and commercial real estate
projects. The largest of the commercial banks advanced money to companies and governments in
“emerging markets”—countries in Asia and Latin America that had only recently started to
develop high-powered economies. All of those lending categories offered the potential for higher
profits for banks and thrifts, but these new loans were inherently riskier—much riskier—than
their traditional lending. The results started coming in almost immediately, especially in the real
estate markets, which had seen a price bubble and massive overbuilding in both residential and
commercial sectors in certain regions. For example, house prices rose 7% per year in Texas from
1980 to 1985. In California, prices rose 13% annually from 1985 to 1990. The bubble burst first
in Texas in 1985 and 1986, surged across the Southeast to the Middle Atlantic States and New
England, then swept back across the country to California and Arizona. Before it was over,

147

H.R. 10, the Financial Services Competitiveness Act of 1997: Testimony of Fed chairman Alan Greenspan before
the House Committee on Banking and Financial Services (May 22, 1997), available at
http://www.federalreserve.gov/boarddocs/testimony/1997/19970522.htm.

national house prices declined 2.5% from July 1990 to February 1992 – the first drop in national
house prices since the Depression - driven by the steep drops in a number of regional markets.148
Spiraling defaults on their residential and commercial real estate loans shattered the thrift
industry. The banks also suffered heavy real estate losses, along with others on many of those
energy-related, leveraged-buyout, and overseas loans.149
In all, almost 3,000 commercial banks and thrifts failed in what became known—somewhat
unfairly for the thrifts—as the “S&L Crisis” of the 1980s and early 90s.150 By 1994, one out of
six federally insured depository institutions had either closed or required financial assistance,
affecting 20 percent of the banking system’s assets. Over 1000 bank and S&L executives were
convicted on felony charges stemming from the crisis [ck] . When the government cleanup was
complete, banks and thrifts failures had cost American taxpayers more than $130 billion, ($xx in
today’s dollars). The deposit insurance funds for the banks and thrifts picked up another $66
billion.151
* *

148

This data series is relatively new. Until [2009], available data series on house prices showed no national house
price decline. First American/CoreLogic, National HPI Single-Family Combined (SFC)

149

For a general overview of the banking and thrift crisis of the 1980s, see Federal Deposit Insurance Corp., History
of the Eighties: Lessons for the Future (1997), Volume I.

150

Specifically, between 1980 and 1994, 1,617 federally insured banks with $302.6 billion in assets and 1,295
savings and loans with $621 billion in assets either closed or received FDIC or FSLIC assistance. See Federal
Deposit Insurance Corp., Managing the Crisis: The FDIC and RTC Experience, 1980-1994 (Aug. 1998) [hereinafter
FDIC (1998)], at 5.
151

FDIC (1997), 186-87; FDIC (1998), 4, 28-29, 98, 807-08. For a more thorough discussion of government
rescues of banks and savings and loan companies, see Financial Crisis Inquiry Commission, Preliminary Staff
Report, “Governmental Rescues of ‘Too-Big-to-Fail’ Financial Institutions” (Aug. 31, 2010), at 9 [hereinafter FCIC
PSR on TBTF], available at http://www.fcic.gov/reports/pdfs/2010-0831-Governmental-Rescues.pdf. For data on
bank and thrift failures between 1980 and 1994, see Federal FDIC (1998), at 4-5, 28-29, 49, 289-91, 794-99 (Charts
C.1-C.6), 807-09 (Charts C.16-C.18), 860 (Table C.13), 862 (Table C.15).

Despite the S & L crisis and the passage of legislation to subject thrifts to bank like supervision,
the impulse toward deregulation continued apace, focusing on dismantling the existing
regulatory framework to allow regulated depository institutions to engage in more activities in
the capital markets –. In 1991, the Treasury Department issued an extensive study that called for
the complete dismantling of the old regulatory framework for banks, including the repeal of the
Glass-Steagall Act. The study urged Congress to repeal all restrictions on interstate banking,
under the belief that large nationwide banks closely tied to the capital markets would be more
profitable and more competitive with the largest banks from the United Kingdom, Europe and
Japan. The Treasury report contended that its proposed reforms would allow banks to embrace
“market innovation” and would produce a “stronger, more diversified financial system that will
provide important benefits to the consumer and important protections to the taxpayer.”152
The biggest banks pushed hard for Congress to enact the Treasury’s proposals, but in opposition
were insurance agents, real estate brokers, and smaller banks who believed that their businesses
would be threatened if the largest banks and their virtually bottomless pool of money were
turned loose to compete. These interests persuaded the House of Representatives to reject
Treasury’s proposal.[cite]
Also on the congressional mind were a spate of recent high-profile bailouts. In 1984, federal
regulators rescued Continental Illinois, the nation’s seventh-largest bank; in 1988, First Republic,
number 14; in 1989, MCorp, number 36; in 1991, Bank of New England, number 33.153 Prior to
their rescues, these banks had relied heavily upon uninsured deposits and other short-term
152

U.S. Treasury Dept., Modernizing the Financial System: Recommendations for Safer, More Competitive Banks
55 (Feb. 1991).

153

FDIC (1998), at 546, 596, 618, 636, 810; Timothy L. O’Brien, “Worries About Loans Revive Ghost of 1980’s
Bank Debacle, New York Times, July 16, 1998, at A1.

financing to pursue aggressive expansions, leaving them vulnerable to precipitous withdrawals
once confidence in their solvency evaporated. Deposits covered by the Federal Deposit
Insurance Corporation were protected from loss, but regulators felt obliged to protect the
uninsured depositors to prevent runs on even the even larger banks like Citicorp, Bank of
America and Chase Manhattan that reportedly lacked sufficient assets to satisfy their
obligations.154
During a hearing concerning the rescue of Continental Illinois, Comptroller of the Currency C.
Todd Conover stated that that federal regulators would not allow any of the eleven largest
“money center banks” to fail.155 This was new regulatory principle, and within moments it had a
catchy name. 156 Representative Stewart McKinney of Connecticut responded, “We have a new
kind of bank. . . . It is called ‘too big to fail’—TBTF—and it is a wonderful bank.”157
In 1990, during this era of federal rescues of large commercial banks, Drexel Burnham Lambert
– once the fifth largest investment bank – failed. Crippled by legal troubles and with losses in its
junk bond portfolio, it became the largest bankruptcy filing in US history to date when the firm
was unable to borrow in the commercial paper [ck] and repo markets. While creditors, including
other investment banks, were rattled and absorbed heavy losses, the government did not step in,
and Drexel’s failure did not cause a crisis. So far, it seemed that among all financial firms only
commercial banks were deemed too big to fail.

154

See Wilmarth (2002), 304-05 and 315, including footnotes.

155

Kaufman, Too Big to Fail in US Banking: Quo Vadis? Page 163

156

FCIC PSR on TBTF (2010), at 6-9.

157

Id. at 7 (quoting from transcript of hearing before the House Committee on Banking, Housing, and Urban
Affairs).

In 1991, Congress tried to restrict this “too big to fail” principle, passing the Federal Deposit
Insurance Corporation Improvement Act (FDICIA) to curb the use of taxpayer funds in rescuing
failing depository institutions. FDICIA mandated that the FDIC intervene early when a bank or
thrift got into trouble; if an institution did fail, the FDIC was required to resolve the matter with
the lowest-cost method to the FDIC insurance fund. However, the legislation undercut these
restrictions by opening two important loopholes. One exempted the FDIC from the least-cost
restrictions if it, the Treasury, and the Federal Reserve determined that the failure of a particular
institution posed a “systemic risk” to financial markets. The other loophole addressed a concern
raised by some Wall Street firms, Goldman Sachs in particular, that commercial banks had been
reluctant to provide help during previous market disruptions, such as Drexel’s failure. 158 They
successfully lobbied for an amendment to FDICIA, to authorize the Fed – for the first time ever
[ck] - to serve as a lender of last resort to investment banks by extending loans collateralized by
the investment banks’ securities.159
In the end, the legislation was a mixed message: you are not too big to fail—until and unless you
are too big to fail. As a result, the possibility of bailouts for the biggest, most centrally placed
institutions would remain an open question until the next financial crisis arrived 16 years later.160

158

Appelbaum & Irwin (2009). See also Wessel (2009), at 160-61.

159

Id at 10 (quoting 12 U.S.C. § 1823(c)(4)(G)(i))..

160

Id. at 10-11.

Part I, Chapter 2. Growth of the GSEs and securitization: “the whole army of lobbyists”

Contents
2. Growth of the GSEs and securitization: “the whole army of lobbyists” .................................. 85
Structured Finance: “it wasn’t reducing the risk” ..................................................................... 94
Growth of derivatives “Essentially fighting the last war”....................................................... 100

The crisis in the thrift industry created an opening for Fannie Mae and Freddie Mac, the two
massive government-sponsored enterprises (GSEs) created by Congress to provide financing for
the home mortgage market.161 Explaining their central role in the mortgage market requires a
quick history lesson.
Fannie Mae (officially, the Federal National Mortgage Association) was chartered by the
Reconstruction Finance Corporation during the Depression—1938, specifically—to provide a
secondary market for mortgages insured by the Federal Housing Administration or FHA. The
new agency would purchase mortgages that adhered to FHA’s underwriting standards, thus
virtually guaranteeing the supply of mortgage credit that lenders could extend to homebuyers.
Fannie Mae either held the mortgages or, less often, resold them to savings and loans (S&Ls),
insurance companies, or other investors. After World War II, it was authorized to provide the
same service for home loans guaranteed by the Veterans Administration (VA).
This system worked well. But, the agency funded its growing mortgage holdings by issuing
increasing amounts of debt. By 1968, Fannie’s mortgage portfolio had grown to $7.2 billion and

161

Fannie Mae is short for the Federal National Mortgage Association, established by Congress as a GSE in 1968.
Freddie Mac is short for the Federal Home Loan Mortgage Corporation, established by Congress in 1970.

the debt to finance its portfolio was weighing on the federal government’s balance sheet. To
address this issue, Congress reconstituted Fannie and created the new Ginnie Mae (officially the
Government National Mortgage Association). Ginnie Mae took over responsibility for the old
Fannie’s subsidized mortgage programs and the government’s loan portfolio and shortly after its
creation began guaranteeing pools of FHA and VA mortgages. The new Fannie was now a
“government-sponsored enterprise” (GSE) - a publicly traded corporation that still purchased
federally insured mortgages.
Two years later, in 1970, at the request of the savings and loan industry, Congress chartered a
second GSE, Freddie Mac (officially, the Federal Home Loan Mortgage Corporation), to help
serve thrifts wanting to sell their mortgages. This legislation also authorized Fannie and Freddie
to expand their purchases to include “conventional” mortgages—that is, mortgages not backed
by either the FHA or the VA – up to a specified mortgage size. These conventional mortgages
were stiff competition to FHA mortgages as they could be issued more quickly and had lower
fees. Still, the conventional mortgages did have to conform to the GSEs’ loan size limits and
existing underwriting guidelines, such as debt-to-income and loan-to-value ratios. The GSEs
could only purchase these “conforming” mortgages.

Before 1968, Fannie had bought mortgages, and generally held them. Fannie Mae made money
from the difference – or spread - between its cost of funds and the interest rates on the mortgages
it held. The 1968 and 1970 laws gave Ginnie, Fannie Mae, and Freddie Mac a new option:
securitization. In 1970, Ginnie began doing just that: a lender would assemble a “pool” of
mortgages and Ginnie would issue a guarantee of timely payment of principal and interest on
that security backed by the full faith and credit of the U.S. government. For providing this
86

guarantee, Ginnie charged a fee. In 1971, Freddie adopted this same basic model, with some
differences. Unlike Ginnie, which could not purchase mortgages, Freddie would purchase
mortgages, pool them, and then sell mortgage-backed securities to investors. It would guarantee
to those investors timely payment of principal and interest from the pool of mortgages. Like
Ginnie, Freddie made money by collecting guarantee fees from investors in their mortgagebacked securities. In 1981, after interest rates had spiked leading to large losses on its portfolio
of mortgages, Fannie finally followed suit. During the 1980s and 1990s, the conventional
mortgage market expanded, the GSEs grew in importance, and the market share of FHA and VA
mortgages declined. By 2000, the GSEs guaranteed or purchased 39% of originated mortgages
and FHA insured 11%.162
Fannie and Freddie had a dual mission: the “public” one of supporting the mortgage market and
the “private” one of seeking maximum returns for shareholders. They did not originate
mortgages, they purchased them – from banks, thrifts, and mortgage companies, and either held
them in their portfolios or securitized and guaranteed them. Congress granted both enterprises
special privileges, such as exemptions from state and local taxes (not property taxes) and a $2.25
billion line of credit each from the Treasury. The Federal Reserve Banks provided various
services for them such as electronically clearing payments for GSE debt and securities as if they
were Treasury bonds. Taken together, the two GSEs’ charters, mandate, and federal perks
created the perception among investors and creditors that their mortgage-backed securities and
their debt enjoyed the implicit guarantee of the U.S. government. Investors believed their
securities were almost as safe as Treasury bills. This is why Fannie and Freddie could borrow
162

Taking dollar volume of mortgages originated in 2000, FHA mortgages were 11% of the total and GSEs were
39% of the total. [Source: IMF Mortgage market Statistical Annual, vol1, for FHA and totals; and FHFA report to
congress for Fannie/Freddie mortgage purchases]

money at rates almost as low as the Treasury paid. Under the law, banks, thrifts, and investment
funds were allowed to invest in GSE securities with favorable capital requirements and without
limits, and they just about did. By contrast, banking laws and regulations strictly limited the
amount of loans a bank could extend to any one borrower and restricted a bank’s authority to
invest in debt obligations of other firms. And, the GSEs had to hold very little capital –
investors’ money at risk – in contrast with banks and thrifts.
Mortgages are long-term assets typically funded by short-term borrowings. For thrifts, these
“short-term borrowings” were generally deposits. Fannie funded its mortgage portfolio with
short and medium-term debt. In 1979, when the Fed hiked short-term interest rates to quell
inflation, Fannie, like the thrifts, found that its cost of funding rose while its income on
mortgages did not. As a result, in the mid-1980s, the Department of Housing and Urban
Development (HUD) estimated that Fannie had a negative net worth of $10 billion on a marketvalue basis.163 Freddie emerged from this episode unscathed because of the GSE’s early
adoption of securitization—unlike Fannie at the time, its primary business was guaranteeing
mortgage-backed securities, not holding mortgages in their portfolio.
To help Fannie, in 1982, Congress stepped in with tax relief and its supervisor, HUD, stepped in
with regulatory forbearance and relaxed capital requirements. Failure was averted.164 These
efforts were consistent with lawmakers’ repeated proclamations that a vibrant market for home
mortgages served the best interests of the country. However, they also served to reinforce the

163

Department of Housing and Urban Development, 1986 Report to Congress on the Federal National Mortgage
Association, 1986, p. 100.
164

The government also supported the Farm Credit System (in the form of emergency funding through the Farm
Credit System Financial Assistance Corp.) after that GSE failed in 1985, and bailed out the Funding Corporation in
1996.

markets’ impression that the government would not abandon Fannie and Freddie, no matter what
might happen. Investors were willing to accept very low returns on GSE-issued debt obligations
and GSE-guaranteed mortgage-backed securities because they believed there was almost no risk.
Fannie and Freddie would soon buy and either hold or securitize mortgages worth hundreds of
billions of dollars, then trillions. Among the investors were US banks, thrifts, investment funds,
and pension funds as well as central banks and funds around the world. This systemic
commitment would put even more pressure on regulators to protect the value of those securities.
Fannie and Freddie were too big to fail. That’s what everyone in the markets assumed.
Even after the government aided Fannie, it further boosted Fannie’s and Freddie’s competitive
position in the mortgage market. For one, measures to toughen regulation of the thrifts following
the savings and loan crisis had the effect of strengthening the GSEs. Thrifts had previously
dominated the mortgage business as large holders of conforming mortgages. In the Financial
Institutions Reform Recovery and Enforcement Act of 1989 (FIRREA), Congress subjected the
thrifts to much tougher bank-style capital requirements and safety and soundness regulations. By
contrast, in the Federal Housing Enterprises Financial Safety and Soundness Act of 1992,
Congress subjected the GSEs to a weaker form of regulation and created a weak supervisor, the
Office of Federal Housing Enterprise Oversight (OFHEO), which lacked the legal powers of
bank and thrift supervisors in enforcement, capital requirements, funding, and receivership
authority. These decisions – cracking down on the thrifts while providing a comparatively easier
regime for the GSEs – were no accident. The GSEs had marshaled immense political power,
which they applied during the writing of the 1992 Act. Their efforts paid off, at least in the short

term.165 Outside the GSEs, critics worried that the GSEs’ structure - a publicly traded company
with the implicit backing of the government - was not sustainable. Moreover, “OFHEO was
structurally weak and almost designed to fail,” Armando Falcon, a former director of the agency,
told the FCIC.166
Fannie and Freddie thus enjoyed substantial competitive advantages: lower capital standards,
weaker financial oversight, tax and regulatory advantages, and cheaper access to the capital
markets. In effect, they enjoyed a generous subsidy. One 2005 study put the value of that
subsidy—calculating its current and future benefits—at a total of $122 billion or more and
estimated that over half of the benefits of the subsidy went to shareholders of the two companies,
not to homebuyers.167
Given these circumstances, regulatory arbitrage worked as it always does: the markets shifted
activities and attendant risks to the least-cost, least-regulated havens. After the imposition of
tougher capital requirements on thrifts in the wake of the S&L crisis, it became increasingly
profitable for them to securitize with or sell their conforming loans to Fannie and Freddie. The
stampede was on. The dollar value of Fannie’s and Freddie's total debt obligations and
mortgage-backed securities outstanding grew from $768 billion in 1990 to $1.3 trillion in 1995
and $2.4 trillion in 2000.168 The annual share of newly originated mortgages that the GSEs
purchased or guaranteed in those years rose hit a high of 52%.
* *
165

See, e.g., Kenneth H. Bacon, “Privileged Position: Fannie Mae Expected to Escape Attempt at Tighter
Regulation,” Wall Street Journal, June 19, 1992, p. A1, and Stephen Labaton, “Power of the Mortgage Twins:
Fannie and Freddie Guard Autonomy,” New York Times, November 12, 1991, p. D1.
166
Testimony of Armando Falcon Submitted to the Financial Crisis Inquiry Commission, April 9, 2010.
167
Wayne Passmore, The GSE Implicit Subsidy and the Value of Government Ambiguity, Federal Reserve Board
Staff Working Paper 2005-05, See also Congressional Budget Office, Updated Estimates of the Subsidies to the
Housing GSEs (April 8, 2004).
168
Source: Federal Housing Finance Agency, Annual Report 2010; Inside Mortgage Finance.

The legislation that rechartered Fannie in 1968 also authorized the Department of Housing and
Urban Development (HUD) to prescribe affordable housing goals: “The [HUD] Secretary may
require that a reasonable portion of the corporation’s mortgage purchases be related to the
national goal of providing adequate housing for low and moderate income families, but with
reasonable economic return to the corporation.”169 In 1978, HUD tried to implement the law and,
after a barrage of criticism from the GSEs and the mortgage and real estate industries, issued a
weak affordable housing goal regulation.170 The 1992 legislation extended HUD’s authority to
set affordable housing goals for Freddie as well, and Congress also refined the language used in
the 1968 act.171 Now, in the instance of affordable housing, “a reasonable economic return…
may be less than the return earned on other activities.”172 The law required that, in establishing
goals for the GSEs, the HUD Secretary should consider “the need to maintain the sound financial
condition of the enterprises.”173 The act specified that the HUD Secretary establish goals for lowand moderate-income housing; special affordable housing; and housing in central cities, rural
areas, and other underserved areas. HUD would periodically set as the goal for each category a
percentage of the GSEs’ total mortgage purchases.
In 1995, President Clinton announced an initiative aimed at boosting homeownership to 67.5%
of families by 2000 – it stood at 65.1% in 1995. One component of the initiative was increased
169

Fannie Mae Charter Act, Sec. 309(h), codified at 12 U.S.C. Sec. 1723a(h). The 1992 Act repealed this provision
and replaced it with more elaborate provisions.
170

Department of Housing and Urban Development, "Regulations Implementing the Authority of the Secretary of
the Department of Housing and Urban Development over the conduct of the Secondary market Operations of the
Federal National Mortgage Association (FNMA)," 43 Federal Register No. 158, pp. 36199-36226, August 15, 1978.
171

Federal Housing Enterprises Financial Safety and Soundness Act.

172

Fannie Mae charter act, Sec. 301 (3) and Freddie Mac charter act, Sec. 301(b)(3), as applied by the 1992 Act,
Section 1331(a), codified at 12 U.S.C. Sec. 4561(a).
173

1992 Act, Secs. 1332 (b), 1333(a)(1), and 1334(b).

affordable housing goals at the GSEs. Since 1993, close to 2.8 million households had become
new homeowners, nearly twice as many as in the previous two years. “But we have to do a lot
better,” Clinton said. “This is the new way home for the American middle class. We have got to
raise incomes in this country. We have got to increase security for people who are doing the right
thing, and we have got to make people believe that they can have some permanence and stability
in their lives even as they deal with all the changing forces that are out there in this global
economy.”174 The push to expand homeownership would continue in the years ahead under
President Bush.
Fannie and Freddie were mainstays of the nation’s housing market, but their dual mission—
promoting mortgage lending while maintaining their duty to shareholders—was always
problematic. Former Fannie CEO Daniel Mudd suggested to the FCIC that the GSE model
might work well enough in good times but would be unworkable in the financial crisis of 2007
and 2008: “The GSE structure required the companies to maintain a fine balance between
financial goals and what we call the mission goals....the root cause of the GSEs' troubles lies
with their business model.”175 Former Freddie CEO Richard Syron concurred, “I don’t think it’s
a good business model.”176
Because the entities were highly dependent on subsidies and the implicit government guarantee,
and were also subject to regulation, affordable housing goals, and legislatively constrained
capital standards, they were politically active. From 1998 to 2008, the two GSEs together
reported spending $163 million on lobbying.[cite] [add information about political
174

President William J. Clinton, “Remarks on the National Homeownership Strategy,” June 5, 1995.

175

Daniel Mudd, statement to the FCIC, April 9, 2010, transcript at pp. 18-19

176

Richard Syron interview transcript, August 31, 2010, p. 29.

contributions] Falcon, OFHEO’s director from 1999 to 2005, testified that the “Fannie and
Freddie political machine resisted any meaningful regulation using highly improper tactics” and
that “OFHEO was constantly subjected to malicious political attacks and efforts of
intimidation.”177 James Lockhart, the director of OFHEO and its successor FHFA from 2006
through 2009, testified that he sought GSE reform legislation from the moment he became
director and that the “companies were so politically strong that for many years they resisted the
very legislation that might have saved them.”178 Former HUD Secretary Mel Martinez described
for the FCIC staff “the whole army of lobbyists that continually paraded in a bipartisan fashion
through my offices...It’s really amazing the number of people that were in their employ.”179
In 1995, that army helped attain new regulations allowing the GSEs to count toward their
mission goals not just their whole loans, but also their mortgage-related securities, whether these
securities were issued by the GSEs or securitized in the private market. The GSEs wanted to
profit by investing in these so-called “private-label” mortgage securities and, to the extent that
the underlying mortgages qualified, could now get credit for meeting their affordable housing
goals. Congressional Budget Office Director June O’Neill commented on the ease with which
the GSEs met their affordable housing goals in the 1990s: “[T]he goals are not difficult to
achieve, and it is not clear how much they have affected the enterprises’ actions. In fact

177

Falcon written testimony at

178

Lockhart written testimony at 4-8, 16-17.

179

Senator Mel Martinez interview, September 28, 2010, at 10:00

...depository institutions as well as the Federal Housing Administration devote a larger
proportion of their mortgage lending to targeted borrowers and areas than do the GSEs.”180
Something else was clear: Fannie Mae and Freddie Mac were immensely profitable throughout
the 1990s, thanks in large part to their low borrowing costs and their lax capital requirements. In
2000, Fannie Mae had a return on equity of 26%; Freddie Mac, 39%. That year, Fannie Mae and
Freddie Mac stood astride the mortgage market. Together they held or guaranteed over $2 trillion
of mortgages.
Structured Finance: “it wasn’t reducing the risk”
While Fannie and Freddie enjoyed a virtual monopoly on the securitization of conforming
mortgages, by the 1980s, the markets began to securitize a wide array of other types of loans,
including mortgages not eligible for purchase by the GSEs – the so-called private-label or nonagency mortgage securities. The basic mechanism worked the same in all cases: a securities firm,
such as Lehman Brothers or Morgan Stanley (or a securities affiliate of a bank) helped to bundle
a collection of loans from a bank or other lender into securities and then sell these securities to
investors, who would receive the principal and interest payments from the pool of loans.
Investors could then hold or trade these securities in the marketplace. Many of these new
securities would be more complicated than the GSE’s basic mortgage-backed securities; the
bundled assets included not just mortgages but also equipment leases, credit card debt, auto
loans, and manufactured housing. Over time, banks and securities firms used securitization to
replicate the activities of the banking system outside of the regulatory framework set up for
banks. For example, whereas banks used to take money from deposits to make loans to

180

Remarks of June E. O’Neill Director, Congressional Budget Office before the Conference on Appraising Fannie
Mae and Freddie Mac, May 14, 1998.

businesses and hold those loans to maturity, securities firms now would use money from the
capital markets -- often provided by money market mutual funds -- to arrange loans to
businesses, packaging those loans into securities held by investors.
For the commercial banks, the benefits of securitization were large. It moved assets off their
books. Holding fewer loans, the banks could then hold less capital as protection against losses,
improving the return for their investors. Securitization also enabled banks to reduce their
reliance on deposits for cash, because the sale of securities raised cash that could be used to
make additional loans. Or, banks could keep a portion of the securities on their books; using
them as collateral for borrowing. Fees on the securitization business became an important source
of revenues.
Larry Lindsey, former Federal Reserve Governor and Director of the National Economic Council
under President George W. Bush, told the FCIC that because of previous housing downturns that
affected banks, regulators did not like banks to hold whole loans on their books. He said, “If you
had a regional…real estate downturn it took down the banks in that region along with it, which
exacerbated the downturn. So we said to ourselves, ‘How on earth do we get around this
problem?’ And the answer was, ‘Let’s have a national securities market so we don’t have
regional concentration.’ … It was intentional.”181
Structured finance securities had two key features designed to benefit investors: pooling and
tranching. A large number of loans pooled into one security would cushion the losses from a
few defaults; the vast majority of the payments would come through on schedule. Structured
finance securities also could be sold in tranches, which allowed payments for a given
181

Lindsey audio

securitization to be customized to suit individual buyers’ preferences. Risk-averse investors
would buy tranches that would be paid first, but receive lower yields. Return-oriented investors
would buy tranches that were paid higher yields but ran a greater risk of losing their investment
should too many borrowers defaulted.182 Bankers often used the analogy of a waterfall, with the
holders of the more senior tranches – at the top of the waterfall – being paid before the more
junior tranches. And if payments came in below expectations, then those at the bottom of the
waterfall could be left dry.
Securitization was designed to provide benefits to both parties to the transaction. The issuers of
these bonds received a better price for securities composed of bundled loans than they would
have received for selling those loans individually, because the securities were customized to
investors’ needs, more diversified, and could be easily traded. The purchasers of the safer
tranches got a higher rate of return than they could have achieved with ultra-safe Treasury notes,
with not much extra risk—at least in theory. However, the financial engineering behind these
investments made them harder to understand and to price than individual loans. To determine
their probable returns, investors had to calculate statistical probabilities of particular proportions
of the loans defaulting, and the revenues lost due to these defaults. Then they had to examine the
priority of the payment streams to determine the effect of these losses on the returns.
This complexity turned the three leading credit rating agencies—Moody’s, Standard & Poor’s or
S&P, and Fitch—into key players in the securitization process, sitting between the issuers and
the ultimate investors. Prior to the increased use of securitization, these agencies had primarily
helped investors make decisions about whether to buy municipal and corporate bonds and

182

Audio of FCIC interview of Vincent Reinhart, ca. 0:7:00.

commercial paper by issuing ratings that succinctly summarized the safety of those
obligations. They did this by analyzing the financial condition of corporations or government
agencies issuing that debt. Securitization was a perfect opportunity to expand their business and
increase their revenues. The ratings agencies would evaluate the new securities and publicize
their ratings, and investors would rely upon these ratings in making their investment decisions.
While evaluating probabilities was their stock in trade, ratings these securities would require
more complex analysis than they had previous undertaken. “The rating agencies were important
tools to do that because you know the people that we were selling these bonds to had no history
in the mortgage business…They were looking for an independent party to develop an opinion,”
Jim Callahan, CEO of PentAlpha, which provides services to the securitization industry and who
worked on some of the earliest securitizations, told the FCIC.183
With the pieces in place – banks that wanted to shed assets and transfer risk, investors ready to
put money to work, securities firms poised to make fees, rating agencies ready to expand, and
information technology ready to handle the job -- the securitization market grew by leaps and
bounds. By 1999—at which point the market was all of 16 years old—about $900 billion of
securitizations, beyond those done by Fannie, Freddie and Ginnie, were outstanding, including
$114 billion of automobile loans, $250 billion of credit card debt, and $70 billion of other types
of assets, such as manufactured housing loans and student loans. Over half a trillion dollars were
mortgages that were ineligible for securitization by Fannie and Freddie. Many of these were
subprime, a subject we will return to shortly.

183

Audio of FCIC interview with Jim Callahan, 0:18:18.

The link ed image cannot be display ed. The file may hav e been mov ed, renamed, or deleted. Verify that the link points to the correct file and location.

Securitization was a boon for the commercial banks and it also provided a lucrative new line of
business for the Wall Street establishment, with which the commercial banks worked to create
the new securities. (Soon enough, as we will see, the banks set up their own securitization
operations, and the Wall Street firms bought their own mortgage lenders.) The Wall Street firms
such as Salomon Brothers and Morgan Stanley became major players in the securitization
market. They were set up perfectly for the business of using the fastest computers to create
complex new investments and then finding investors to buy them. They adjusted their business
practices to accommodate the new markets. As early as the 1970s, Wall Street executives had
hired “quants”—such as mathematicians—to develop models that would represent how various
markets or securities behaved and predict how they might change over time. Securitization only
increased the importance of this expertise. Scott Patterson, author of the The Quants, told the
FCIC that the trend toward models dramatically changed finance. “Wall Street now floats on a

sea of mathematics and computer power,” Patterson said.184
The increasing reliance upon mathematics allowed the quants to create more complex products
and their managers to say, and maybe even believe, that they could better manage the risks
associated with those products. JP Morgan developed the first “Value at Risk” model, with
different versions and copycats soon adopted throughout the industry. These models purported to
pin down how much a firm could lose with at least 95% certainty, but it would turn out that the
unaccounted-for fraction was where the real risk lay. The modeling assumptions relied on
limited historical data; for mortgage-backed securities, they would turn out to be woefully
inadequate in a crunch. And, modeling human behavior was different from the problems the
quants had addressed in graduate school. “It isn’t like trying to shoot a rocket to the moon where
you know the law of gravity,” Emanuel Derman, a Columbia University finance professor who
worked at Goldman Sachs for 17 years, told the Commission. “The way people feel about
gravity on a given day isn’t going to affect how the rocket behaves.”185
The rapid rise of securitization raised concerns. Paul Volcker, Fed Chairman from 1979 to 1987,
said regulators were concerned as early as the late 1980s that once banks securitized the loans
they were making, “they’re not going to pay any attention to the credit.” Yet, as these
instruments became increasingly complex, regulators relied more and more on the firms
themselves to police their own risks. After all, risk management models such as Value at Risk
suggested that firms had matters well in hand. “It was all tied up in the hubris of financial

184

FCIC interview of Scott Patterson, taken from MFR of interview at p1, 8/12/2010, available on NetDocs
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4820-7084-4167&open=Y

185

FCIC interview of Emmanuel Derman, May 12, 2010, available at net docs at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4831-0115-7127&open=Y

engineers, but the greater hubris let markets take care of themselves,” Volcker told the FCIC.186
Vincent Reinhart, former Director of the Fed’s Division of Monetary Affairs, told the
Commission that he thought that he and his fellow regulators had failed to appreciate the
complexity and the difficulties complexity posed for all the market participants--financial firms,
investors, and creditors—in assessing risk.187
Lindsey saw the failures of securitization in hindsight. “It was diversifying the risk. But it
wasn’t reducing the risk. And that was one of the big confusions at the time…You as an
individual can diversify your risk. The system as a whole though cannot reduce the risk. And
that’s where the confusion lies.”
Of course, the complexity was also a problem for the credit rating agencies. What chance did
they have of truly understanding the new products? And what motive?
Growth of derivatives “Essentially fighting the last war”
During the financial crisis, the issues of leverage and complexity became closely identified with
one element of the story: derivatives. In essence, a derivative is simply a financial contract
whose price is determined, or “derived,” from the value of some underlying asset, rate, index or
event. They are not used for capital formation or investment, but rather they are instruments for
hedging business risk or speculation on changes in prices, interest rates, and the like. They come
in many forms, the most common being exchange-traded futures and options and over-thecounter swaps.188 They may be based on commodities (including agricultural products, metals
186

FCIC interview with Paul Volcker.

187

Audio of FCIC interview with Vincent Reinhart, Sept. 10, 2010, at 0:34:24.

188

Definition of futures, options and swaps

100

and energy products), interest rates, currency rates, equity securities, and credit risk. They can
even be tied to events such as hurricanes or announcements of government data. One example is
a futures contract that provides a farmer with the opportunity to effectively lock in a price on his
crop prior to harvest and sale. Another type is an interest rate swap, in which two parties agree to
exchange a floating interest rate payment for a fixed-rate payment. Many financial and
commercial firms use derivatives. For example, pension funds, which are generally risk-averse,
sometimes use such swaps to reduce the inflation risk and interest-rate risk of their investment
portfolios by transferring them to risk-taking entities, such as hedge funds. In addition to
hedging, derivatives can also be used for the purpose of speculating, which is when a firm or
individual takes a derivatives position in hopes of profiting on the rise or fall of a price or rate.
There are two basic ways the derivatives markets are organized, as exchanges or over-thecounter markets, although some recent electronic trading facilities blur the traditional
distinctions. The oldest U.S. exchange is the Chicago Board of Trade, where futures and options
are traded. Such exchanges are regulated by federal law and play a useful role in price discovery
– meaning the views of market participants’ views on prices - relating to the underlying
commodities or rates. Over-the-counter (OTC) derivatives are traded by large financial
institutions, traditionally bank holding companies and investment banks, which act as derivatives
dealers, buying and selling contract with their customers. Unlike the futures and options
exchanges, the OTC market is not centralized or regulated. Nor is it transparent, limiting its
benefits for price discovery. No matter the measurement used—trading volume, dollar volume,
risk exposure— derivatives represent a very significant sector of the U.S. financial system.

101

The principal legislation governing these markets is the Commodity Exchange Act, first passed
in 1936 and originally applied only to domestic agricultural futures.189 In 1974 the Act was
amended to require that futures contracts on all commodities including financial instruments
must be traded on a regulated exchange and to create a new federal independent agency, the
Commodity Futures Trading Commission (CFTC), to regulate and supervise the market.
Outside of this regulated market, an over-the-counter market in derivatives began to develop and
grow rapidly in the 1980s. The large financial institutions that were acting as over-the-counter
derivatives dealers were concerned that the exchange-trading requirement of the Commodity
Exchange Act might be applied to the products they were buying and selling. In 1993, the CFTC
sought to address these concerns by exempting certain non-standardized OTC derivatives from
the exchange-trading requirement and from certain other provisions of the Act, except for
prohibitions against fraud and manipulation.
As the OTC market grew in the wake of the CFTC’s 1993 action, there was a wave of
spectacular losses and scandals in the market. Among the many examples, in 1994, Proctor and
Gamble reported the largest derivatives losses ever by a non-financial firm, stemming from OTC
interest and foreign exchange rate derivatives sold to them by Bankers Trust. Proctor and
Gamble sued Bankers Trust for fraud – a suit Bankers Trust settled by forgiving most of the
money P and G owed the bank. That same year, the CFTC and the Securities and Exchange
Commission (SEC) fined Bankers Trust $10 million for misleading Gibson Greeting Cards on
interest rate swaps that resulted in losses to the company, which were more than double its prior
year profits. In late 1994, Orange County in California announced it had lost $1.5 billion on its

189 The Black-Scholes model is named for the two economists who developed it, Fischer Black and Myron Scholes.

102

speculation in OTC derivatives. As a result, the county filed for bankruptcy – the largest filing
of a municipality in U.S. history.190 Its derivatives dealer, Merrill Lynch, paid $400 million to
the county to settle claims related to the losses.191
Then, in 1996, Sumitomo Corporation lost $2.6 billion on copper derivatives traded on a London
exchange. The CFTC charged the company with using derivatives to manipulate copper prices,
including the use of OTC derivatives contracts to disguise the speculative nature of its
transactions. The company settled the matter, paying $150 million in penalties and restitution.192
The CFTC also charged Merrill Lynch with knowingly and intentionally aiding, abetting, and
assisting the manipulation of copper prices; it settled for a fine of $15 million.
Debate over the regulation of over-the-counter derivatives intensified during the spring of 1998.
In May, the CFTC under the leadership of Chairperson Brooksley Born issued a formal “concept
release” that announced that it would be reexamining its regulatory approach to the OTC
derivatives market given the rapid evolution of the market and the recent string of major losses
tied to derivatives since 1993. The CFTC requested comments and it got them.
Other financial regulators took the unusual step of publicly criticizing these efforts of the CFTC.
Treasury Secretary Robert Rubin, Federal Reserve Chairman Alan Greenspan, and SEC
Chairman Arthur Levitt issued a joint statement denouncing the concept release the day it was
issued. The statement read, “We have grave concerns about this action and its possible
consequences…We are very concerned about reports that the CFTC's action may increase the
190

http://www.pbs.org/wgbh/pages/frontline/warning/etc/warnings.html,
http://money.cnn.com/magazines/fortune/fortune_archive/1995/03/20/201945/index.htm
191

http://www.cftc.gov/opa/speeches/opaborn-33.htm

192

http://www.financialpolicy.org/DSCSPB3.htm

103

legal uncertainty concerning certain types of OTC derivatives.”193 They proposed a statutory
moratorium prohibiting the agency from regulating over-the-counter derivatives.
For months, the three co-signers of the joint statement, joined by Deputy Treasury Secretary
Larry Summers, actively opposed the CFTC’s efforts through testimony in Congress and public
pronouncements. In October, Congress would pass the moratorium just a few weeks after the
Federal Reserve Bank of New York had orchestrated a $3.6 billion bailout of Long Term Capital
Management by the major OTC derivatives dealers. LTCM had managed to amass $1.25 trillion
in OTC derivatives on $4 billion of capital without the knowledge of its major derivatives
counterparties or any federal regulator.194 Afterward, Greenspan noted that it was the New York
Fed’s judgment that allowing a forced liquidation of LTCM “would not only have a significant
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 involved with LTCM.”195
In 2000, in the wake of these events, Congress passed and President Clinton signed the
Commodity Futures Modernization Act of 2000 (CFMA), which effectively deregulated the
OTC derivatives market and eliminated market oversight by both the CFTC and the SEC. The
CFMA also preempted the application of state laws on gaming and bucket shops that could have

193

http://www.ustreas.gov/press/releases/rr2426.htm

194

Define notional amount of a derivative contract.

195

Hedge Fund Operations: Hearing Before the House Comm. On Agriculture, Nutrition, and Forestry, 105th Cong.
5 (1998).

104

made OTC derivatives transactions illegal.196 The SEC did retain anti-fraud authority over
securities based OTC derivatives such as stock options.
The law effectively shielded derivatives from virtually all government regulation or oversight.
Subsequently, other laws were adopted that encouraged the expansion of this market. For
example, under a 2005 amendment to the bankruptcy laws, derivatives counterparties were given
advantages over other creditors because they can immediately terminate their contracts at the
time of bankruptcy.
The over-the-counter derivatives market boomed. As of year-end 2000 when the CFMA was
passed, the notional amount of OTC derivatives outstanding globally was $95.2 trillion, and the
gross market value was $3.2 trillion. In the more than seven years from that time until June
2008, outstanding OTC derivatives had increased more than seven fold to $683.8 trillion in
notional amount; their gross market value was $20.4 trillion. Subsequently, other laws were
adopted that encouraged the expansion of this market.
[Quotes from Rubin, Greenspan, and Summers re their reflections on CFMA]
As discussed above, financial firms may use derivatives to hedge or manage their risks. Such
use of derivatives can lower a firm’s “Value at Risk” in the computer models introduced above.
In addition to this risk management advantage, such hedges can lower the amount of capital
banks are required to hold thanks to a 1996 amendment to the regulatory regime known as the
Basel International Capital Accord or “Basel I.” Meeting in Basel, Switzerland, in 1988, the
world’s central banks and bank supervisors adopted a set of principles to guide banks’ capital
standards, and US banking regulators adopted the Basel I capital rules to implement them.
196

A bucket shop is a fraudulent stock-selling operation..

105

Among the most important principles was the requirement for banks to hold more capital against
riskier assets. Fatefully, the Basel rules would loosen capital requirements for mortgages and
mortgage-backed securities relative to all other assets related to corporate and consumer loans.
Indeed, capital requirements for banks’ holdings of Fannie and Freddie securities were less than
all other assets except those explicitly backed by the full faith and credit of the US government.
As it turned out, these international capital standards accommodated the shift to increased
leverage. In 1996, large banks sought more favorable capital treatment for their trading activity,
and the Basel Committee on Banking Supervision adopted the Market Risk Amendment to Basel
I. This amendment provided that if these banks were hedged, they would not have to hold as
much capital against their exposures stemming from trading and other activities.
However, the use of OTC derivatives carried a great deal of risk itself. It enabled derivatives
traders, including the large banks and investment banks, to increase their leverage, which proved
dangerous during the financial crisis, as we will see. The increase in leverage could work like
this: Entering into an equity swap that mimicked the same returns as owning the actual stock
may have had some upfront costs, but the amount of collateral posted when initiating such a
derivatives transaction was always much smaller than the upfront cost of purchasing the stock
directly. Often there was no collateral required at all. Thus traders could use derivatives to
receive the same gains - or losses - while making only a fraction of the financial commitment.[4]
That’s leverage, with its upside and its downside.
A key OTC derivative in the financial crisis was the credit default swap (CDS), which offered
the seller the potential for a little upside at the relatively small risk of a potential large downside,
[4]

For more on derivatives, see Financial Crisis Inquiry Commission, Preliminary Staff Report, “Overview on
Derivatives” (Jun. 29, 2010), available at http://fcic.gov/reports/pdfs/2010-0630-psr-derivative-overview.pdf.

106

which is exactly what would happen during the housing boom. In a credit default swap, one party
transfers to another party the default risk associated with an underlying debt. The referenced debt
security can be any kind of bond or loan obligation. The buyer of the CDS protection makes
periodic payments to the seller during the life of the swap. In return, the CDS seller provides
protection in the event of a default or specified “credit event” (which could be a partial default or
a ratings downgrade) related to the debt. Should a “credit event” occur, the CDS seller typically
pays the buyer the face value of the bond.
The credit default swap is often compared to insurance, with the seller insuring against a default
in the underlying asset. But these derivatives are very different from insurance in two important
respects. First, only a person with an insurable interest can obtain an insurance policy. A car
owner can only insure the car she owns—not her neighbor’s -- but a purchaser of a CDS can use
it to speculate on the default of an asset the purchaser does not own. Second, when an insurance
company sells a policy, regulations require that it put aside some reserves in case of a loss. In the
housing boom, credit default swaps were sold—that is, protection was offered--without putting
up any reserves or any initial collateral or hedging the seller’s exposure. In the run-up to the
crisis, American Insurance Group (AIG) would accumulate a one-half trillion dollar position in
credit risk through the OTC credit derivatives market without initially posting one dollar’s worth
of collateral or making any other provision for loss. And AIG was not alone in selling CDS. The
value of the underlying assets for outstanding credit default swaps worldwide grew from $6.4
trillion at the end of 2004 to a peak of $58.2 trillion at the end of 2007.
Much of the risk associated with credit default swaps and other derivatives were also
concentrated among a few very of the largest banks and investment banks, which- along with
AIG, the largest U.S. insurance company - dominated the business of dealing in OTC
107

derivatives. Among bank holding companies, 97% of the notional amount of OTC derivatives—
millions of contracts—were traded by just five large institutions (in 2006 for example, JPMorgan
Chase, Citigroup, Bank of America, Wachovia, and HSBC ) – some of the same financial firms
that would find themselves in trouble during the financial crisis.197 The country’s five largest
investment banks were also among the world’s largest OTC derivatives dealers. When the
nation’s biggest financial institutions were teetering on the edge of failure in 2008, all eyes—
market participants’ and regulators’--turned to the derivatives markets. What were their
holdings? Who were their counterparties? How would they fare? Before the crisis, regulators
had concentrated their attention elsewhere. Responding to the near-failure of the Long Term
Capital Management hedge fund, which we will discuss below, they focused their derivatives
oversight efforts on other hedge funds, not on the largest dealers of these instruments.
[Chanos quote]
“There was a lot of focus, essentially fighting the last war, about worrying about exposures to
hedge funds and not so much about exposures to other entities who might be large and highly
leveraged,” Fed official Patrick Parkinson explained to the Commission.[i]
When that next war did come in the form of the financial crisis of 2007 and 2008, market
participants and the regulators would find themselves straining to understand the new battlefield
of unknown exposures and interconnections as they fought to keep the financial system from
collapse.

197

Include list for 2007

[i]

Patrick Parkinson Interview, at 23.

108

109

Part I, Chapter 3. Deregulation redux: “Shatterer of Glass-Steagall”

Contents
3. Deregulation redux: “Shatterer of Glass-Steagall” .............................................................................. 110
Long-Term Capital Management: “A lot of firms that would have been irrevocably harmed” ........... 120
Dotcom crash: “And how should any rational investor respond to a less risky world? They should lay
on more risk.”........................................................................................................................................ 126
The wages of finance: “‘Well, this one’s doing it, so how can I not do it…” ...................................... 133
Financial sector growth “I think we overdid finance versus the real economy”................................... 140

By the mid-1990s, parallel banking was booming, the traditional commercial banks were looking
more and more like the shadow banks, and all of them were becoming larger, more complex, and
more active in securitization. Some made the case that technological advances in data
processing, telecommunications, and information services created economies of scale in finance
and encouraged and justified the growth of larger financial institutions. The argument was that
bigger would be safer, and it would also be more diversified, more innovative, more efficient,
and better able to serve the needs of an expanding U.S. economy.198 This view was not universal
by any means, and others argued that the largest banks were not necessarily more efficient but
were rewarded simply by virtue of their market power and the perception that they were too big
to fail.199 Nonetheless, the large banks and their supporters urged regulators, state legislatures

198

Examples of research making similar arguments include Calomiris & Karceski (2000); Danielson (1999); Hughes
& Mester (1998, and Wheelock & Wilson (2009).
199

Amel et al. (2004); Hanweck & Shull (1999), at 259-63, 273-77; Stern & Feldman (2004), at 66. Similarly, a
recent study concluded that banks larger than $30 billion in twelve European nations did not produce favorable
economies of scale and operated with inferior levels of efficiency between 1998 and 2004. The study’s results
indicated that the advantages accruing to the largest banks from technological changes were not sufficient to create
favorable economies of scale or superior levels of efficiency for those banks. Papadopoulos (2010), at 288-92. Boyd
& Gertler (1994); Hanweck & Shull (1999), at 273-77; Stern & Feldman (2004), at 18-19, 60-79.

110

and Congress to remove virtually all remaining barriers to growth and competition, and they had
a great deal of success. Already successfully targeted were the obstacles to interstate branching
and interstate bank mergers. In 1994 Congress had authorized nationwide banking by passing the
Riegle-Neal Interstate Banking and Branching Efficiency Act. This legislation allowed bank
holding companies to acquire banks in every state, and it also removed most restrictions on
interstate branching.200 It preempted any state law that restricted the ability of out-of-state banks
to compete within the state’s borders.201
This removal of legal barriers to expansion contributed to a far-reaching consolidation of the
U.S. banking industry. Between 1990 and 2005, there were 74 “megamergers,” in which both the
acquiring and acquired banks held more than $10 billion of assets. During the same period, the
10 largest U.S. banks increased their share of total industry assets from 25% to 55%. From 1998
to 2007, the combined assets of the five largest U.S. banks – in 2007, Bank of America,
Citigroup, JP Morgan, Wachovia and Wells Fargo – would more than triple, growing from $2.2
trillion to $6.8 trillion.202 Meanwhile, securities firms were growing bigger as well. Smith
Barney acquired Shearson in 1993 and Salomon Brothers in 1997, while Paine Webber
purchased Kidder, Peabody in 1995. Two years later, Morgan Stanley merged with Dean Witter,
and Bankers Trust purchased Alex. Brown & Sons. The assets held by the five largest
investment banks – Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear
Stearns – increased from $1 trillion in 1998 to $4 trillion in 2007.

200

For instance, banks could hold no more than 30 percent of the deposits of a single state and no more than 10
percent of all deposits nationwide.
201
202

Some states prior to 1994 had voluntarily opened themselves up to out-of-state banks.
FCIC PSR on TBTF (2010), at p 14.

111

In 1996, the Economic Growth and Regulatory Paperwork Reduction Act required all regulators,
including financial regulators to review their rules every 10 years to solicit public comments to
identify rules that were “outdated, unnecessary, or unduly burdensome.”203 Some agencies took
up this challenge with gusto. In 2003, for instance, the FDIC’s annual report would include a
photograph of the agency’s vice chairman, John Reich; Office of Thrift Supervision Director
James Gilleran; and three banking lobbyists using a chainsaw to cut the “red tape” that bound
together a large stack of documents.204
For the less enthusiastic agencies, there were less formal methods. Former SEC Chairman
Arthur Levitt told the FCIC that once word of a proposed new regulation got out, industry
lobbyists would rush to the members of the congressional committee with jurisdiction.
According to Levitt, these members would then “harass” the SEC with frequent letters
demanding answers to complex questions and requests for Congressional appearances. These
requests would consume a lot of the SEC’s time and discourage the agency from further attempts
at regulation. Levitt characterized the relationship between Congress and some regulatory
agencies as “kind of a bloodsport to make the particular agency look stupid or inept or venal.”205
However, other regulators said that they found interference to be modest, at least from the
executive branch. For instance, John D. Hawke, former director of the Office of the Comptroller
of the currency, told the FCIC that he found the Treasury Department to be “exceedingly
sensitive” about his agency’s independence. Similarly, his successor, John Dugan, said that the

203

Congressional Register (Sept. 28, 1996), 11754.

204

Available at http://www.fdic.gov/about/strategic/report/2003annualreport/intro_insurance.html

205

Audio of interview with Arthur Levitt, 0:09:15.

112

“statutory firewalls” prevented interference from the executive branch during his tenure at the
OCC.
In practice, the governing model that became known as deregulation was not just about
dismantling regulations that had previously been in place but also about a disinclination to
challenge the financial services industry on the potential risks of new innovations and practices.
Federal Reserve officials argued that financial institutions, operating under strong incentives to
protect the interests of their shareholders, would exercise self-regulation through improved risk
management. Fed Vice Chairman Roger Ferguson noted “the truly impressive improvement in
methods of risk measurement and management and the growing adoption of those technologies
by mostly large banks and other financial intermediaries…”206 Likewise, financial markets
would exert strong and effective “private regulation” over financial institutions through the
activities of market analysts and investors. “[I]t is critically important to recognize that no
market is ever truly unregulated,” Greenspan explained in 1997. “Rather, the real question is
whether government intervention strengthens or weakens private regulation.”207
Richard Spillenkothen, the Fed’s Director of Banking Supervision and Regulation from 1991 to
2006, would provide the following explanation in a memorandum to the Commission:
Supervisors understood that forceful and proactive supervision, especially early
intervention before management weaknesses were reflected in poor financial
performance, might be viewed as i) overly-intrusive, burdensome, and heavy-

206

10/8/2003 Ferguson speech.

207

Alan Greenspan, “Government Regulation and Derivative Contracts,” speech at the Financial Markets
Conference of the Federal Reserve Bank of Atlanta, Coral Gables, FL (Feb. 21, 1997),

113

handed, ii) an undesirable constraint on credit availability, or iii) inconsistent with
the Fed’s public posture.208
Senior policymakers expressed concerns that regulators would too aggressively use their
authority. As a method of creating “checks and balances,” they spoke out in favor of retaining
multiple regulators as a restraint against any agency becoming arbitrary or inflexible.209 In 1994
Federal Reserve Chairman Alan Greenspan testified against proposals to consolidate bank
regulation:
The current structure provides banks with a method…of shifting their regulator, an
effective test that provides a limit on the arbitrary position or excessively rigid posture of
any one regulator. The pressure of a potential loss of institutions has inhibited excessive
regulation and acted as a countervailing force to the bias of a regulatory agency to
overregulate…210
Emboldened by their successes and encouraged by the tenor of the times, the largest banks, their
regulators, and Congress continued their push for an integrated financial system under which
institutions would be free to engage in an unrestricted set of activities and to grow to whatever
size was most profitable. The legal and regulatory barriers separating banks and securities firms
had been crumbling, little by little, and now the time seemed ripe for removing the last remnants
of the New Deal restrictions that had once hemmed in the banks—that is, killing the GlassSteagall Act, once and for all.
208

Richard Spillenkothen, Notes on the performance of prudential supervision in the years preceding the financial
crisis by a former director of banking supervision and regulation at the Federal Reserve Board (1991 to 2006), May
2010
209

See U.S. Department of the Treasury, Modernizing the Financial System, February 1991, page XIX-6 "the
existence of fewer agencies would concentrate regulatory power in the remaining ones, raising the danger of
arbitrary or inflexible behavior. . . . Agency pluralism, on the other hand, may be useful, since it can bring to bear on
general bank supervision the different perspectives and experiences of each regulator, and it subjects each one,
where consultation and coordination are required, to the checks and balances of the others' opinion.”
210

Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System before the
Committee on Banking, Housing, and Urban Affairs, U.S. Senate, March 2, 1994, reprinted in the Federal Reserve
Bulletin, May 1, 1994

114

In the spring of 1996, after years of opposing the repeal of Glass Steagall, the Securities Industry
Association – the trade organization of Wall Street firms such as Goldman Sachs and Merrill
Lynch – changed course.211 Restrictions on banks had been slowly dismantled for years,
allowing them to make inroads into the securities and insurance industries. Securities firms
famously sued the Fed in 1987 after it allowed bank holding companies to enter into the
commercial paper and other securities-related markets. The association now saw that repeal
would enable U.S. securities firms to better compete in foreign markets.212 The chief lobbyist for
the American Bankers Association, Edward Yingling, said “Because we had knocked so many
holes in the walls separating commercial and investment banking and insurance, we were able to
aggressively enter their businesses -- in some cases more aggressively than they could enter ours.
So first the securities industry, then the insurance companies, and finally the agents came over
and said let's negotiate a deal and work together.”213
In 1998, Citicorp forced the issue of finally repealing the Act by merging with the insurance
giant Travelers to form Citigroup.214 The Fed approved the Citigroup merger based on a
technical exemption to Glass-Steagall. Citigroup would be required to divest itself of many of
Travelers’ assets within two to five years--unless the old law was repealed once and for all, and
the Bank Holding Company Act was also amended. Congress now had to make a decision:
Would it finally repeal Glass-Steagall, or was it prepared to force a break-up of the largest
financial firm in the nation?
211

Securities Industry Press Release, December 6, 1987

212

Kathleen Day, “Reinventing the Bank; With Depression-Era Law About to Be Rewritten, the Future Remains
Unclear,” Washington Post, October 31, 1999.

213

“The making of a law,” ABA Banking Journal, December 1999.

214

The two-year exemption is contained in Section 4(a)(2) of the BHC Act. The Fed could have granted up to three
one-year extensions of that exemption.

115

When Congress went to work fashioning a new bill, banking representatives were close at hand.
In 1999, the financial sector215 spent $186 million on lobbying at the federal level, and
individuals and political action committees (PACs) in that sector donated $202 million to federal
election campaigns in the 2000 election cycle.216 Over the ten year period from 1999 through
2008 federal lobbying by the financial sector would reach $2.7 billion and total campaign
donations from individuals and PACs would top $1 billion.
In November of 1999, Congress passed and President Clinton signed the Gramm-Leach-Bliley
Act (GLBA),217 which lifted [many] remaining Glass Steagall-era restrictions. The new law
embodied many of the proposals that Federal Reserve Chairman Greenspan had been advocating
for at least two decades, and many of the measures the Treasury had advocated in 1991. A news
story reported that Citigroup CEO Sandy Weill hung in his office “a hunk of wood — at least 4
feet wide — etched with his portrait and the words ‘The Shatterer of Glass-Steagall.’”218
Under GLBA, as long as holding companies satisfied certain safety and soundness conditions,
they were free to underwrite and sell a full spectrum of banking, securities and insurance
products and services. Their securities affiliates were no longer bound by the Fed’s 25% limit on
bank-ineligible activities – from now on, their primary regulator, the SEC, would set the only
bounds on what they could do. Supporters of the new legislation argued that the new bank

215

“Financial Sector” Here Includes Insurance Companies; Commercial Banks; Securities & Investment Firms;
Finance & Credit Companies; Accountants; Savings & Loan Institutions; Credit Unions; And Mortgage Bankers &
Brokers.
216

Data from the Center for Responsive Politics at www.opensecrets.org. “Finance” is defined using the CRP’s
numbers for commercial banks, insurance, finance/credit companies, and securities and investments.
217

Public Law 106-102, 113 Stat. 1338 (Nov. 12, 1999).

218

http://www.nytimes.com/2010/01/03/business/economy/03weill.html?pagewanted=all

116

holding companies – designated formally by the Fed as “financial holding companies”– would
be more profitable (due to favorable economies of scale and scope); safer (due to a broader
diversification of risks); more useful to consumers (due to the convenience of “one-stop
shopping” for financial services); and more competitive with large foreign banks, which already
offered loans, securities and insurance products.219 The legislation’s opponents warned that this
final push allowing banks to combine with securities firms would promote excessive speculation
in the capital markets and could ultimately trigger a financial crisis akin to the crash of 1929.220
Indeed, in retrospect, John Reed, the former co-CEO of Citigroup, testified to the Commission
that “the compartmentalization that was created by Glass-Steagall would be a positive factor,”
[ck quote context]
To achieve the support of the securities industry for the legislation, GLBA reaffirmed two
exceptions in the law that allowed securities firms to own industrial loan companies and thrifts
and thereby access FDIC-insured deposits without being supervised by the Fed. Some of the
firms immediately expanded their industrial loan company and thrift subsidiary
activities. Merrill’s industrial loan company grew its assets from under $1 billion in 1998 to $4
billion in 1999, and eventually to $78 billion in 2007. Lehman’s thrift grew from $88 million in
1998 to $3 billion in 1999, rising as high as $24 billion in 2005.

For institutions regulated by the Fed, the new law also established a hybrid regulatory structure
known colloquially as “Fed-Lite.” The Federal Reserve would supervise each financial holding
219

Senate Report No. 106-44, at 4-6 (1999); 145 Cong. Rec. S13783-84 (daily ed. Nov. 4, 1999) remarks of Sen.
Gramm); id. S13880-81 (remarks of Sen. Schumer); id. H11527-28 (daily ed. Nov. 4, 1999) (remarks of Rep.
Leach).
220

Cong. Rec. S13871-74 (daily ed. Nov. 4, 1999) (remarks of Sen. Wellstone); id. S13896-97 (remarks of Sen.
Dorgan); id. 145 Cong. Rec. H11530-31, H11542 (daily ed. Nov. 4, 1999) (remarks of Rep. Dingell).]

117

company as a whole, looking for risks that cut across the component firms. To prevent
duplicating other regulators’ work, the Fed was to rely “to the fullest extent possible” on the
examinations and reports of those agencies regarding the many subsidiaries of the holding
company, including securities broker-dealers. The Fed’s authority to impose capital requirements
on those subsidiaries was restricted.
The expressed intent of Fed-Lite was to eliminate excessive or duplicative regulation.221
However, current Fed chairman Ben Bernanke would argue to the FCIC that Fed-Lite created a
“statutory gap” that “made it difficult for any single regulator to reliably see the whole picture of
activities and risks of large, complex banking institutions.”222 Indeed, the various regulators,
including the Fed, would fail to identify excessive risks and unsound practices that were building
up in nonbank subsidiaries of financial holding companies, such as Citigroup or Wachovia.[need
cite for nonbank subsidiaries]
In addition, the convergence of banks and securities firms confirmed by the legislation
undermined the mutually supportive relationship between the banking and securities sectors that
Fed Chairman Alan Greenspan had considered a source of financial market stability. He had
often invoked the image of the “spare tire” to explain this relationship: If large commercial banks
ran into trouble, he argued, their large customers could borrow from securities firms and other
credit providers in the capital markets; if the capital markets froze up, banks could provide the
necessary credit by drawing on their deposits to make loans. And after 1990, the emergence of
221

The Implications of Financial Modernization Legislation for Bank Supervision. Remarks by Fed Governor
Laurence H. Meyer presented at the Symposium on Financial Modernization Legislation, sponsored by Women in
Housing and Finance (December 15, 1999), available at
http://www.federalreserve.gov/boarddocs/speeches/1999/19991215.htm.
222

Statement by Fed Chairman Ben S. Bernanke before the Financial Crisis Inquiry Commission (Sept. 2, 2010), at
14, available at www.fcic.gov/hearings/pdfs/2010-0902-Bernanke.pdf.

118

securitized mortgage lending had provided an alternative source of credit to home buyers and
other borrowers that softened the impact of the steep decline in lending by thrifts and banks. The
system’s resilience following a crisis in Asian financial markets in the late 1990s had further
proven his point, Greenspan said.223
The new regime encouraged growth and consolidation within and across the banking, securities
and insurance sectors. It was finally official—the new bank-centered financial holding
companies such as Citigroup, JP Morgan and Bank of America had free rein to compete head-tohead with the “big five” securities firms – Goldman Sachs, Morgan Stanley, Merrill Lynch,
Lehman Brothers and Bear Stearns – in markets for securitization, stock and bond underwriting,
and trading in over-the-counter derivatives. The biggest financial holding companies became
major players in the investment banking business. The business strategies of the largest
commercial banks and their bank holding companies converged with the strategies of investment
banks. Each had their own advantages: the commercial banks had greater access to insured
deposits, and the investment banks had less regulation. Both prospered. Greenspan’s “spare tire”
that had helped make the system less vulnerable would not last, however - all the wheels of the
financial system were beginning to spin on the same axle.
The late 1990s saw a spectacular growth in the issuance of corporate securities . Annual public
underwritings and private placements of corporate securities in U.S. financial markets almost
quadrupled, rising from $600 billion in 1994 to $2.2 trillion in 2001. Annual initial public
offerings of stocks (IPOs) soared from $28 billion in 1994 to $76 billion in 2000, as banks and
securities firms promoted IPOs for newly-established Internet and telecommunications

223

Alan Greenspan, Lessons from the Global Crises, September 27, 1999.

119

companies, more widely known as dotcoms and telecoms. This onrush of new securities
contributed to a stock market boom comparable to the great bull market of the 1920s. The total
value of publicly traded U.S. stocks rose from $5.8 trillion in December 1994 to $17.8 trillion in
March 2000.224 This boom was heavily concentrated in recently issued dotcom and telecom
stocks listed on the NASDAQ stock exchange. In the same time period, this particular index
skyrocketed from 752 to 5,132.[cite]

Long-Term Capital Management: “A lot of firms that would have been irrevocably
harmed”
In August 1998, Russia defaulted on part of its national debt. Investors had always assumed that
neither the U.S. government nor the International Monetary Fund—an international organization
that was supposed to help maintain stability in global financial markets—would allow a nation
with large stockpiles of nuclear weapons to experience a credit crisis. When the cavalry did not
arrive—when Russia announced that it would be restructuring its national debt and postponing
some payments—spooked investors panicked and dumped all types of higher-risk securities,
including those that had nothing to do with Russia, and fled to the safety of U.S. Treasury bills
and FDIC-insured certificates of deposit.225 In response, the Federal Reserve cut short-term
interest rates three times in a seven-week period. With the commercial paper market in turmoil
following the Russian default, the Fed turned to the commercial banking sector to take up the
slack from capital markets by providing lines of credit to corporations that could not roll over
224

Board of Governors of Federal Reserve System, Federal Reserve Statistical Release Z.1.: Flow of Funds
Accounts of the United States, 4th Qtr. 1996, at 88 (Table L.213, line 19) (reporting that domestic corporations had a
total market value of $5.8 trillion at the end of 1994); Board of Governors of Federal Reserve System, Federal
Reserve Statistical Release Z.1.: Flow of Funds Accounts of the United States, 4th Qtr. 2001, at 90 (Table L.213,
line 20) [hereinafter 2001 Flow of Funds Report ](reporting that domestic corporations had a total market value of
$17.8 trillion as of March 31, 2000).
225

http://www.chicagofed.org/digital_assets/publications/economic_perspectives/2001/1qepart1.pdf

120

their short-term borrowing needs. U.S. banks extended $30 billion of commercial loans in
September and October of 1998—about 2½ times greater than typical lending levels,226 and
helped prevent a serious disruption in the capital markets from becoming much worse. The U.S.
economy avoided a slump. 227
The same could not be said for Long Term Capital Management, a large U.S. hedge fund. LTCM
had been devastated by losses on its $125 billion portfolio of high-risk debt securities, including
junk bonds and emerging-market debt, the very “assets” that investors were now fleeing in
droves. To buy them, the firm had borrowed $25 for every $1 of its investors’ equity; the lenders
included Merrill Lynch, JP Morgan, Morgan Stanley, Lehman Brothers, Goldman Sachs, and
Chase Manhattan. For the previous four years, LTCM’s leveraging strategy had produced
magnificent returns: 19.9%, 42.8%, 40.8 %, and 17.1%—a period when the S&P 500 yielded an
average of 21% per year.
But leverage works both ways, as we have noted, and in just one month following Russia’s
partial default the high-flying hedge fund lost $4.4 billion—about 88% of the not-quite $5 billion

226

Commercial and Industrial Loans at All Commercial Banks, monthly, seasonally adjusted, from the Federal
Reserve Board of Governors H.8 release. St. Louis FRB website, accessed Nov 16, 2010.
http://research.stlouisfed.org/fred2/series/BUSLOANS?cid=100. FCIC staff calculation of average change in loans
outstanding over any two consecutive months in 1997 and 1998.
227

Many researchers have attributed this growth to corporations’ decisions to use bank credit lines instead of issuing
commercial paper into a tight market. Marc Saidenberg and Philip Strahan , Are Banks Still Important for Financing
Large Businesses? Current Issues in Economics and Finance: Federal Reserve Bank of New York. August, 1999.
Lowenstein (2000), at 28-130; Wilmarth (2002), at 236-37, 346-50, 370-71.

121

in capital held at the beginning of the year. Debts were on the order of $120 billion. The firm
was on the brink of insolvency.228
If it were only a matter of $5 billion, LTCM’s failure might have been manageable, but it had
further leveraged itself by taking $1.25 trillion in derivatives positions—mostly interest rate and
equity derivatives.229 LTCM’s suffered large losses after the Russia default, and with very little
capital in reserve, threatened to default on its obligations to its derivatives counterparties—
including large banks and securities firms. Because LTCM had negotiated its derivatives
transactions in the opaque over-the-counter market, financial market participants had little way
of knowing the size of LTCM’s positions. If all of the fund’s counterparties tried to liquidate
their positions simultaneously, then asset prices across the market may have dropped “sharply”
which would have created “exaggerated” losses.230 This was a classic set-up for a run: losses
were likely, but nobody knew who was going to get burned. The Federal Reserve feared that
with financial markets already fragile, these exaggerated losses would spill over to investors with
no prior relationship with LTCM and credit and derivatives markets might have “cease[d] to
function for one or more days or even longer.”231

228

Franklin R. Edwards, “Hedge Funds and the Collapse of Long-Term Capital Management,” 13 Journal of
Economic Perspectives 189, 197-205 (1999); Roger Lowenstein, When Genius Failed: The Rise and Fall of LongTerm Capital Management 36-54, 77-84, 94-105, 123-30 (New York: Random House, Inc., 2000).
229

One of the architects of LTCM’s strategy was Myron Scholes, one of the names behind the Black-Scholes
formula, and a Nobel Prize winner. Another was Robert Merton, who shared the Nobel Prize in part for improving
on the formula.
230

Statement by William J. McDonough, president of the Federal Reserve Bank of New York, before the Committee
on Banking and Financial Services, US House of Representatives” (Oct. 1, 1998), available at
www.newyorkfed.org/newsevents/speeches/1998/mcd981001.html.
231

122

So the Fed assembled an emergency meeting of major banks and securities firms with large
exposures to LTCM. On September 23, after considerable urging, 14 institutions agreed to
organize a consortium that would inject $3.6 billion of capital into LTCM in exchange for 90%
of its stock. The firms injected between $100 million and $300 million each. Famously, Bear
Stearns declined to participate. An orderly liquidation of LTCM’s portfolio of securities and
derivatives followed.
William McDonough, the president of the New York Fed at the time, insisted that “no Federal
Reserve official pressured anyone, and no promises were made.”232 The rescue involved no
government funds. Nevertheless, the Fed’s orchestration of this rescue raised a question: How far
would it go to forestall what it saw as a systemic event?
Its aggressive response to the 1998 crisis seemed of a piece with several interventions in the
previous two decades. For example, in 1970, the Fed had intervened to support the commercial
paper market; in 1980, to support dealers in commodities futures; in 1982, to support the repo
market; in 1987, to support the stock market itself, after the Dow Jones Industrial Average had
fallen by 26% percent within three days.233 All of these actions had followed a similar pattern
and provided a template for future interventions, including the 2008 crisis. Each time, the Fed cut
short-term interest rates and encouraged financial firms in the parallel banking and the traditional
banking sector to help the ailing market. In some cases, it organized a consortium of banks to
rescue ailing firms.234

232

McDonough (1998).

233

Bloomberg.

234

Andrew F. Brimmer, “Distinguished Lecture on Economics in Government: Central Banking and Systemic
Risks in Capital Markets,” Journal of Economic Perspectives (Spring, 1989), at 3, 3-16 (lecture by a former Fed

123

In that same period, as we have seen, federal regulators rescued several large banks believed to
be “too big to fail” so that all creditors, including uninsured depositors, were protected . That
rationale was based on the idea that major banks were crucial players in the financial markets
and the broader economy, and regulators therefore couldn’t allow the collapse of one large bank
to trigger a panic among uninsured depositors that might lead to a cascade of failures among
other major banks. Regulators also pointed out that banks at least paid premiums for the
insurance on their insured depositors.[cite]
But it was a completely different proposition to argue that large nonbanking firms should be
considered too big to fail because their collapse might destabilize the capital markets. Did
LTCM’s orchestrated rescue mean that the Fed was now prepared to protect creditors of any
firm, if its disorderly collapse might threaten the stability of the capital markets? Harvey Miller,
who would be bankruptcy counsel for Lehman Brothers when in failed in 2008, told the FCIC
that, “all of the hedge funds” expected the Fed to intervene to save Lehman from failing, based
on the Fed’s involvement in LTCM’s rescue. In Miller’s view, “That’s what history proved to
them.”
The resolution of the 1998 and prior crises had convinced many market participants and federal
regulators of the safety of the dual system of traditional and parallel banking that had emerged
during that decade. Even institutions that lost money understood that these events could have
turned into a full-blown crisis. Merrill Lynch, which suffered almost $1 billion of trading losses
as a result of the Russian debt crisis, was one of them.235 For Stanley O'Neal, then Merrill’s
Governor, analyzing the Fed’s market interventions in 1970, 1980 and 1987, and concluding that the Fed had
consciously assumed a “strategic role as the ultimate source of liquidity in the economy at large”); Kaufman (2000),
at 208-16, 226-28, 238-40, 310-12.
235

Joseph Kahn, “The Merrill Steamroller Encounters Potholes,” New York Times, Mar. 20, 1999, at C1.

124

CFO, the experience was “indelible.” He remarked to the FCIC, “I took away from it that had the
market seizure and panic lasted longer, there would have been a lot of firms that would have
been irrevocably harmed. Merrill would have been one of them”236 - words that would ring true
in 2008.
Now, Greenspan stated, the successful resolution of the 1998 crisis showed that “diversity within
the financial sector provides insurance against a financial problem turning into economy-wide
distress.”237 This was the so-called “spare tire” theory. The other recent crises had buttressed his
point.
The President’s Working Group on Financial Markets, a committee composed of the heads of the
Treasury, Federal Reserve, SEC, and the Commodity Futures Trading Commission charged with
keeping tabs on the financial system, came to a less definitive conclusion than Greenspan. In a
report issued the following year, 1999, the group pointed out that LTCM and its counterparties
had “underestimated the likelihood that liquidity, credit, and volatility spreads would move in a
similar fashion in markets across the world at the same time.” Many financial firms would make
exactly the same mistake a decade later. For the Working Group, this miscalculation brought up
an important issue:
[A]s new technology has fostered a major expansion in the volume and, in some cases,
the leverage of transactions, some existing risk models have underestimated the
probability of severe losses. This shows the need for insuring that decisions about the
appropriate level of capital for risky positions become an issue that is explicitly
considered; when outlier events are omitted from risk models, such decisions are made by
default.
236

Stanley O’Neal FCIC interview.

237

Do efficient financial markets mitigate financial crises? Remarks by Fed chairman Alan Greenspan before the
1999 Financial Markets Conference of the Federal Reserve Bank of Atlanta (Oct. 19, 1999), available at
http://www.federalreserve.gov/boarddocs/speeches/1999/19991019.htm.

125

That statement would pertain verbatim ten years later. That Working Group was already
concerned that neither the markets nor their regulators were prepared for the possibility of socalled “tail risk”—an unanticipated event that would cause catastrophic damage to financial
institutions and the economy. Nevertheless, the Working Group cautioned against taking such
warnings too far: “[P]olicy initiatives that are aimed at simply reducing default likelihoods to
extremely low levels might be counterproductive if they unnecessarily disrupt trading activity
and the intermediation of risks that support the financing of real economic activity.”238 It
concluded that benefits of reducing risk were not worth the costs, because an overreaction to
threats that firms such as LTCM posed to the system would diminish the dynamism of the
financial sector and, with it, the real economy.
Markets were relatively calm after 1998, Glass-Steagall would be deemed unnecessary, over-thecounter derivatives would be unregulated, and the stock market and the economy continued to
prosper. Like all of the others (with the exception of the Depression), this crisis soon faded into
memory. In February 1999, Rubin, Summers, and Greenspan were featured on the cover of
Time Magazine with the title, “The Committee to Save the World”. Federal Reserve Chairman
Alan Greenspan became a cult hero – the “Maestro” – who could handle every emergency.239

Dotcom crash: “And how should any rational investor respond to a less risky
world? They should lay on more risk.”
In the spring of 2000, the tech bubble burst. Revenue and earnings from the “new economy”
dotcoms and telecoms had failed to match the lofty expectations of investors, who had relied on
238

President's Working Group on Financial Markets, Hedge Funds, Leverage, and the Lessons of Long-Term
Capital Management (Washington, DC, April 1999), 16, available at
http://www.ustreas.gov/press/releases/reports/hedgfund.pdf.
239

Bob Woodward, Maestro: Greenspan’s Fed and the American Boom (New York: Simon & Schuster, 2000).

126

bullish, and as it turned out, often deceptive research reports issued by the very banks and
securities firms that had underwritten the IPOs for these firms; the pervasive euphoria about
these sectors’ business prospects was not grounded in reality. Between March 2000 and March
2001, the NASDAQ index fell by more than half.240 After a temporary lull in mid-2001, this
slump resumed and accelerated in response to the terrorist attacks on September 11. The nation
was in recession. 241 Nor did the accounting fraud and other scandals at certain prominent firms
help. Investment banks settled charges with regulators over practices in the allocation of shares
through initial public offerings (IPOs) during the bubble – for example, spinning (doling out
shares in “hot” IPOs in return for favorable business treatment) –and laddering (doling out shares
to investors who agreed to buy more shares later at higher prices).242 The regulators also found
that investment banks’ public research reports were plagued by conflicts of interest. In the end,
the SEC, the New York State Attorney General, the National Association of Securities Dealers
(now known as FINRA), and other state regulators settled enforcement actions against 10 firms
for $875 million, explicitly forbade certain practices, and instituted a number of reforms.243
The sudden collapses of Enron and WorldCom were especially shocking to investors. With
assets of $63 billion and $104 billion, respectively, they represented the largest U.S. corporate
bankruptcies prior to the default of Lehman Brothers in 2008.244

240

Bloomberg

241

Lowenstein (2004), at 192, 211.

242

http://www.sec.gov/news/testimony/ts050703whd.htm

243

SEC Fact Sheet on Global Analyst Research Settlements, 2003;
http://www.finra.org/Newsroom/NewsReleases/2004/P011463
244

Lowenstein (2004), at 166-212; Wilmarth (2009), at 998-99.

127

Legal proceedings and investigations of the Enron debacle revealed that Citigroup, JPMorgan
Chase, Merrill Lynch and other Wall Street banks had helped the firm hide its debt from
investors until just before its collapse.[will cite] Enron and their bankers had created special
purpose entities to engage in complex transactions that generated fictitious earnings, disguised
debt as sales and derivative transactions, and understated the firm’s leverage. Executives at these
banks had pressured their analysts to write glowing evaluations of Enron to the public; Merrill
Lynch, Citigroup, UBS, and BNP Paribas fired analysts who conveyed contrary opinions. The
scandal cost Citigroup, JPMorgan Chase, CIBC, Merrill Lynch, and others over $400 million in
settlements with the SEC; Citigroup, Chase, CIBC, Lehman Brothers, and Bank of America paid
$6.9 billion to the investors to settle a class-action lawsuit.245 In the wake of the terrorist attacks,
the 2001 and 2002 failures of Enron and WorldCom, and the dot-com bust, investors fled the
stock market. From December 1994 to March 2000, the total value of publicly traded U.S.
stocks had risen from $5.8 trillion to $17.8 trillion. Then, one year after the attacks, the value
had fallen by almost half, to $9.4 trillion.246 Some of the financial institutions that had lent to
companies that failed during the bust successfully hedged themselves by purchasing credit
default swaps (CDSs) on these firms. Invented about five years earlier by JP Morgan, these
swaps enabled a lender to lay off the risk of default or any other specified “credit event”—maybe
missed payments or a downgrade by a credit rating agency—by purchasing protection from a
counterparty.

245

Arthur E. Wilmarth, Jr., “Conflicts of Interest and Corporate Governance Failures at Universal Banks During the
Stock Market Boom of the 1990s: The Cases of Enron and WorldCom,” George Washington University Public Law
and Legal Theory Working Paper 234 (2007), available at http://ssrn.com/abstract=952486.

246

2001 Flow of Funds Report, at 90 (Table L.213, line 20) (providing March 2000 figure); Board of Governors of
Federal Reserve System, Federal Reserve Statistical Release Z.1.: Flow of Funds Accounts of the United States, 4th
Qtr. 2003, at 90 (Table L.213, line 21) (providing September 2002 figure).

128

Speaking in November 2002, Fed Chairman Alan Greenspan said that credit derivatives “appear
to have effectively spread losses from defaults by Enron [and other large corporations] . . . from
banks . . . to insurance firms, pension funds, or others.” Although he conceded that the market
was “still too new to have been tested” thoroughly, he noted that “to date, it appears to have
functioned well.”247 The following year, Fed Vice Chairman Roger Ferguson noted the adverse
impact of the recession, from which recovery had been unusually slow, but declared that “the
most remarkable fact regarding the banking industry during this period is its resilience and
retention of fundamental strength.”248
This resilience during the upheavals of 2000-2002 led many executives and regulators to believe
that the U.S. financial system had achieved an unprecedented level of stability and excellence in
risk management. The banks’ pivotal role in the Enron debacle did not seem to trouble senior
Fed officials. In a memorandum sent to the FCIC, former Director of the Federal Reserve
Division of Banking Supervision and Regulation Rich Spillenkothen described a presentation to
the Board of Governors. According to Spillenkothen’s account, some Fed directors received the
details of the banks’ complicity “coolly” and were “clearly unimpressed” by its findings. “The
message to some supervisory staff was neither ambiguous nor subtle,” Spillenkothen wrote.
Later in the decade, when supervisors were developing policies to govern certain derivatives
transactions, senior economists at the Board would point to Enron as an example of a derivatives
247

International Financial Risk Management. Remarks by Fed Chairman Alan Greenspan before the Council on
Foreign Relations (Nov. 19, 2002), available at
http://www.federalreserve.gov/boarddocs/speeches/2002/20021119/default.htm. See also Wilmarth (2009), at 1000
(noting that banks that provided loans to Enron and WorldCom “quietly entered into CDS and other transactions to
reduce their credit exposure” to both companies).
248

The Future of Financial Services – Revisited. Remarks by Fed Vice Chairman Roger W. Ferguson, Jr. at the
Future of Financial Services Conference (Oct. 8, 2003), available at
http://www.federalreserve.gov/boarddocs/speeches/2003/200310082/default.htm.

129

counterparty that had been successfully regulated by market discipline, without the aid of
government oversight.249
Another factor in the resilience of major financial institutions was the Fed’s aggressive
intervention to contain the damage from the dotcom-telecom bust, the terrorist attacks, and the
financial market scandals by cutting interest rates. In January 2001, the overnight bank-to-bank
rate was 6.5%. By mid-2003, it was just 1%, the lowest level in half a century. It would stay right
there for another year. In addition, the Fed flooded the financial markets with money by
purchasing more than $150 billion of government securities and extending $45 billion of
discount window loans to banks. It also suspended the legal restrictions on affiliate transactions
within bank holding companies so that the banks could make large loans to securities affiliates.
These emergency actions prevented a protracted liquidity crunch in the financial markets during
the fall of 2001, just as equivalent actions had accomplished during the 1987 stock market crash
and the 1998 Russian crisis.250
Now the list of episodes in which the Fed’s market stabilization efforts had proved decisive was
even more impressive: 1970, 1980, 1982, 1987, 1998, and 2001. Why wouldn’t the markets be
convinced that the central bank would act likewise in the future--and that such measures would
again save the day? Two weeks before the Fed had cut the short-term rates in January 2001, The
Economist anticipated the move by reporting, “[T]he ‘Greenspan put’ is once again the talk of

249

Rich Spillenkothen, “Notes on the performance of prudential supervision in the years preceding the financial
crisis by a former director of banking supervision and regulation at the Federal Reserve Board (1991 to 2006),”
memorandum to the Financial Crisis Inquiry Commission (May 31, 2010), 28.
[explain market discipline]

250

Wilmarth (2002), supra, at 471-73; Wilmarth (2009), at 998-99, 1005; Anita Raghavan et al., “Team Effort:
Banks and Regulators Drew Together to Calm Markets After Attack, Wall Street Journal, Oct. 18, 2001, at A1.

130

Wall Street. . . . The idea is that the Federal Reserve can be relied upon in times of crisis to come
to the rescue, cutting interest rates and pumping in liquidity, thus providing a floor for equity
prices.”251 Analysts used “Greenspan put” as a short-hand description for investors’ faith that the
Fed’s commitment to stability would keep the capital markets functioning no matter what befell
the system, including the bursting of an asset bubble.
The Fed’s policy was clear: it would only take limited steps to restrain the growth of the asset
bubble in the first place—such as warning investors that some asset prices might fall, but it
would use all of its available tools to stabilize the markets after the bubble burst.252 Fed
Chairman Greenspan argued that intentionally bursting a bubble would cause too much damage
to the general economy. Let it burst of its own accord, then act. “Instead of trying to contain a
putative bubble by drastic actions with largely unpredictable consequences,” he explained in
2004, by which time the housing boom was in full swing, “we chose . . . to focus on policies to
mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.”253

251

“First the Put, Then the Cut?” Economist, Dec. 16, 2000, at 81.

252

See Edward Chancellor, “Inefficient market: Ponzi Nation,” Breakingviews (Sept. 25, 2007), available on
LexisNexis (“Under then-chairman Alan Greenspan, the [Fed’s] official policy was that speculative bubbles could
not be accurately identified before they popped and, therefore, the authorities should do nothing to hinder their
growth. It is enough . . . for the central bank to deal with the bubble’s aftermath”)’ W. Max Corden, “The World
Credit Crisis: Understanding It, and What to Do” (Melbourne Institute Working Paper No. 25/08, Dec. 2008), at 13
(“[T]he Greenspan policy seems to involve no monetary policy concern with the bubble when an asset market
bubble starts, or no intervention to prevent the start of such a bubble, but it does call for intervention when the
bubble ends if this ending reduces spending and thus aggregate demand”), available at
http://www.melbourneinstitute.com/wp/wp2008n25.pdf
253

“Risk and Uncertainty in Monetary Policy.” Remarks of Fed Chairman Alan Greenspan at the Meetings of the
American Economic Ass’n (Jan. 3, 2004), available at
www.federalreserve.gov/boarddocs/speeches/2004/20040103/default.htm. See also “Asset-Price ‘Bubbles’ and
Monetary Policy.” Remarks by Fed Governor Ben S. Bernanke before the N.Y. Chapter of the Nat’l Ass’n of
Business Economics (Oct. 15, 2002), available at
www.federalreserve.govboarddocs/speeches/2002/20021015/default.htm.

131

Of course, this asymmetric policy—allowing unrestrained growth of the bubble, then working
hard to cushion the impact of a bust—raised the question of “moral hazard.” Did the policy
skew the risk analyses of both investors and financial institutions by encouraging them to take
speculative gambles on the assumption that their upside was unlimited while their downside was
protected (at least against catastrophic losses) by no less than the Federal Reserve Board?254
Greenspan would warn about this in a speech in the summer of 2005, saying that higher asset
prices were “in part the indirect result of investors accepting lower compensation for risk.”
While he saw that the higher values, to some extent, reflected the assessment that markets were
more resilient, he worried that market participants would view the increase in value as
permanent. He cautioned that “newly abundant liquidity can readily disappear.”255 But, the only
real action he would take would be to continue the upward march of the federal funds rate that
had begun in the summer of 2004. As he pointed out in that summer 2005 speech, these actions
had little effect.
The markets were undeterred. “We had convinced ourselves that we were in a less risky world,”
former National Economic Council Director Lawrence Lindsey told the Commission. “And how
should any rational investor respond to a less risky world? They should lay on more risk.”256

254

Chancellor (2007) (“Greenspan’s policy fostered an appetite for risk-taking in the financial markets. . . . Wall
Street learned that panics were likely to be short and relatively painless”). See also Hu (2000), at 865-73, 883-84;
Kaufman (2000), at 208-16, 219-21, 310-12; Wilmarth (2002), supra, at 470-73. .
255

http://www.federalreserve.gov/boarddocs/speeches/2005/20050826/default.htm

256

Lindsey interview, ca. 34:00.

132

The wages of finance: “‘Well, this one’s doing it, so how can I not do it…”
While financial institutions accepted lower compensation for risk, compensation at the firms rose
dramatically. As the graph below demonstrates, for almost half a century after the Great
Depression, compensation in the financial sector had been virtually the same as in the private
sector. Beginning in 1980, compensation diverged. To be sure, jobs in the financial system got
more complicated and demanded new skills, such as computer programming and risk modeling.
By 2007, financial sector compensation was around 50% greater than in the private sector, the
same relationship in the years leading up to the Great Depression.

Until 1970, the rules of the New York Stock Exchange, a private organization, effectively
mandated that the member firms (not the companies whose stocks were traded on that exchange,
but the firms that ran it) operate as partnerships.257 Among these member firms were the
investment banks, key players in the shadow banking industry. Former Lehman Brothers partner

257

“The Demise of the Professional Partnership? The emergence and diffusion of publicly-traded professional
service firms” Andrew von Nordenflycht, September 2006.

133

Peter J. Solomon testified before the FCIC that this organizational arrangement had a profound
impact on the operations of the firm. In the old days, Solomon said, he and the other Lehman
partners would sit in a single room at the firm’s headquarters not because they wanted to be
sociable, but so that they could “overhear, interact, and monitor” each others’ activities. They did
this because they were all on the hook together. Solomon said, “Since they were personally liable
as partners, they took risk very seriously.”258 Brian Leach, a former executive at Morgan Stanley,
told FCIC staff about how compensation practices worked before his firm went public, “When I
first started in Morgan’s family, it was a private company. When you’re a private company, you
don’t get paid until you retire. I mean, you get a good, you know, year-to-year compensation.
But in terms of the retained earnings that’s multiplying inside the company, the exit is retained -is when you retire.”259
When the investment banks, one by one, went public in the 1980s and 1990s, the close
relationship between the bankers’ decisions and their own financial fates was dramatically
altered.260 They were now trading with shareholders’ money, and compensation practices
generally became more focused on the short term. At the investment banks, talented traders and
managers who had historically been tethered to their firms were now free agents who could play
companies against each other regarding their compensation packages. In order to keep these free
agents from going to competitors, firms began providing aggressive incentives, often tied to the

258

Peter Solomon testimony to the FCIC (Jan. 13, 2010), 2, http://fcic.gov/hearings/pdfs/2010-0113-Solomon.pdf.

259

FCIC Interview of Brian R. Leach, March 4, 2010, p. 22.

260

The NYSE decided to allow members to be publicly traded in 1970. “The Demise of the Professional
Partnership? The emergence and diffusion of publicly-traded professional service firms” Andrew von Nordenflycht,
September 2006. Page 25.

134

price of publicly traded shares, and often with accelerated payout timetables.261 Commercial
banks adopted the same practices to keep up. Many compensation packages included
“clawback” provisions providing for the return of compensation in some circumstances,
including certain losses. Yet, the employees at firms that the FCIC investigated were never
subjected to these provisions.
As we will see, executives and managers made decisions that would cost shareholders, first, and
then American taxpayers tens of billions of dollars, but the millions in salary and bonuses they
received was often theirs for good.
One study shows that the real value of executive pay across the economy grew at a sluggish rate
of 0.8% per year during the 30 years after World War II, not keeping pace with the increasing
size of firms. The rate of increase in the level of pay began to pick up during the 1970s and rose
at a faster rate in each subsequent decade, reaching an average growth rate of more than 10% per
year from 1995 to 1999.262 Much of this growth reflected higher earnings in the banking and
finance industries. By 2005, executives in banking and finance earned the highest pay, totaling
$3.4 million per executive. The next highest was the transportation and utility sector at $2.6
million. It was not base salaries that differed much across sectors. Banking and finance paid
significantly higher bonuses and awarded more stock. Within banking and finance, brokers and
dealers did the best by far, making over $7 million in compensation on average.263

261

See Jensen and Murphy, “Compensation,” 24-25, especially Figure 1.

262

Carola Frydman and Raven E. Saks, Historical Trends in Executive Compensation 1936-2005

263

http://www.clevelandfed.org/research/commentary/2010/2010-13.cfm

135

Even before going public, investment banks typically allocated about half of their revenues to
compensation. For example, Goldman Sachs paid out between 44% and 49% of net revenues in
any given year between 2005 and 2008. Morgan Stanley allotted between 46% and 59% in those
same years. Merrill paid out similar percentages in 2005 and 2006, but gave out 141% of net
revenues in 2007 when they suffered dramatic losses.
As the scale, revenue, and profitability of the firms grew, the compensation packages soared. In
1986, John Gutfreund the CEO of Salomon Brothers, reported to be the highest paid executive
on Wall Street in the late 1980s, received $3.2 million in 1986.264 Stanley O’Neal received a
compensation package worth more than $91million in 2006, the last full year he was CEO of
Merrill Lynch.265 In 2007, Lloyd Blankfein, CEO of Goldman Sachs, received $70 million.
Richard Fuld, CEO of Lehman Brothers and Jamie Dimon, CEO of JPMorgan Chase, each
received approximately $34 million in the same year. In 2007, the Wall Street firms doled out
roughly $33 billion in bonuses alone.266
Stock options became especially popular as a form of compensation. Stock options allow
employees to buy the company’s stock in the future at some predetermined price, most
importantly when the stock price is higher than this predetermined price. In fact, the option
would have no value when the stock price was below the predetermined price. Part of the

264

http://www.nytimes.com/1987/12/23/business/gutfreund-s-pay-is-cut.html

265

Merrill Lynch 2007 Proxy Statement at 38,
http://www.ml.com/annualmeetingmaterials/2007/ar/pdfs/2008Proxy.pdf
266

2/23/2010 New York State Comptroller Report available online
http://www.osc.state.ny.us/press/releases/feb10/bonus_chart_2009.pdf (last retrieved 11/22/2010).

136

motivation for this shift was to align pay with performance.267 Indeed, typically, these options
could not be used unless employees were at the firm for a given period of time.
Other factors that made options more common included 1993 legislation making compensation
in excess of $1 million taxable to the corporation unless it was performance-based. Stock options
had the potential for unlimited upside while the downside was effectively capped. Compensation
structures tying pay to stock price had the unintended consequence at financial firms of creating
an incentive to increase leverage. That leverage would magnify the movement of the stock’s
price in both directions, but the options meant executives would win more than they could lose.
At the same time, that compensation gave financial firms the motive to lever up, the evolution of
the financial system gave them the means. As we have seen, shadow banking institutions
operated with few regulatory constraints on leverage and in the traditional banking sector,
changes in regulations had allowed leverage to increase. And, as we will see, risk management
practices, which were thought to be keeping ahead of these developments, would be ineffective
in counteracting these motives and lack of oversight.

The dangers of the evolving compensation structures on Wall Street were self-evident and wellunderstood, but senior executives at these firms believed they were powerless to do anything
about it. Former Citigroup CEO Sandy Weill told the Commission, “I think if you look at the
results of what happened on Wall Street, it became, ‘Well, this one’s doing it, so how can I not
do it, if I don’t do it, then the people are going to leave my place and go someplace

267

Lucian A. Bebchuck, Fixing Bankers’ Pay, The Economists’ Voice, www.bepress.com, November 2009.

137

else.’…[R]isk became less of an important function in a broad base of companies, I would
guess.”268
Tying compensation to earnings and other metrics was intended to foster stronger alignment of
interests, but in some cases, it created the temptation to manipulate the numbers. For example,
former Fannie Mae regulator Armando Falcon Jr. told the FCIC, “Fannie began the last decade
with an ambitious goal – double earnings in 5 years to $6.46. A large part of the executives’
compensation was tied to meeting that goal.”269 By achieving that earnings-per-share goal,
Fannie CEO Franklin Raines received $52 million out of the $90 million he took home from
1998 to 2003. However, Falcon explained, “[T]he earnings goal turned out to be unachievable
without breaking rules and hiding risks. Fannie and Freddie executives worked hard to persuade
investors that mortgage-related assets were a riskless investment, while at the same time
covering up the volatility and risks of their own mortgage portfolios and balance
sheets.”270 Specifically, in 1998, Fannie’s prepayment model showed an unexpected expense of
$400 million at year end, but “if the full $400 million was properly recognized in 1998, the
executives would have received no bonus compensation for that year.”271 To solve this problem,
Fannie recognized only half of the $400 million, which allowed CEO Raines and other
executives to meet the 1998 earnings target and receive 100% bonus compensation for the

268

Sandy Weill interview, 0:20:50.

269

Testimony of Armando Falcon Jr., Former Director Office of Federal Housing Enterprise Oversight Fannie,
before the Financial Crisis Inquiry Commission, date, at pp. 9-10.
270

Testimony of Armando Falcon Jr., Former Director Office of Federal Housing Enterprise Oversight Fannie,
before the Financial Crisis Inquiry Commission, date, at pp. 9-10.
271

Testimony of Armando Falcon Jr., Former Director Office of Federal Housing Enterprise Oversight Fannie,
before the Financial Crisis Inquiry Commission, date, at pp. 9-10.

138

year.272 Compensation structures were an issue not just for executives and traders, but as we will
see, compensation practices were skewed all along the mortgage securitization chain, from
mortgage origination to mortgage-related assets being packaged by Wall Street. Along the
chain, quantity was directly rewarded and often took precedence over quality. FDIC Chairman
Sheila Bair spoke about compensation for mortgage brokers, those often at the first step in the
chain, telling the FCIC, the “standard compensation practice of mortgage brokers … was based
on the volume of loans originated rather than the performance and quality of the loans made.”273
In the middle of the securitization chain, the investment banks made record profits from
subprime underwriting by collecting a percentage of the sales proceeds.274
Overall, Bair testified, “The crisis has shown that most financial-institution compensation
systems were not properly linked to risk management. Formula-driven compensation allows
high short-term profits to be translated into generous bonus payments, without regard to any
longer-term risks. Many derivative products are long-dated, while employees’ compensation

272

“[I]n the aggregate, the structure of executive pay affects the incentive to inflate earnings. For example, pay
arrangements that enable executives to time the unwinding of equity incentives have been correlated with attempts
to increase short-term stock prices by inflating earnings.” Bebchuk, Lucian A. and Fried, Jesse M., Executive
Compensation at Fannie Mae: A Case Study of Perverse Incentives, Nonperformance Pay, and Camouflage. Journal
of Corporation Law, Vol. 30, No. 4, pp. 807-822, 2005; UC Berkeley Public Law Research Paper No. 653125;
Harvard Law and Economics Discussion Paper No. 505, February 2005. Available at SSRN:
http://ssrn.com/abstract=653125 or doi:10.2139/ssrn.653125, at 811 (citing Scott L. Summers & John T. Sweeney,
Fraudulently Misstated Financial Statements and Insider Trading: An Empirical Analysis, 73 ACCT.. REV. 131
(1998)).
273

Sheila C. Bair, FDIC Chairman, Testimony Before Financial Crisis Inquiry Commission, Jan. 14, 2010, available
at http://fcic.gov/hearings/pdfs/2010-0114-Bair.pdf
274

John M. Quigley, “Compensation and Incentives in the Mortgage Business.” Economists’ Voices,
www.pepress.come/ev, October, 2008 (“The bond issuer is paid a fee, typically between 0.2 and 1.5 percent, when
the bond is issued.”)

139

was weighted toward near-term results. These short-term incentives magnified risk-taking.”275
SEC Chairman Mary Schapiro told the FCIC, “There can be a direct relationship between
compensation arrangements and corporate risk taking. Many major financial institutions created
asymmetric compensation packages that paid employees enormous sums for short-term success,
even if these same decisions result in significant long-term losses or failure for investors and
taxpayers.”276

Financial sector growth “I think we overdid finance versus the real economy”

The financial sector grew faster than the overall economy for about two decades beginning in the
early 1980s—rising from about 4% of Gross Domestic Product to about 5½% in the early 2000s.
In 1980, financial sector profits comprised about 15% of all corporate profits. In 2003, that
percentage hit an all time high of 33% but then fell back a little to 27% in 2006, on the eve of the
financial crisis.277 And, the largest financial firms became considerably larger. For example, at
JP Morgan Chase, assets increased from $667 billion in 1999 to $2.2 trillion at the end of 2008, a
compound annual growth rate of 14% a year. Over this same time period, Bank of America and
Citigroup grew by 12% a year, with Citigroup reaching $2.2 trillion in assets and Bank of
America $1.8 trillion. The investment banks grew significantly from 2000 to 2007, at often at a
much faster pace than these commercial banks. Goldman’s assets increased from $251 billion at
275

Sheila C. Bair, FDIC Chairman, Testimony Before Financial Crisis Inquiry Commission, Jan. 14, 2010, available
at http://fcic.gov/hearings/pdfs/2010-0114-Bair.pdf
276

Mary L. Schapiro, SEC Chairman, Testimony Before Financial Crisis Inquiry Commission, Jan. 14, 2010,
available at http://fcic.gov/hearings/pdfs/2010-0114-Schapiro.pdf
277

Bureau of economic Analysis

140

the end of 1999 to $1.1 trillion by the end of 2007, a growth rate of 20%. At Lehman, assets rose
from $152 billion to $691 billion, a growth rate of 16%.
Like the commercial and investment banks, Fannie and Freddie enjoyed strong growth. From
2000 to 2008, Fannie’s assets and guaranteed mortgages increased from $1.4 trillion to $3.2
trillion, a compound annual growth rate of 10%. At Freddie, they increased from $925 billion to
$2.3 trillion during the same time period, a growth rate of 11%.
As firms grew bigger, they often became more leveraged. Banks, thrifts, investment banks,
insurance companies and the GSEs used highly leveraged growth strategies in the years leading
up to the financial crisis. Increasing leverage meant higher returns for shareholders – and more
money available for compensation - if the company reported profits. Leverage is only one
measure of risk, which has to be viewed in the context of other risk metrics, including asset
quality, duration of debt, and liquidity. But increasing leverage certainly meant that there was
less capital to absorb losses.
Fannie and Freddie were the most levered of them all. The regulations discussed earlier required
the GSEs to maintain a minimum capital of 2.5% of total assets plus 0.45% of the mortgage
backed securities they guaranteed. That meant they could borrow more than $200 for each dollar
of capital for guaranteeing mortgage backed securities. If they wanted to own the securities they
could borrow $40 for each dollar of capital. Combined, Fannie and Freddie owned or guaranteed
$5.3 trillion of mortgage-related assets at the end of 2007 with just $70.7 billion of capital. That
translated to a leverage ratio of 75:1.
From 2000 to 2007, banks and thrifts generally borrowed $16 to $22 for each dollar of capital,
meaning the leverage ratio was between 16:1 and 22:1. For some banks, leverage remained
141

roughly constant over this period. JP Morgan’s reported leverage was between 20:1 and 22:1.
Wells Fargo’s generally ranged from between 16:1 and 17:1 (except for one year when it dipped
to 14:1).278
For other banks, leverage increased over this period. Bank of America’s reported leverage rose
from 18:1 in 2000 to 27:1 in 2007. And Citigroup’s reported leverage increased from 18:1 in
2000 to 22:1 in 2006. It then shot up to 32:1 by the end of 2007, when off-balance sheet assets
were brought on balance sheet. To a greater extent than other banks, Citigroup held assets off of
its balance sheet to – among other reasons – have fewer assets subject to minimum capital
requirements. In 2007, even after bringing on balance sheet $80 billion worth of assets,
Citigroup had substantial off-balance sheets assets. Including all of its off-balance sheet assets,
leverage in 2007 would have been 51:1 or - about 60% higher than reported. In comparison,
including off-balance sheet assets, the 2007 leverage ratios of Wells Fargo and Bank of America
would have been 17% and 28% higher, respectively.
Investment banks were not subject to the same capital requirements as the banks. Investment
banks were given greater latitude to rely on their internal risk models to determine capital
requirements. Not surprisingly, they reported higher leverage. Goldman Sachs’ reported that
leverage increased from 17:1 in 2000 to 32:1 in 2007. Leverage at Morgan Stanley and Lehman
increased about 70% and 20% over these years, respectively, and they both reached a ratio of
40:1 by the end of 2007. Several of the investment banks, as discussed in later chapters, lowered
their reported leverage ratios by temporarily selling assets right before the reporting period and
subsequently buying them back.

278

All leverage ratios reported are the ratio of tangible common assets to tangible common equity.

142

As the investment banks grew in size and leverage, their business models transformed.
Traditionally, investment banks had provided financial advisory services and equity and debt
underwriting services to corporations, financial institutions, investment funds, governments and
individuals. As securitization and similar activities became new sources of profit, an increasing
amount of the investment banks’ revenues and earnings were generated by trading and
investments. For example, at Goldman, revenues from these activities increased from 39% of
total revenues in 1997 to 68% in 2007. At Lehman, trading and investments generated as much
as 80% of pretax earnings in 2006, up from 32% in 1997. At Merrill Lynch, these segments
generated 55% of revenue in 2006, up from 42% in 1997. At Bear, trading and investments
accounted for more than 100% of pretax earnings in some years after 2002 due to pretax losses
reported in other business lines.279

Between 1978 and 2007, the amount of debt held by the financial sector grew from $3 trillion to
$36 trillion, doubling its share of GDP.280

Reflecting on the role of the financial system in the

American economy, former Treasury Secretary John Snow told the FCIC that while the financial
sector must always play a “critical” role in allocating capital to its most productive uses, over the
last 20 or 30 years it had become too large. He pointed out that financial firms had gotten bigger,
largely by simply loaning to each other—not by creating more opportunities for investment. 281
In 1978, the financial sector borrowed $13 in the credit markets for every $100 borrowed by the
non-financial sector. By 2007, the financial sector borrowed $51 for every $100.282 “We have a
279

Proxies

280

Federal Reserve Flow of Funds. These figures are also cited in 13 Bankers.

281

Audio of FCIC interview with Harvey Pitt, roughly at 1:30:00.

282

Federal Reserve Flow of Funds. These figures are also cited in 13 Bankers.

143

lot more debt than we used to have, which means we have a much bigger financial sector. I think
we overdid finance versus the real economy and got it a little lopsided as a result.”283

283

Audio of FCIC interview with Harvey Pitt, roughly at 1:30:00.

144

Part 1, Chapter 4. The Rise of the Subprime Market

Contents
1. 4 The Rise of the Subprime Market .................................................................................................... 145
Overview ............................................................................................................................................... 145
The early years of subprime: “the private bank for the unbanked” ...................................................... 146
Innovation and Transformation in Subprime: “This stuff is so complicated how is anybody going to
know?” .................................................................................................................................................. 148
Technological change: “a whole infrastructure now built up”.............................................................. 154
Subprime lenders in turmoil: “adverse market conditions” .................................................................. 158
The regulators: “Oh, I see” ................................................................................................................... 161

Overview
The total amount of debt outstanding in US credit markets tripled during the 1980s, reaching
$13.7 trillion in 1990, with one-ninth of that debt being securitized mortgages. One decade later,
mortgage securities comprised xx% of the debt markets, overtaking government treasuries as the
single largest component of those markets, a position they would maintain through the financial
crisis. Since the 1970s, Fannie Mae and Freddie Mac had dominated the business, but in the ‘90s
the two GSEs faced a growing challenge from mortgage companies, banks, and Wall Street
securities firms that had begun securitizing mortgages. And more and more of those mortgages
were subprime.

Innovations in technology, new business practices, and regulatory policies played important roles
in expanding the subprime market. At the beginning of the decade, mortgage companies, Wall
Street securities firms, and even the federal government established a new infrastructure for
securitizing non-GSE mortgages, which gave subprime lenders increased access to world capital
markets. Then, midway through the 1990s, lenders developed computerized processes that
145

streamlined the mortgage application process for all borrowers. Meanwhile, a change in the way
regulators enforced an eighteen-year-old law, the Community Reinvestment Act, prompted
banks to figure out new ways to responsibly lend to borrowers that mortgage markets had
previously left behind.

With these changes, the mortgage market evolved, particularly the subprime market. Originally
offering second-lien mortgages and lines of credit to borrowers with little or impaired credit
histories, the subprime market shifted to offering primarily first-mortgages for purchases and
refinancing of homes. Between 1994 and 2000, subprime mortgage originations grew from $35
billion to $140 billion [reconcile with chart] annually. By 2000, just over half of the roughly 1.2
million subprime loans made that year were sold by the lenders in the securitization market. The
subprime sector grew not only in absolute terms, but relative to the overall mortgage market as
well. Its share of total dollar value of mortgage originations rose from 4.5% in 1994 to 12.5% in
1999.284

The early years of subprime: “the private bank for the unbanked”
In the early 1980s, consumer finance companies such as Household Financial Services and S&Ls
such as Long Beach Savings and Loan made home equity loans, often second mortgages, to
borrowers who had yet to establish credit histories or who had troubled credit histories,
sometimes brought on by events such as temporary financial setbacks, unemployment, divorce,
or medical emergencies. Banks might have been unwilling to extend credit to these borrowers,
but a subprime lender would make a loan if it were paid for the extra risk. “No one can debate

284

Elizabeth Laderman, " Subprime Mortgage Lending and the Capital Markets,” FRBSF Economic Letter (Dec. 28,
2001), 1, “http://www.frbsf.org/publications/economics/letter/2001/el2001-38.pdf

146

the need for legitimate non-prime lending products,” Gail Burks, the president of the Nevada
Fair Housing Commission, told the FCIC.285
The interest rates on subprime mortgages weren’t as high as those for car loans, and were much
less than those on credit cards. Often enough, the money from second mortgages went to pay off
other debts. The advantages of a mortgage over other forms of debt were solidified in 1986 with
the Tax Reform Act, which eliminated the tax deductibility of interest payments on consumer
loans but kept the deduction in place for mortgage interest payments.
For the lenders, these loans were riskier than prime mortgages, but given the higher interest rates,
higher fees, and the collateral—an actual house—they could be profitable. In the 1980s and into
the early 1990s, before computerized “credit scoring” fully allowed risk to be translated into hard
numbers, the companies underwrote these subprime loans based on subjective factors. As Tom
Putnam, a Sacramento-based mortgage banker, explained to the Commission, the mortgage
lending industry as a whole had traditionally made loans based on the “four C’s: credit (quantity,
quality and duration of [the borrower’s] credit obligations), capacity (amount and stability of
borrower income), capital (sufficient liquid funds to cover down payment, closing costs and
reserves) and collateral (value and condition of property).”286 Their final decisions depended
upon personal judgments about how well the strength in one area, such as collateral, might offset
weaknesses in others, such as credit. Subprime lenders tended to put the most weight on the
fourth “C” – collateral [ck fact]. As Mark Adelson, a research analyst at Standard & Poors,
explained to the FCIC, “Each placed only secondary emphasis on a borrower's credit history or a
285

Written testimony of Gail Burks at FCIC hearing in Las Vegas (Sept. 8, 2010), 3,
https://vault.netvoyage.com/neWeb2/goID.aspx?id=4826-1195-8024&open=1.
286

Written testimony of Tom Putnam to FCIC hearing in Sacramento (Sept. 23, 2010), [3],
http://fcic.gov/hearings/pdfs/2010-0923-Putnam.pdf

147

borrower's capacity to make monthly loan payments.”287 They underwrote borrowers one at a
time, case by case, out of their local offices. CitiFinancial, one subprime lender, referred to its
network of formal-style branches as “the private bank for the unbanked.”
In a few cases, such as CitiFinancial, these firms were part of a bank holding company, but most
of them were independent consumer finance companies, including Household Financial Services,
Beneficial Finance, The Money Store, and Champion Mortgage. These companies—without
access to deposits – were generally funded by short-term lines of credit, or “warehouse lines,”
from commercial or investment banks. In most cases, these finance companies did not keep the
mortgages. The Money Store—for example—securitized over 80% of the mortgages they
originated. Some companies sold the loans, often to the same banks extending the warehouse
lines. In turn, the banks would securitize and sell off the loans to investors, or, instead, keep
them on their balance sheets. In other cases, the finance company packaged and sold them –
often partnering with the banks extending the warehouse lines. Major warehouse lenders in the
late 1990s supporting the industry included Chase Manhattan Bank, First National in Chicago,
and Bank of America. Meanwhile, the S&Ls that originated subprime loans generally financed
their own mortgage operations and kept the loans on their balance sheets.

Innovation and Transformation in Subprime: “This stuff is so complicated how is
anybody going to know?”
Subprime lenders moved toward greater integration with Wall Street in the late 1980s. Salomon
Brothers, Merrill Lynch, and other Wall Street firms began packaging and selling “non-agency”
mortgages, that is, loans that did not conform to the standards set by Fannie Mae and Freddie

287

FCIC interview with Mark Adelson [need to check]

148

Mac. Selling these non-agency securities required adjusting investors’ expectations. With
Fannie and Freddie securitizations, “it was not will you get the money back, it was when you
will you get the money back,” former Salomon Brothers trader Jim Callahan told the FCIC.
With these new securities, investors had to worry about not getting paid back, and that concern
created an opportunity for S&P and Moody’s. As Lewis Ranieri, a pioneer in the market,
explained to the Commission:
When we wrote the rules on which all securitization rests … when we were going
around to [Capitol] Hill begging people to pay attention to something that didn’t
exist except in our heads, and they asked us really good questions, like this stuff is
so complicated how is anybody going to know? How are the buyers going to
buy? That was a really good question. How are you going to sell this stuff to the
public? Are they going to become mortgage savants? It’s not going to happen.
… It was a legitimate question that Congress asked us. One of the solutions was,
it had to have a rating. And that put the rating services in the business.288
Non-agency securitizations were only a few years old when they received a powerful stimulus
from an unlikely source—the federal government. The savings and loan crisis had left Uncle
Sam with $402 billion in loans and real estate from failed thrifts and banks.289 Congress
established the Resolution Trust Corporation (RTC) in 1989 to offload the mortgages and real
estate the government now owned, and sometimes the thrifts themselves. Most of these assets
were related to commercial loans and properties, but there was an estimated $34 billion or more
in single-family home mortgages.290 This posed a challenge. While the RTC was able to sell
$6.1 billion of these mortgages to Fannie and Freddie,291 the majority did not meet the GSEs’
standards. Some were what might be called subprime today, but others had documentation errors
288

Interview with Lewis Ranieri.

289

FDIC, Managing the Crisis, 29, available at http://www.fdic.gov/bank/historical/managing/history1-01.pdf.

290

FDIC, Managing the Crisis, 405, available at http://www.fdic.gov/bank/historical/managing/history1-16.pdf.

291

FDIC, Managing the Crisis, 407-08, available at http://www.fdic.gov/bank/historical/managing/history1-16.pdf

149

or servicing problems, not unlike the low-documentation loans that would later become
popular.292
Soon enough, RTC officials concluded that they had neither the time nor the resources to sell off
the assets in their portfolio, one by one and thrift by thrift. They turned to the private sector for
help, contracting with real estate and financial professionals to securitize some of the assets in
the failed thrifts’ portfolios. Thus the RTC ended up effectively subsidizing the expansion of
securitization of mortgages ineligible for GSE guarantees. As investors became more familiar
with these new types of assets, mortgage specialists and Wall Street bankers got in on the action
in the early 1990s. From then on, securitization and subprime originations grew hand in hand.
As the chart below shows, total subprime originations increased from $65 million in 1995 to
$xxx million in 2000. The proportion securitized in the 1990s peaked at 55%.

292

FDIC, Managing the Crisis, 38, available at http://www.fdic.gov/bank/historical/managing/history1-01.pdf.

150

Year

Subprime
Total
Originations Originations

Subprime As a
Share of All
Originations

Securitization
Rate

1995

$65

$636

10.2 percent

28.4 percent

1996

$97

$785

12.3 percent

39.5 percent

1997

$125

$859

14.5 percent

53.0 percent

1998

$150

$1,430

10.5 percent

55.1 percent

1999

$160

$1,275

12.5 percent

37.4 percent

2000
Source: HUD-Treasury Report, Curbing Predatory Home Lending, June 2000, and Chomsisengphet and PenningtonCross (2006), using data from Inside MBS & ABS. Staff is still reconciling these numbers using various sources.
Securitization rate = securities issued divided by originations in dollars. Subprime securities include both MBS and
ABS backed by subprime loans.

Securitizations done by the RTC and by Wall Street were similar in many ways to the Fannie and
Freddie securitizations we described in Chapter 2, but there were differences. As with GSE
securitizations, the first step in the process was for the aggregate principal and interest payments
from a group of mortgages to flow into a single pool. But in “private-label” securities (that is,
securitizations not put together by Fannie or Freddie), the payments out of the pool were then
”tranched.” In contrast to the relatively simple securitization done with GSE mortgages,
investors in the different tranches of these deals were entitled to receive different streams of
principal and interest in different orders.

151

Most of the earliest private-label deals, dating to the late 1980s and early 1990’s, already used a
rudimentary form of tranching, discussed in an earlier chapter. There were typically two tranches
in each deal, one more risky and one less risky. The less risky tranche received principal and
interest payments first and was usually guaranteed by an insurance company. The more risky
tranche received payments next, was not guaranteed, and was usually kept by the company that
originated the mortgages.
Within a decade, those non-GSE securitizations had become much more complex, set up with
more tranches that carried more varied payments streams and different risks, tailored to
investors’ demands. The entire mortgage-securitization market—those who created, sold, and
bought the investments—would come to depend greatly on this slice-and-dice process, and
regulators and market participants alike took it for granted that it efficiently allocated risk to
those best able and willing to bear that risk.
To demonstrate how this process ended up working in actual practice, we’ll jump forward to
2006, the height of the housing boom, and describe a typical deal with $947 million in mortgagebacked bonds. In this case, New Century, a California-based lender, originated and then sold
about 4,499 subprime mortgage loans to Citigroup, which sold them to a trust that Citi
sponsored. The trust purchased the loans with the cash it had raised by selling the securities that
would be backed by these loans. The trust had been created as a separate legal structure so that
the assets would sit “off balance sheet” from Citigroup, which had tax and regulatory benefits.
The 4,499 mortgage loans carried with them the rights to the 4,499 borrowers’ monthly
payments, which the Citigroup trust divided into 19 tranches of mortgage-backed securities, each
tranche giving its investors a different priority claim on the flow of payments due from the

152

borrowers, and a different interest rate and repayment schedule. The credit rating agencies would
assign ratings to each one of these tranches for investors, who – as securitization became
increasingly complicated – relied more and more on these ratings. In this Citigroup deal, the
four senior tranches – the safest slices of the deal - were rated AAA by the agencies, their highest
grade.
Below the senior tranches and next in line for payments were eleven “mezzanine” tranches named thus because they sat between the riskiest and the safest tranches. These carried higher
credit risk than the senior tranches and, because they were paid off more slowly, a higher risk
that an increase in interest rates would make the locked-in interest payments on these tranches
less valuable. As a result, they paid a correspondingly higher interest rate. In the Citigroup deal,
each mezzanine tranche had between two and five investors. Three of these tranches were rated
AA, four were rated A, three were rated BBB, the lowest investment-grade rating, and one was
rated BB, or junk.
The last to be paid was the most junior tranche, called the “equity,” “residual,” or “first loss”
tranche, which was set up to receive whatever cash flow was left over after all the other investors
had been paid. This tranche suffered the first losses from any defaults of the mortgages in the
pool. Commensurate with this high risk, it provided the highest yields. In the Citigroup deal, and
as was common, this piece of the deal was not rated at all. Citigroup and a hedge fund each held
half of the equity tranche.
[INSERT MBS SCHEMATIC HERE]
While investors in the lower-rated tranches received higher interest rates because they knew
there was a risk of loss, investors in the AAA senior tranches did not expect losses. They
153

believed these investments, which paid interest rates roughly xx% higher than Treasury bonds
were as safe as AAA-rated corporate bonds, which paid xx% more than Treasury bonds. This
expectation of safety was important, so the securitizers focused intently on structuring securities
in order to achieve high ratings In the structure of this Citigroup deal, which was typical in this
regard, over 85% of the $x billion deal – or $737 million - was rated triple-A. It was magical,
nothing less.

Technological change: “a whole infrastructure now built up”
As private-label securitization began to take hold, new technologies were reshaping the mortgage
market. In the mid-1990s, standardized data with loan-level information on mortgage
performance became more widely available. Furthermore, mortgage providers learned how to
adapt credit scores, previously used only for consumer loans, to mortgage underwriting. Of
these, the most famous was—and still is – the FICO score, developed by the Fair, Isaac
Corporation. With credit risk reduced to a single number, underwriters could use their
computers to match an applicant with a pool of similar borrowers with similar collateral,
capacity, and capital, look at the mortgage repayment history of that pool, and generate an
estimate of the application’s riskiness almost immediately. In 1994, Freddie Mac rolled out Loan
Prospector, an automated system for mortgage underwriting for use by lenders, and Fannie Mae
released its own system, Desktop Underwriter, two months later.293 No more laborious, slow,
and subjective underwriting of individual mortgages.
This newly-minted underwriting process was based on a set of formalized expectations. Given
the borrower, the home, and the mortgage characteristics, what was the probability that payments
293

John W. Straka, “A Shift in the Mortgage Landscape: The 1990s Move to Automated Credit Evaluations,”
Journal of Housing Research 11 (2000), 207-32.

154

would be made on time? What was the probability that borrowers would pre-pay their loans,
either because they sold their homes or refinanced with lower interest rates? In the case of
subprime mortgages, the lenders did not have a long history of lending on which to base their
expectations, so they modeled subprime repayment with extrapolation from prime borrowers’
behavior and some guesswork.
Technology and data availability also had an effect in the 1990s on the implementation of the
Community Reinvestment Act (CRA). Congress had enacted CRA in 1977 to ensure that
regulated banks and thrifts served their local communities, in response to concerns that banks
had “redlined”--or in other words, refused to lend on a wholesale basis to certain neighborhoods.
Federal Reserve Board Chairman Ben Bernanke explained the motivation behind the legislation
in a speech years later:
Public and congressional concerns about the deteriorating condition of America's
cities, particularly lower-income and minority neighborhoods, led to the
enactment of the Community Reinvestment Act. In the view of many, urban
decay was partly a consequence of limited credit availability, which encouraged
urban flight and inhibited the rehabilitation of declining neighborhoods. Some
critics pinned the blame for the lack of credit availability on mainstream financial
institutions, which they characterized as willing to accept deposits from
households and small businesses in lower-income neighborhoods but unwilling to
lend or invest in those same neighborhoods despite the presence of creditworthy
borrowers.294
CRA called on banks to make investments, extend loans, and provide banking services in areas
where they took deposits, so long as these activities were consistent with the banks’ financial
safety and soundness. It directed regulators to consider CRA performance whenever a bank

294

Ben Bernanke, “The Community Reinvestment Act: Its Evolution and New Challenges,” speech at the
Community Affairs Research Conference, Washington, DC (Mar. 30, 2007), available at
http://www.federalreserve.gov/newsevents/speech/bernanke20070330a.htm.

155

applied to merge with another bank, open new branches, or receive regulatory permission to
engage in new activities.295
To comply with the law, banks now extended credit to borrowers who had previously been
categorically denied. Sometimes these borrowers had a lower credit score than the average
borrower. Often they had lower income. Nonetheless, some studies indicated that the
performance of loans made under the CRA was consistent with the rest of the banks’ portfolios,
suggesting that CRA lending was not riskier than lending otherwise done by the banks.[cite]
“There is little or no evidence that banks’ safety and soundness have been compromised by such
lending, and bankers often report sound business opportunities,” Federal Reserve Board
Chairman Alan Greenspan said of CRA lending in 1998.296
In 19## President Clinton directed the regulators of the banks and thrifts to address criticisms
that proving compliance with CRA to the regulators was burdensome and that the process was
subjective. In 1995, the Federal Reserve, OTS, OCC, and FDIC finalized new regulations that
shifted regulators’ focus from the efforts that banks made to the results of those efforts. These
changes were intended to decrease the regulatory burden, but also to bolster enforcement of the
act.297 In the process, these changes made a lack of adherence to the law easier to uncover.

295

Financial Crisis Inquiry Commission, “The Community Reinvestment Act and the Mortgage Crisis,” Preliminary
Staff Report (Apr. 7, 2010), http://fcic.gov/reports/pdfs/2010-0407-Preliminary_Staff_Report__CRA_and_the_Mortgage_Crisis.pdf.
296

Glenn Canner and Wayne Passmore, “The Community Reinvestment Act and the Profitability of MortgageOriented Banks,” Working Paper (Mar. 3, 1997),
http://www.federalreserve.gov/pubs/feds/1997/199707/199707pap.pdf.
297
Statement of Sandra F. Braunstein, Director, Division of Consumer and Community Affairs
Board of Governors of the Federal Reserve System before the Committee on Financial Services
U.S. House of Representatives, February 13, 2008. See also, Federal Register, May 4, 1995, pp. 22155-22223
(“Specifically, the President asked the agencies to refocus the CRA examination system on more objective,
performance-based assessment standards that minimize compliance burden while stimulating improved
performance. He also asked the agencies to develop a well-trained corps of examiners who would specialize in CRA

156

Regulators and community advocates could now point to objective, observable numbers to
measure banks’ compliance.
Former Comptroller of the Currency John Dugan told FCIC staff that, in his opinion, the
Community Reinvestment Act had made a lasting impact on the banks’ lending to people that in
the past might not have had access to credit:
There's a whole infrastructure now built up in banks and in the agencies and in the
advocate's groups and there is a tremendous amount of investment that goes on in
inner cities and other places to build things that are quite impressive....And the
bankers say this is proven to be a business where we can make some money; not a
lot, but when you factor in the good will we get for this, it kind of works.298
Larry Lindsey, a former Federal Reserve Governor who was responsible for the Fed’s Consumer
and Community Affairs Division, which oversaw 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 profitable, such as creating credit scoring models customized
to the market. Shadow banks not covered by the CRA would use these same credit scoring
models, estimated off of now more substantial historical lending data, to underwrite loans. “We
basically got a cycle going which particularly the shadow banking industry could, using recent
historic data, show the default rates on this type of lending were very very low,” he said. Indeed,
default rates were low during the prosperous 1990s, and regulators, bankers and lenders in the
shadow banking system took note of this success.299

examinations. The President requested that the agencies promote consistency and even-handedness, improve CRA
performance evaluations, and institute more effective sanctions against institutions with consistently poor
performance.”)[ this is actually clearer than our text]
298
John Dugan interview, March 12, 2010; recording starting about 1:04:20.
299

Audio of FCIC interview with Larry Lindsey, ca. 5:00.

157

Subprime lenders in turmoil: “adverse market conditions”
Among nonbank mortgage originators, the late 1990s was a turning point. We have reported on
the market disruption caused by the Russian debt crisis and the collapse of Long Term Capital
Management hedge fund. That was in 1998, and it momentarily put a crimp in the subprime
market. The markets saw a ‘flight-to-quality’ – in simpler terms, the demand among investors for
risky assets plummeted, including for loans originated by subprime lenders. As shown in the
chart above, the rate of subprime mortgage securitization dropped from 55.1% in 1998 to 37.4%
in 1999. Meanwhile subprime originators saw the interest rate at which they could borrow in
credit markets skyrocket. They were caught in a squeeze: increased borrowing costs at the very
moment their revenue stream dried up.300 And, some were caught holding tranches of subprime
securities that they had valued well above what they turned out to be worth.
Mortgage lenders dependent on liquidity and short-term funding from the capital markets had
immediate problems. For example, Southern Pacific Funding (SFC), an Oregon-based subprime
lender that securitized its loans, reported relatively positive second quarter figures in August
1998.301 Then, in September, SFC notified investors about “recent adverse market conditions” in
the securities markets and expressed concern about “the continued viability of securitization in
the foreseeable future.”302 A week later, SFC filed for bankruptcy protection.303 Several other
nonbank subprime lenders dependent on the short-term financing from the capital markets also
300

Souphala Comsisengphet and Anthony Pennington-Cross, “The Evolution of the Subprime Mortgage Market,”
Federal Reserve Bank of St. Louis Review 88 (Jan./Feb. 2006), 40.

302

September 11, 1998, SFC SEC Form 8-K

303

October 1, 1998, SFC, SEC Form 8-K

158

filed for bankruptcy in 1998 and 1999, including Citiscape, Criimi Mae, FirstPlus and United
Companies Financial. In the two years following the Russian default crisis, eight of the top ten
subprime lenders declared bankruptcy, ceased operations, or sold out to stronger firms.304 Even
when they sold, their buyers would take big hits.
First Union, a large regional bank headquartered in North Carolina, incurred charges of almost
$5 billion after it bought The Money Store, due in large part to a failed plan to securitize The
Money Store’s loans. First Union eventually shut down or sold off most of The Money Store’s
operations--one of the first decisions by newly named First Union CEO Ken Thompson. Despite
this experience, at the height of the housing bubble, Thompson, CEO of the merged First
Union/Wachovia bank, would champion the purchase of Golden West Financial Corp the
[largest] originator of risky, option ARM mortgages that would see a wave of defaults.305
Conseco, a leading insurance company, experienced even more disastrous results after buying
Green Tree, another big subprime lender, in 1998. Green Tree was the largest lender for mobile
homes and the fourth-largest provider of retailer-issued credit cards. Like The Money Store,
Green Tree had pursued an aggressive program for securitizing the subprime loans it created, and
disruptions in the securitization markets, as well as unexpected defaults that partly stemmed from
the lenders’ relaxation of underwriting standards, eventually drove Conseco into bankruptcy in

304

FCIC tabulation from various sources including IMF. “A Short History of Subprime, By White, Brenda
Mortgage Banking, March 1 2006 says “6 of the top 10 suffered their demise”.
305

PLACEHOLDER FOR FUTURE CITATION.

159

December 2002. At the time, this was the third-largest bankruptcy in U.S. history (after
WorldCom and Enron).306
But the liquidity crunch would not be the only problem for the subprime lending industry –
accounting misrepresentations would also bring firms down. Keystone, a small national bank in
West Virginia that made home improvement and debt consolidation subprime mortgage loans,
failed in 1999. Keystone had pooled its own subprime loans with those purchased from other
firms and issued mortgage-backed securities. In the process—this was common practice in the
1990s -- Keystone retained the riskiest “first loss” tranches for its own account. These holdings
far exceeded the bank’s capital. But, Keystone assigned them grossly inflated values based on
aggressive cash-flow assumptions. The Office of the Comptroller of the Currency closed the
bank in September 1999, after discovering that the bank’s executives had fraudulently overstated
the value of the residual tranches and other bank assets. [verify fraudulence/prosecution?] That
collapse cost the FDIC’s deposit insurance fund more than $800 million.307
Perhaps the most significant failure occurred at Superior Bank, one of the most aggressive
subprime mortgage lenders. Superior originated or purchased more than $4.5 billion in subprime
loans between 1997 and 1999, using mortgage brokers to generate three-quarters of them. Of
course, Superior earned originating and securitizing fees. And, like Keystone, it also produced
substantial ‘profits’ by keeping and valuing the “first loss” tranches on its balance sheet. In
1999, Superior held first-loss tranches valued at almost $1 billion, more than three times the

306

Alex Berenson, “Trailer Owners and Conseco Are Haunted by Risky Loans,” New York Times, November 25,
2001, http://www.nytimes.com/2001/11/25/business/25GARY.html?pagewanted=all.
307

General Accounting Office, “Bank Regulation: Analysis of the Failure of Superior Bank, FSB, Hinsdale,
Illinois,” GAO-02-419T (Feb. 7, 2002), 24, www.gao.gov/new.items/d02419t.pdf.

160

amount of its capital. In 2000, OTS and FDIC examiners determined that Superior had
overstated the value of residual assets by $150 million.308 Superior failed in July 2001, costing
the FDIC’s deposit insurance fund more than $400 million.
Many of the lenders who survived or were bought in the 1990s reemerged in other forms. Long
Beach S&L was the ancestor of Ameriquest and Long Beach Mortgage (in turn purchased by
Washington Mutual), two of the more aggressive lenders during the 2000s. First Associates sold
out to Citigroup, and Household Finance bought Beneficial Mortgage, before itself being
acquired by HSBC in 2002.
With all these problems, the total subprime business fell off a little. In 2000, subprime
originations totaled $100 billion, down from $135 billion two years earlier. Over the next years,
subprime lending and securitization would more than rebound.

The regulators: “Oh, I see”
During the 1990s, various federal agencies had taken increasing notice of abusive lending
practices in the subprime mortgage market. But the regulatory system was not well equipped to
respond consistently—and on a national basis--to protect borrowers. State regulators, as well as
either the Fed or the FDIC, supervised the mortgage practices of state banks. The OCC
supervised the national banks. The Office of Thrift Supervision or state regulators were
responsible for the thrifts. State regulators also registered mortgage brokers, a growing portion of
the market, but did not supervise them.

308

Material Loss Review of Superior Bank FSB (OIG-02-040)

http://www.ustreas.gov/inspector-general/audit-reports/2002/oig02040.pdf.

161

Amid the diffuse authority, there was nonetheless no question that Congress had authorized one
entity to write strong and consistent rules regulating mortgages for all types of lenders: the
Federal Reserve, through the Truth In Lending Act, passed by Congress in 1968. The following
year, the Fed adopted Regulation Z for the purpose of implementing the Act. However, while
Regulation Z applied to all lenders, its enforcement was divided among America’s many
financial regulators.
The Fed had the legal mandate to supervise bank holding companies, including the authority to
supervise nonbank subsidiaries such as subprime lenders. The Federal Trade Commission was
given explicit authority by Congress to enforce consumer protections embodied in the Truth in
Lending Act with respect to these nonbank lenders. The FTC had a limited budget and staff
relative to its mandate to supervise these lenders although it did bring enforcement actions
against mortgage companies [follow up with FTC]. “We could have had the FTC oversee
mortgage contracts,” former HUD Secretary Henry Cisneros told the Commission. “But the
FTC is up to their neck in work today with what they’ve got. They don’t have the staff to go out
and search out mortgage problems.”309
Glenn Loney, Deputy Director of the Fed’s Consumer Division from 1992 to 2010, told the
FCIC that Fed officials had been debating whether they—in addition to the FTC—should
enforce rules for nonbank lenders since he had joined the agency in 1975.310 But they worried
about whether the Fed would be stepping on Congressional prerogatives by assuming

309

Audio of FCIC interview with Henry Cisneros (Oct. 13, 2010), 1:32:59.

310

Transcript of FCIC interview with Glenn Loney (Apr. 1, 2010), 5, 21 . [p. 5 is his bio, p. 21 is his comment on
authority

162

enforcement responsibilities it had delegated to the FTC.311 “A number of governors came in
and said, ‘You mean to say we don’t look at these?’” Loney said. “And then we tried to explain
it to them, and they’d say, ‘Oh, I see.’”312 The Federal Reserve would not exert its authority in
this area, nor others it would receive in 1994, with any real force until after the housing bubble
burst.
That 1994 legislation was the Home Ownership and Equity Protection Act, passed by Congress
and signed by President Clinton to address the growing problem of abusive and predatory
mortgage lending practices, especially with low-income borrowers. HOEPA specifically noted
that certain communities were “being victimized … by second mortgage lenders, home
improvement contractors, and finance companies who peddle high-rate, high-fee home equity
loans to cash-poor homeowners.”313 For example, a Senate report highlighted hearing testimony
from a 72-year-old homeowner who paid more than $23,000 in upfront finance charges on a
$150,000 second mortgage. The monthly payments exceeded her income.314
HOEPA curbed abusive practices relating to certain high-cost refinance mortgage loans,
including prepayment penalties, negative amortization, and balloon payments with a term of less
than five years. The legislation also prohibited lenders from making high-cost loans based on
collateral value of the property alone (a common practice, as noted above) and “without regard to

311

Transcript of FCIC interview with Glenn Loney (Apr. 1, 2010), 15.

312

Transcript of FCIC interview with Glenn Loney (Apr. 1, 2010), 28.

313
314

Senate Report 103-169 (Oct. 28, 1993), 23.
Senate Report 103-169 (Oct. 28, 1993), 24.

163

the consumers’ repayment ability, including the consumers’ current and expected income,
current obligations, and employment.”315
Only a certain small set of mortgages were initially subject to the HOEPA restrictions.316 Yet,
HOEPA specifically directed the Fed more broadly to “prohibit acts or practices in connection
with mortgage loans that the Board finds to be unfair, deceptive or designed to evade the
provisions of the [act].”
In June 1997, two years after HOEPA took effect, the Fed held the first set of public hearings
required under the act. The venues were Los Angeles, Atlanta, and Washington, D.C. Consumer
advocates reported abuses by home equity lenders. Mortgage lenders acknowledged that some
abuses existed, blamed some of these on mortgage brokers, and suggested that increasing
securitization of subprime mortgages had limited the opportunity for widespread abuses.
Lenders noted that “[c]reditors that package and securitize their home equity loans must comply
with a series of representations and warranties. These include creditors’ representations that they
have complied with strict underwriting guidelines concerning the borrower’s ability to repay the
loan.”317 But, these representations and warranties proved to be inaccurate in the years to come.
The Fed continued not to press its prerogatives. In January 1998, it formalized its longstanding
policy of “not routinely conduct[ing] consumer compliance examinations of nonbank

315

15 U.S.C. Sec. 1639(h)

316

Loans were only subject to HOEPA if they hit the interest rate trigger or fee trigger, namely if the annual
percentage rate for the loan was more than 10 percentage points above the yield on Treasury securities 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..
317

Board HUD Report at 56

164

subsidiaries of bank holding companies,”318 an action that would be criticized as creating a “lack
of regulatory oversight” by a November 1999 Government Accountability Office report. In July
1998, the Federal Reserve jointly issued a report with the Department of Housing and Urban
Development (HUD) which, among other things, summarized its findings from its HOEPA
hearings and made recommendations on mortgage reform. While preparing draft
recommendations for the report, Fed staff wrote to the Fed’s Committee on Consumer and
Community Affairs that “Given the Board’s traditional reluctance to support substantive
limitations on market behavior, the draft report discusses various options but does not advocate
any particular approach to addressing these problems”319
In the end, the two agencies did not agree on the full set of recommendations addressing
predatory lending. But, recommendations that were supported by both the Fed and HUD
included instituting legislative bans on balloon payments and advance collection of lump-sum
insurance premiums, stronger enforcement of current laws, and non-regulatory strategies such as
community outreach efforts and consumer education and counseling.320
A year later, the Gramm-Leach-Bliley Act overturned the Depression-era Glass-Steagall
restrictions on banks and, as noted, set forth the so-called “Fed-Lite” provisions that limited the
Fed’s authority to examine, impose capital requirements on, or obtain reports from banking,
securities or insurance subsidiaries of bank holding companies. While Fed-Lite did not
specifically address consumer compliance examinations [check] or deal with mortgage lending
318

Board of Governors of the Federal Reserve System, Division of Consumer and Community Affairs, Letter CA
98-1, dated Jan. 20, 1998.
319

Memo to the Committee on Consumer and Community Affairs, Apr. 8, 1998 (FRB-FCIC-114038-114094, at
114080).
320

HUD-Board report, 57-85. See also Chapter 2 at page 17, Chapter 7 at page 76, and Appendix D.

165

subsidiaries of bank holding companies, it was consistent with the Fed’s hands-off approach to
mortgage lending at the time.

Even so, the shakeup in the subprime industry in the late 1990s had drawn regulators’ attention
to at least some of the risks associated with this lending, The failures of many non-bank
subprime lenders led officials at the Federal Reserve System, FDIC, Office of the Comptroller of
the Currency, and Office of Thrift Supervision to anticipate that the banks, no doubt believing
they could do a better, safer job, would rush to fill the vacuum.
Focusing on the effect of subprime defaults on the safety and soundness of depository
institutions, the four federal banking agencies jointly issued subprime lending guidance on
March 1, 1999.321 This guidance would only apply to regulated banks and, even then, it would
not be binding—only laying out the criteria underlying regulators’ bank examinations. It
explained that “recent turmoil in the equity and asset-backed securities market has caused some
non-bank subprime specialists to exit the market, thus creating increased opportunities for
financial institutions to enter, or expand their participation in, the subprime lending business.”
The agencies then identified key features of subprime lending programs and the need for
increased capital, risk management, and board and senior management oversight. They further
noted concerns about various accounting issues, notably the valuation of any residual tranches
held by the securitizing firm. The guidance went on to say, “Institutions that originate or
purchase subprime loans must take special care to avoid violating fair lending and consumer
protection laws and regulations. Higher fees and interest rates combined with compensation
incentives can foster predatory pricing…An adequate compliance management program must
321

See March 1, 1999, Interagency Guidance on Subprime Lending Located at
http://www.federalreserve.gov/boarddocs/srletters/1999/sr9906a1.pdf (accessed on October 14, 2010)

166

identify, monitor and control the consumer protection hazards associated with subprime
lending.” 322 Six months later, Keystone Bank went under.323
In April 2000, in response to growing complaints about lending practices, and at the urging of
Senator Barbara Mikulski, 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 associations representing mortgage lenders, brokers,
and appraisers, local and state officials, and academics. Like the Fed’s hearings three years
earlier, this new one took to the field, conducting hearings in Atlanta, Los Angeles, New York,
Baltimore and Chicago. The task force found “patterns” of abusive practices, writing that,
“throughout the HUD-Treasury forums, there was substantial evidence of too-frequent abuses in
the subprime lending market.”324 Practices included loan flipping (repeated refinancing of
borrowers’ loans in a short time); high fees and prepayment penalties that resulted in borrowers
losing the equity in their homes; and outright fraud and abuse involving deceptive or highpressure sales tactics.325 The report cited a Consumers Union report that identified forgery of
signatures, falsification of incomes and appraisals, illegitimate fees, and bait-and-switch
tactics.326 The report confirmed that subprime lenders often preyed on the elderly, minorities,
and borrowers with lower incomes and less education, often individuals who had “limited access
322

See March 1, 1999, Interagency Guidance on Subprime Lending Located at
http://www.federalreserve.gov/boarddocs/srletters/1999/sr9906a1.pdf (accessed on October 14, 2010)

324

HUD- Treasury report, pg 2

325

The National Predatory Lending Task Force, convened by Housing and Urban Development Secretary Andrew
Cuomo and Treasury Secretary Lawrence Summers, included consumer advocates, industry representatives, local
and state officials, and academics. It held field hearings in Atlanta, Los Angeles, New York, Baltimore and
Chicago.
326

HUD-Board report, 55.

167

to the mainstream financial sector,” meaning the banks, thrifts, and credit unions which the task
force considered subject to more extensive government oversight.327
Consumer protection groups took the same message to public officials. In interviews and
testimony to the FCIC, representatives of the National Consumer Law Center, Nevada Fair
Housing Center, and California Reinvestment Coalition each said they had contacted Congress
and the four bank regulatory agencies multiple times about their concerns over unfair and
deceptive lending practices.328 “It was apparent on the ground as early as 1996, and clear in
1998, that the market for low-income consumers was being flooded with inappropriate
products,” Diane Thompson of the NCLC told the Commission.329
The HUD-Treasury task force recommended a set of reforms aimed at protecting borrowers from
the most egregious practices in the mortgage market, including better disclosure, improved
financial literacy, strengthened enforcement, and new legislative protections. However, the
report also recognized the downside of restricting lending practices, which created the possibility
of homeownership for many borrowers with less-than-prime credit. It was a dilemma. Gary
Gensler, then a senior Treasury official who worked on the report, told the FCIC that the report’s

327

Ibid., pp. 1-2.

328

Gail Burks: testimony of the FCIC Las Vegas hearing (Sept. 8, 2010), 242, http://fcic.gov/hearings/pdfs/20100908-transcript.pdf; Kevin Stein: transcript of to the FCIC Sacramento hearing (Sept. 23, 2010), 8,
http://fcic.gov/hearings/pdfs/2010-0923-Stein.pdf; Audio of FCIC interview with Diane Thompson and Margot
Saunders (Sept. 10, 2010), 0:08:22, https://vault.netvoyage.com/neWeb2/goId.aspx?id=4849-1787-5975&open=Y;
329

Audio of FCIC interview with Diane Thompson and Margot Saunders (Sept. 10, 2010), 0:12:03,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4849-1787-5975&open=Y

168

recommendations “lasted on Capitol Hill a very short time. There wasn’t much appetite or mood
to take these recommendations.”330

But, problems persisted and others would take up the mantle. Through the early years of the
decade “the really poorly underwritten loans, the payment shock loans” continued to proliferate
outside the traditional banking sector, said FDIC Chairman Sheila Bair, who served at Treasury
as the assistant secretary for financial institutions from 2001 to 2002. In testimony to the
Commission, she said that these poor-quality loans pulled market share from traditional banks
and “created negative competitive pressure for the banks and thrifts to start following suit.”
“It was started and the lion’s share of it occurred in the non-bank sector, but it clearly created
competitive pressures on banks,” Bair said. “…I think nipping this in the bud in 2000 and 2001
with some strong consumer rules applying across the board that just simply said you’ve got to
document a customer’s income to make sure they can repay the loan, you’ve got to make sure the
income is sufficient to pay the loans when the interest rate resets, just simple rules like
that….could have done a lot to stop this.”331
When she was nominated to her position at Treasury, and was making the rounds on Capitol Hill,
Senator Paul Sarbanes, Chairman of the Committee on Banking, Housing, and Urban Affairs,
told her about lending problems in Baltimore, where foreclosures were on the rise. He asked Bair
to read the HUD/Treasury report on predatory lending, and she became interested in the issue.

330

Transcript of FCIC interview with Gary Gensler (May 14, 2010), 7,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4832-6892-9287&open=Y.
331

Bair testimony to FCIC, Jan. 13, 2010.

169

Sarbanes introduced legislation to remedy the problem, but it faced significant resistance from
the industry and within Congress, Bair told the Commission.332 Bair decided to try to get the
industry to adopt a set of “best practices” that would include a voluntary ban on mortgages which
strip borrowers of their equity, and would offer borrowers the opportunity to avoid prepayment
penalties by agreeing to instead pay a higher interest rate. She reached out to Edward Gramlich, a
governor at the Fed, to enlist his help in getting companies to abide by these rules. Gramlich,
who shared her concern, indicated to her that the Fed, where he was one of seven governors, was
unlikely to consider imposing such a rule on lenders. Bair said that Gramlich “didn’t talk out of
school,” but that he made it clear to her that “the Fed avenue wasn’t going to happen.”333
Similarly, Sandra Braunstein, director of the division of consumer and community affairs at the
Fed, said that Gramlich told the staff that Greenspan was not interested in increased
regulation.334
Bair and Gramlich approached a number of lenders about the voluntary program. Some
originators, she told the Commission, were sympathetic to the idea and appeared willing to
participate. But the Wall Street firms that securitized the loans resisted the effort, saying they
were concerned about possible liability if they did not adhere to these best practices, she said.
The effort died.335
Of course, while these initiatives went nowhere, the market did not stand still. Subprime
mortgages were becoming mainstream. Originations were increasing, and products were
332

FCIC interview with Sheila Bair.

333

FCIC memorandum for the record, of Sheila Bair interview of March 29, 2010, p.2.

334

FCIC memorandum for the record, Sandra Braunstein interview of April 1, 2010, p. 4.

335

FCIC interview with Sheila Bair.

170

changing. By 1999, three of every four subprime mortgages was a first lien. Of those first lien
mortgages, 82 percent were used for refinancing rather than home purchase. Fifty-nine percent
of those refinancings were “cash out,”336 helping to fuel consumer spending while whittling
away homeowners’ equity.

336

US Treasury and Department of Housing and Urban Development, “Curbing Predatory Home Lending” (Jun. 1,
2000), 31, http://www.huduser.org/portal/publications/hsgfin/curbing.html.

171

Part II: The Mortgage Market

Part II, Chapter 1: Credit Expansion
By the end of 2000, the economy had grown for 39 straight quarters. Federal Reserve Chairman
Alan Greenspan seemed to have good reason to argue that the financial system had achieved an
unprecedented resilience to financial shocks. Large financial companies were—or appeared to be
on paper—profitable, diversified, and, their executives and government regulators agreed,
protected from catastrophe by sophisticated new risk management techniques.
The housing market was also strong. Between 1995 and 2000, prices had risen at an annual rate
of 5.2%; in the next five, the annual rate would hit 11.6%.337 These prices were higher in part
due to lower interest rates for all mortgage borrowers and increased access to mortgage credit for
households who traditionally had been kept out of the market—including subprime borrowers.
Indeed, these lower interest rates and broader access to credit applied not just to mortgages, but
also to other types of household borrowing, such as credit cards and auto loans.
Increased access to credit meant a more stable, secure life for those who managed their finances
prudently. It meant that families could borrow to smooth out temporary drops in their incomes,
to pay for unexpected expenses, and to make large purchases such as household appliances and
cars. Most of all, it meant a shot at homeownership, with all of the benefits that entailed.

337

Figures represented the compound average growth rate and are from CoreLogic National Home Price Index,
Single-Family Combined (SCF). CoreLogic Loan Performance HPI August 2010. Available at
http://www.corelogic.com/About-Us/ResearchTrends/Home-Price-Index.aspx, authors’ calculations.

172

As home prices rose, homeowners felt more financially secure and – partly as a result – saved
less and less out of their income. The effect was unprecedented debt: between 2000 and 2006,
Americans would borrow more money than they had over the previous 200 years.338 Household
debt rose from 80% of personal income in 1993 to 130% by mid-2006.339 Over [XXX]% of this
increase was in higher mortgage debt. Part of the increase in mortgage debt was from new home
purchases, part was from more debt placed on homes. Leverage, in a word. But, as the thinking
went, housing prices don’t go down.
Access to mortgage credit expanded when subprime lending resumed its strong growth after the
first round of independent subprime lenders had largely gone out of business in 1998 and 1999.
In the wake of these failures, the banks—the biggest banks--moved in. Citigroup, with roughly
$800 billion in assets, paid $31 billion for Associates First Capital, the second-biggest subprime
lender. Still, subprime remained only a small corner of the market, accounting for just 9.5% of
new mortgages in 2000. 340
Risks associated with subprime lending and questionable lending practices remained a concern.
Still, the Federal Reserve was not aggressive about employing the unique authority granted it by
the HOEPA legislation. While in 2004 the Fed did fine Citigroup $70 million for several lending
violations, it only instituted minor revisions to the specific rules on mortgage lending practices
for a narrow set of high-cost loans. It and other regulators, however, did revise the capital

340

Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual—Volume 1, Mortgage Originations by
Product, p4.

173

standards for banks following the losses suffered by Keystone, Superior, and other banks
involved in subprime securitization.

Fed: “Technology called the printing press”
By the beginning of 2001, the economy was starting to slow, even though unemployment
remained at a 30-year low of 4%. For all of 2001, Gross Domestic Product, or GDP – the most
commonly used measure of the economy – would inch up only slightly more than 1%. To
stimulate borrowing and spending, the Federal Reserve’s Open Market Committee lowered
short-term interest rates aggressively. On January 3, 2001, in a rare conference call in between
scheduled meetings, it cut the benchmark Fed Funds Rate—the rate at which banks lend to each
other overnight—by a half percentage point,341 rather than the more typical adjustment of a
quarter percentage point. Later that month, the committee cut the rate another half percentage
point, and it would continue to cut throughout the year – 11 times, to 1.75%, the lowest level in
40 years.
In response to the slowing economy and the 9/11 attacks, the Federal Reserve flooded the
financial system with cash. In the end, the recession of 2001 turned out to be relatively mild,
lasting only eight months, from March to November, and GDP dropped by only 0.3% Some
policy-makers came to the conclusion that perhaps, with effective monetary policy, the economy
had reached “the end of the business cycle”[cite] which some economists had been predicting
since before the tech crash. “[R]ecessions have become less frequent and less severe,” Ben
Bernanke, then a Fed Governor, said in an early 2004 speech. “Whether the dominant cause of

341

May need to be careful here - there is the argument that they should have cut earlier but the election season
created political constraints.

174

the Great Moderation is structural change, improved monetary policy, or simply good luck is an
important question about which no consensus has yet formed.”342
With the recession officially over and mortgage rates at their lowest levels in XX years, the
housing industry kicked into gear—again. In 2002, California would lose 41,700 jobs overall but
gain 17,400 in construction. Florida would add 54,000 construction jobs in 2002 and 2003;
nationwide, the figure was 189,000.343 In 2003, more than 1.8 million single-family dwellings
were started, a level unseen since the late 1970s. From 2002 to 2005, the total contribution of
residential construction to the overall economy was three times larger than its average
contribution since 1990.
But other sectors of the economy remained sluggish, and overall employment gains were
frustratingly small. Private sector employment continued to fall through the summer of 2003 and
did not return to pre-recession levels until 2005. Shortly after the recession ended, experts began
talking about a “jobless recovery”—an increase in production without a corresponding increase
in employment. For those who did have jobs, wage growth remained stagnant. [insert data]
Faced with these challenges, the Fed shifted its perspective. While normally focused on keeping
inflation down, it now considered the possibility that consumer prices could fall, a phenomenon
that had worsened the impacts of the Great Depression seven decades earlier. But the Fed
believed that deflation would be avoided. In a widely quoted 2002 speech, Bernanke said the
chances of deflation happening again in the U.S. were “extremely small” for two reasons. First,
the economy’s natural resilience: “Despite the adverse shocks of the past year, our banking
342

Ben Bernanke, The Great Moderation, Remarks at the meetings of the Eastern Economic Association, February
20, 2004. See also, Blanchard, Olivier, and John Simon (2001). “The Long and Large Decline in U.S. Output
Volatility,” Brookings Papers on Economic Activity, 1, pp. 135-64.
343
Author’s calculation, Bureau of Labor Statistics, Current Employment Survey, accessed 10/15/10,
http://data.bls.gov/cgi-bin/surveymost?sm

175

system remains healthy and well-regulated, and firm and household balance sheets are for the
most part in good shape.” Second, the Fed would not allow it. “I am confident that the Fed would
take whatever means necessary to prevent significant deflation in the United States… the U.S.
government has a technology, called a printing press (or, today, its electronic equivalent), that
allows it to produce as many U.S. dollars as it wishes at essentially no cost.”344
The Fed’s monetary policy kept short-term interest rates low across financial markets. During
2003, the strongest U.S. companies could borrow for 90 days in the commercial paper market at
a slim average rate of 1.1%, compared to an average rate of 6.3% just three years earlier; rates on
3-month US Treasury bills dropped below 1% in late 2003, down from 6%.
Low rates brought down the cost of home ownership – interest rates for the typical 30-year fixedrate mortgage traditionally moved with the overnight Fed Funds rate, and over the 2000 to 2003
period, this relationship held. By 2003, creditworthy homebuyers could secure fixed mortgages
for 5.2%, a full 3 percentage points lower than three years earlier.345 For homeowners, the
savings were immediate and large. For the median home price of $180,000,346 and assuming a
20% down payment, the monthly mortgage payment would be $286 cheaper than it had been
three years earlier. Or to turn the perspective around—as many people did: for the same monthly

344

Ben Bernanke, “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” speech before the National Economists
Club, Washington, DC (Nov. 21, 2002).
345

Freddie Mac, Primary Mortgage Market Survey, Conventional Conforming 30-Year Fixed-Rate, Monthly
Average Commitment Rate and Points on 30-Year Fixed-Rate Mortgages since 1971, available at
http://www.freddiemac.com/pmms/pmms30.htm
346

Existing Home Sales Index, National Association of Realtors, Index Values obtained by FCIC on 8/24/10 From
NAR Research

176

mortgage payment of $1,077, a homeowner could move up from the home costing $180,000 to
one costing more than $245,000.347

This is the caption to accompany the
chart.

In this low interest rate environment, an adjustable rate mortgage would allow even lower
interest payments at first or instead, make a larger house affordable—unless interest rates rose. In
2001, just 5% of prime borrowers chose ARMs; in 2003, nearly 20% did. Among subprime
borrowers, who were heavy users of ARMs to begin with, the fraction rose from around 60% to
75%.
As more people jumped into the housing market, prices naturally rose, and in hot markets they
really took off. In Florida, average home prices gained 4.1% annually from 1995 to 2000 and
then 11.1% annually from 2000 to 2003. In California, the numbers were even higher, 6.1% and
13.6%. In California, a house bought for $100,000 in 1995 was worth $227,214 nine years
later.348 However, such soaring prices were not necessarily the norm. In Washington State,
prices continued to appreciate, but more slowly: 5.9% annually from 1995 to 2000, 5.5%
347

However, the example assumes that the homeowner is able to come up with a larger downpayment to cover 20%
of the higher-priced home. The difference in the example would be about $13,000.
348

Source: CoreLogic. [Need to verify these numbers.]

177

annually from 2000 to 2003. In Ohio, the numbers were 4.3% (already below the national
average) and 3.6%.349 On a national level, home prices rose 9.8% from 2000 to 2003, still a high
number historically, but well under the levels in the fastest-growing markets.
The homeownership rate increased steadily, peaking at a record 69.2% in 2004, before it began
its decline.350 With so many families benefitting from higher home prices, household wealth rose
to nearly six times income, up from five times income a few years earlier. The top 10% of
households by net worth, of whom 96% own their homes, saw the value of their primary
residences rise from $372,800 to $450,000 between 2001 and 2004, adjusted for inflation, an
increase of more than $77,000. Overall, net worth for these households was $[XXX] in 2004.
Homeownership rates for the bottom 25% of households ticked up from 14% to 15% between
2001 and 2004; the median value of their primary residences rose from $52,700 to $65,000, an
increase of more than $12,000.351 Overall, net worth for these households was $[XXX] in 2004.
With the increase in household wealth, many homeowners tapped into their growing equity with
refinancing and home equity loans, which led directly to an increase in household spending.
Reasonable estimates conclude that every $1,000 increase in housing wealth boosts consumer
349

Corelogic State Home Price Index, provided to the FCIC by Corelogic. Authors’ calculations, all annual growth
rates are compound annual growth rates from January to January.
350

US Census Bureau, Housing Vacancies and Homeownership, CPS/HVS, Table 14 Homewonership rates for the
US 1965 to Present, http://www.census.gov/hhes/www/housing/hvs/historic/files/histtab14.xls

351

Brian K. Bucks, Arthur B. Kennickell, and Kevin B. Moore, “Recent Changes in US Family Finances: Evidence
from the 2001 and 2004 Survey of Consumer Finances,” Federal Reserve Bulletin (2006),
This increase in housing wealth helped to narrow the overall wealth distribution to some degree. The percentage
gains in wealth were larger for the bottom end of the wealth distribution. The bottom 25% of the wealth distribution
had median of $1,700 in net worth in 2004 (up more than 40% from 2001), the 50% to 75% of the wealth
distribution had median of $170,700 in net worth (up 2% from 2001), and the top 10% of the wealth distribution had
median of $1,430,100 in net worth (up 3% from 2001). Interestingly, as the wealth distribution was narrowing, by
some measures the income distribution stayed roughly the same. In both 2001 and 2004 the median income from
the top 10% of the distribution was 16.6 times greater than the bottom 20% of the distribution.

178

spending by roughly $50 a year.352 Economists debated whether the effect on spending would be
larger than historically the case because so many homeowners across the income and wealth
distribution were enjoying these increases and because of the ease and low cost of tapping home
equity.
With higher home prices and low mortgage rates, the prime mortgage market experienced a
wave of refinancing. In 2003 alone, lenders refinanced over 15 million mortgages, more than one
in four of all outstanding mortgages – a level without precedent.353 Many of these were “cashout” refinances that gave the homeowners lower interest rates and cash, too. From 2001 through
2003, xx million cash-out refinancings netted these households an estimated $400 billion, or an
average of xx per household.354
Homeowners$[XXX] per household, up from just over $125 billion from 1998- to 2000.355
From 2000 to 2003, homeowners accessed another $130 billion by taking out home equity loans.
Some of these were typical second liens; others a newer invention, the home equity line of credit.
These credit lines operated much like a credit card, allowing the borrower to borrow and repay as
needed, often with the convenience of an actual credit card.
According to the 2004 Survey of Consumer Finances, 47.5% of homeowners who tapped their
equity used that money for expenses, such as medical bills, taxes, and vacations, or debt

352

Housing Wealth and Consumer Spending, January 2007, Congressional Budget Office Background Paper

353

Mortgages may have been refinanced more than once in that year.

355

Kennedy and Greenspan paper on cash-outs.

179

consolidation; another 37% used it for home improvements; the rest purchased other real estate,
cars, or other investments.356
Looking back on the extraordinary house price gains, a Congressional Budget Office paper from
2007 stated, “As housing prices surged in the late 1990s and early 2000s, consumers boosted
their spending faster than their income rose. That was reflected in a sharp drop in the personal
saving rate.”357 Between 1998 and 2003, increased consumer spending accounted for between
77% and 168% of US GDP growth in any given year – as in some years spending growth offset
declines in other sectors of the economy.358 Meanwhile, the personal saving rate dropped from
5.3% to 1.4%. Indeed, in every year but one over this period, consumer spending grew faster
than the overall economy, and in a number of these years it grew faster than real disposable
income, whose growth was kept down by sluggish wages.
The economic situation looked stable regardless. By 2003, the U.S. economy had weathered
some of the blow from the dotcom collapse and the brief recession of 2001. With new financial
products like the home equity line of credit, households were able to borrow against their homes
to compensate for income lost due to unemployment or losses on their investments. Deflation
did not materialize. Monetary policy, housing wealth, and new sources of credit had cushioned
the economy from the largest loss of wealth in decades stemming from the dotcom bust.
At a Congressional hearing in November 2002, Greenspan acknowledged – at least implicitly –
that the Fed had deliberately cut interest rates following the bursting of the dotcom-telecom

356

Housing Wealth and Consumer Spending, January 2007, Congressional Budget Office Background Paper

357

Housing Wealth and Consumer Spending, January 2007, Congressional Budget Office Background Paper

358

Bea.gov

180

bubble in order to boost the housing sector. Greenspan argued that the Fed’s policy of cutting
interest rates had stimulated the economy by encouraging home sales and housing starts based on
“mortgage interest rates that are at lows not seen in decades.” As Greenspan explained to
Congress, “[M]ortgage 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 homeowners
had built up.” In February 2004, he reiterated his point, referring to “a large extraction of cash
from home equity.”359

Subprime: “Buyers will pay a high premium”
The shakeout in the subprime market in the late 1990s did not last long. The dollar value of
subprime loans more than doubled from 2001 through 2003 [ck], to $203 billion. In 2000, 52%
of these loans were securitized, in 2003, 63%. [RECONCILE WITH CHART/TABLE IN 1.4]
This boom was spurred by low interest rates, of course, but also by the more widespread use of
computerized credit scores, the ever-growing statistical history on subprime borrowers, and by
the breadth and scale of the firms now entering the market.
The subprime market was dominated by an ever narrower field of ever larger firms; the marginal
players from the last decade had either merged or vanished. By 2003, the top 25 subprime
lenders were responsible for 90% of all new loans in that sector, up from 40% only a few years
earlier.
There were now primarily three kinds of companies in the subprime origination and
securitization business-- commercial banks and thrifts, Wall Street investment banks, and
independent mortgage lenders. Some of the biggest banks and thrifts—including Citigroup, JP
359

Cite.

181

Morgan, National City Bank, HSBC, and Washington Mutual—spent billions to boost their
ability to generate subprime loans, either with new units, acquisitions or financing for other
mortgage originators. In almost all cases, their subprime operations were carefully sequestered
within non-bank subsidiaries, which left them in a regulatory no man’s land.
When it came to subprime lending, now it was Wall Street investment banks who were
concerned about competitive pressures from the largest commercial banks. Former Lehman
president Bart McDade told the FCIC, “[T]he banks [had] gained their own securitization skills
and didn’t need the investment banks to structure and distribute.” So the investment banks
moved into the mortgage origination business to guarantee a supply of loans that they could
securitize and sell to the growing legions of investors interested in these securities. For example,
Lehman Brothers, the fourth largest, purchased six different US lenders between 1998 and 2004,
including BNC and Aurora.360 Bear Stearns, the fifth largest, ramped up operations of its
subprime lending arm, eventually acquiring three subprime originators in the United States,
including Encore. In 2006, Merrill Lynch would acquire First Franklin and Morgan Stanley
would buy Saxon Capital.
At the same time, several independent mortgage companies embarked on rapid growth strategies.
New Century and Ameriquest were especially aggressive in pursuing volume and market share.
New Century’s “Focus 2000” plan concentrated on “originating loans with characteristics for
which whole loan buyers will pay a high premium.”361 Those “whole loan buyers” worked on
Wall Street, where they bundled loans into mortgage-backed securities. They were eager
customers. In 2003, New Century sold $20.8 billion in whole loans, up from $3.1 billion three
360

6/20/07 Lehman board presentation: LBHI - FCIC -0001275

361

1999 New Century 10-K (March 30, 2000), 2.

182

years before, launching the firm from tenth to second place among subprime originators. Threequarters of this volume was sold to two securitizing firms --Morgan Stanley and Credit Suisse-but New Century reassured its investors there were “many more prospective buyers.”362
Ameriquest, in particular, pursued a volume-driven strategy. According to the company’s public
statements, it paid its account executives less per mortgage than the competition did, but it
encouraged them to make up the difference in the number of mortgages they underwrote. “Our
people make more volume per employee than the rest of the industry,” Aseem Mital, the CEO of
Ameriquest’s holding company, said in 2004. The company cut costs in other segments of the
origination process as well. The back office for the firm’s retail division operated “in assemblyline fashion,” observed a reporter for American Banker, with the work divided into specialized
tasks, including data entry, underwriting, customer service, account management, and funding.
With these savings, Ameriquest undercut the prices competing originators charged to securitizing
firms by as much as 0.55%, according to an estimate by an industry analyst.363 Between 2000
and 2003, Ameriquest increased its loan originations from an estimated $4 billion to $39 billion
annually. That increase in volume vaulted the firm from eleventh to first place among subprime
originators in just three years. “They are clearly the aggressor,” Countrywide CEO Angelo
Mozilo told his investors in 2005.364 By 2005, Countrywide was third on the list.

362

2000 New Century 10-K (April 2, 2001), 15; 2003 New Century 10-K (March 15, 2004), 13. Rankings from
Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual (2009), 221, 223.
363

Scott Valentin, need document citation

364

Erick Bergquist, “Under Scrutiny, Ameriquest Details Procedures,” American Banker 170, no. 125 (Jun. 30,
2005), 1. Volume and rankings from Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual
(2009), 221, 223.

183

The players in the subprime business pursued different business strategies. Lehman Brothers and
Countrywide pursued a “vertically integrated” model with stakes in every link of the mortgage
chain: funding and originating the loans, packaging them into securities, and finally selling the
securities to investors. Others were content with one niche: New Century, for example,
primarily originated mortgages for immediate sale to securitizers. But all of them competed hard
for the growing business of lending money to subprime borrowers and then selling those
mortgages to investors in the form of securities.
For many of these lenders, mortgage brokers were a major source of loans. These independent
professionals worked with the borrowers to complete the application process and to get them aa
loan, with access to a variety of lenders. From a lender’s perspective, using brokers allowed for
more rapid expansion, since there was no need to build outlets or branches, possibly a greater
geographic reach, and lower costs, since there was no need for fulltime salespeople. [add
interview or hearing quote, add available data on use of brokers]
The creation of this subprime mortgage pipeline, over which more than one-half of all mortgages
traveled in the years before the crisis, had profound long-term repercussions. When originators
of any sort made loans with the intention of holding them through maturity—known in the
business as originate-to-hold--they had a clear incentive to underwrite carefully and set pricing
according to the possible risks. When they originated mortgages with the intention of selling
them, for securitization or otherwise--known as originate-to-distribute---they did not bear the
same risk of loss if the loan went delinquent or defaulted. As long as they made accurate
representations and warrantees, originate-to-distribute firms only bore some risk to their
reputations if a lot of their loans went bad, but during the housing boom, loans weren’t going
bad.
184

For decades, the originate-to-distribute model had helped to produce safe mortgages. Recall that
Fannie and Freddie had been buying, guaranteeing, or securitizing prime, conforming, mortgages
since the 1970s [ck]. These mortgages was protected by strict underwriting standards.
But, some observers of this market saw that this model now had problems. “If you look at how
many people are playing, from the real estate agent all the way through to the guy who is issuing
the security and the underwriter and the underwriting group and blah, blah, blah, then nobody in
this entire chain is responsible to anybody,” Lewis Ranieri, one of the founders of securitization,
told the FCIC. This was not the outcome he and his fellow investment bankers had expected
when they developed securitization, he said. “None of us wrote and said, ‘Oh, by the way, you
have to be responsible for your actions,’” Ranieri said. “It was pretty self-evident.”
For brokers, compensation often came as up-front fees so that the loan’s eventual performance
was of little consequence. These fees were paid, often without the knowledge of the borrower.
Indeed, many borrowers mistakenly believed the mortgage brokers were acting in their best
interest.365 Within the trade, one common fee paid by the lender was called the “yield spread
premium,” for good reason: on higher interest loans, the lending bank would pay the broker a
higher premium. The message for the broker was clear: once all the parties had agreed on the
size of the mortgage, the incentive was to sign the borrower to the mortgage with the highest
possible interest rate. “If the broker decides he’s going to try and make more money on the loan,
then he’s going to raise the rate,” Jay Jeffries, a former sales manager for Fremont Investment &

365

HUD study.

185

Loan, explained to the Commission at its Las Vegas field hearing. “We’ve got a higher rate
loan, we’re paying the broker for that yield spread premium.”366
In theory, borrowers are the first line of defense against abusive lending in all its manifestations.
Shopping around should have made it clear, for example, if a broker was trying to sell them
higher priced loans or to place them into subprime loans, even if they qualified for a less
expensive prime loan. But, many borrowers don’t understand the most basic aspects of their
mortgage. A study by two Federal Reserve economists estimated that at least 38% of borrowers
with adjustable-rate mortgages did not understand how much their interest rates could reset
during a single adjustment, and more than half underestimated how high their interest rates could
reach over the lives of their mortgages.367 The same lack of awareness extended to other terms
of the loan. “Most borrowers didn’t even realize that they were getting a no doc loan,” Michael
Calhoun, the President for Residential Lending at the Center for Responsible Lending. “They’d
come in with their W-2 and end up with a no doc loan simply because the broker was getting
paid more and the lender was paid more and there was extra yield leftover for Wall Street
because the loan carried a higher interest rate.”368
And, borrowers with less access to credit are particularly ill-equipped to challenge the expert
across the desk. As Annamaria Ludsardi, a Professor of Economics at Dartmouth College,
explained to the Commission, “while many [consumers] believe they are pretty good at dealing

366

Transcript of the FCIC field hearing in Las Vegas (Sept. 8, 2010), 177, http://fcic.gov/hearings/pdfs/2010-0908transcript.pdf.
367

Brian Bucks and Karen Pence, “Do Borrowers Know Their Mortgage Terms?” Journal of Urban Economics 64
(2008), 218-33 at 223

368

Audio of FCIC interview with Michael Calhoun and Julia Gordon (Sept. 16, 2010) 0:15:25,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4834-0412-9287&open=Y.

186

with day-to-day financial matters, in actuality they engage in financial behaviors that generate
expenses and fees: overdrawing checking accounts, making late credit card payments, or
exceeding limits on credit card charges. Comparing terms of financial contracts and shopping
around before making financial decisions are not at all common among the population.” 369
To return to the securitization deal discussed in Section I -- the one in which New Century sold
4,499 mortgages to Citigroup, which then sold to its own trust, which then bundled them into the
security with 19 tranches. Out of those 4,499 mortgages, 3,466 were originated by brokers on
behalf of New Century. For each of those 3,466 mortgages, the broker received an average fee
from the borrowers of $3,756, or 1.81% of the loan amount. On top of the fees paid by the
borrower, the brokers also received from New Century yield spread premiums averaging $2,586
for 1,746 of these loans. In total, the brokers received more than $17.5 million in fees for the
3,466 loans they originated.
With this much money at stake, critics argued that the mortgage brokers had every incentive to
seek “the highest combination of fees and mortgage interest rates the market will bear.”370 Not
mincing words, Herb Sandler, founder and CEO of the thrift Golden West Financial Corp., told
the FCIC that brokers were the “whores of the world.”371 [ck whether Golden West used
brokers] Understandably, as the housing and mortgage market boomed, so did the related
brokerage business. Wholesale Access, a firm tracking changes in the mortgage industry,

369

Annamaria Lusardi, “Americans’ Financial Capability,” testimony at the FCIC Forum to Explore the Causes of
the Financial Crisis (Feb. 26, 2010), [3], http://fcic.gov/hearings/pdfs/2010-0226-Lusardi.pdf.
370

William C. Apgar and Allen J. Fishbein, "The Changing Industrial Organization of Housing Finance and the
Changing role of Community-Based Organizations," working paper, Jopint Center for Housing Studies, Harvard
University, May 2004, p. 9.
371

FCIC interview with Herb Sandler.

187

reported that from 2000 to 2003, the number of brokers rose from 33,000 to 44,000. [reconcile
with Section A].372 In 2000, brokers originated 55% of all loans; in 2003, their production
peaked at 68%.373 JP Morgan CEO Jamie Dimon testified to the FCIC that his firm ended its
broker-originated business in 2009 after discovering that such loans had two to three times more
losses than the business it originated itself.374
As the housing market was expanding, another problem emerged, in subprime and prime
mortgages alike - inflated appraisals. From the perspective of the lender, inflated appraisals
meant greater losses if a borrower defaulted. But for the broker or loan officer who hired the
appraiser, an inflated value could make the difference between closing and losing the
deal. Imagine a home selling for $200,000, which an appraiser says is actually worth only
$175,000. In this case, a bank won’t lend a hopeful borrower, say, $180,000 to buy the home.
The deal dies. Sure enough, appraisers began feeling pressure. One 2003 survey found that 55%
of the appraisers had felt pressure to inflate the home’s value. Most frequently, this pressure
came from the mortgage brokers, but appraisers reported pressure from real estate agents,
lenders, and in many cases borrowers themselves. Refusal to raise the appraisal meant, most
often, losing the client.375 In Miami, Dennis J. Black, an appraiser with 24 years of experience in
real estate, was holding continuing education sessions for the National Association of
Independent Fee Appraisers and heard the appraisers in attendance tell him that they had been

372

Wholesale Access, Mortgage Brokers 2006 Survey, August 2007, pg 35, available on NetDocs as
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4817-2746-3173&open=Y
373

Wholesale Access, Mortgage Brokers 2006 Survey, August 2007, pg 37, available on NetDocs as
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4817-2746-3173&open=Y
374

Transcript of FCIC Hearing (Jan. 13, 2010), 13, http://fcic.gov/hearings/pdfs/2010-0113-Transcript.pdf.

375

http://www.appraisalinstitute.org/newsadvocacy/downloads/ltrs_tstmny/2007/Ntnl_Apprsl_Srvy.pdf

188

ordered to ignore missing kitchens, damaged walls, and inoperable mechanical systems. Black
told the FCIC, “The story I have heard most often is the client saying he could not use the
appraisal because the value was [not] what they needed.”376 The client would move on to
somebody else.
Changes in regulations reinforced the trend toward more lax appraisal standards, as explained by
Karen Mann [title ck] in testimony to the FCIC. In 1994, the Federal Reserve, OCC, OTS, and
FDIC raised the minimum value at which they required an appraisal from a licensed professional
from $100,000 to $250,000, increasing the number of home mortgages made by lenders they
regulated that qualified for the exemption. In addition, Mann cited the lack of oversightof
appraisers noting that, “We had a vast increase of licensed appraisers in [California] in spite of
the lack of qualified/experienced trainers”377

[insert Crabtree]

In 2005, the four bank regulators issued new guidance intended to strengthen the appraisal
process. One of the recommendations was that an originator’s loan production staff should not
select appraisers. That led Washington Mutual to use an “appraisal management company,”
First American Corporation, to choose its appraisers for the thrift. Despite this change, the New
York State Attorney General brought suit in 2007 against First American, relying on internal
company documents, alleging that the corporation allowed Washington Mutual’s loan production
staff “to hand-pick appraisers who bring in appraisal values high enough to permit WaMu’s

376

Dennis J. Black, prepared testimony to the FCIC, Miami hearing (Sept. 21, 2010), 8.

377

Written testimony of Karen J. Mann to the FCIC field hearing in Sacramento (Sept. 23, 2010), 2,
http://fcic.gov/hearings/pdfs/2010-0923-Mann.pdf

189

loans to close, and improperly [permitted] WaMu to pressure ... appraisers to change appraisal
values that are too low to permit loans to close.”378
An Ameriquest loan officer, in subsequent litigation, made a declaration about inflated
appraisals: “Ameriquest taught and encouraged me and other Account Executives to inflate the
stated value of the customer’s property for the purpose of qualifying them for a refinance loan. I
recall an Ameriquest area manager indicating that appraisal values should regularly be pushed by
at least 10-15%. This area manager oversaw at least several Ameriquest branches in
Minnesota…Ameriquest made it clear that they would not continue to give business to appraisers
who did not come in with the ‘‘right’ appraisal values.”379

Citigroup: “Invited scrutiny”
As subprime originations continued to grow, Citigroup decided to expand its presence in the
market. Barely a year after the Gramm-Leach-Bliley Act validated its 1998 merger with
Travelers, Citigroup made its next big move. In September 2000, it paid $31 billion for
Associates First, then the second largest subprime lender in the country after Household
Financial Corp. Because Associates First owned three small banks (in Utah, Delaware, and
South Dakota),380 the merger would usually have required approval from the Federal Reserve
and the other bank regulators. But because of the specialized nature of these banks, a provision
tucked away in Gramm-Leach-Bliley kept the Fed out of the mix. The Office of the Comptroller
of the Currency, the Federal Deposit Insurance Corporation, and the New York State banking
378

People of the State of New York v. First American Corporation and First American eEAppraiseIT, Complaint,
Supreme Court of the State of New York, November 1, 2007, paragraph 8, p. 3; paragraph 20, p. 7; and paragraph
22, p. 8..

379

Ricci et al. v. Ameriquest Mortgage Co., United States District Court for the District of Minnesota, Court File No.
05-1214 JRT/FLN, Declaration of Mark Bomchill, January 2007, paragraph 14, p. 4
380

Associates First SEC Filing 10K1999: http://www.secinfo.com/dsvrp.52Jk.9.htm

190

regulators reviewed the deal. Consumer groups mobilized to stop it, citing a long record of
alleged lending abuses by Associates First, including high prepayment penalties, excessive
points, and other minimally disclosed fees in loan documents—all targeted at unsophisticated
borrowers who typically lacked the ability to evaluate loan documents.381 “It’s simply
unacceptable to have the largest bank in America take over the icon of predatory lending,” said
Martin Eakes, the founder of a nonprofit community lender in North Carolina.382,383
Advocates for the merger argued that a large bank under the eye of a rigorous bank regulator
could reform the company. And Citigroup executives promised to act. Regulators okayed the
merger in November 2000, and Citigroup did act by the next summer, eventually suspending
mortgage purchases from close to two-thirds of the brokers and half of the banks that had sold
their loans to Associates First prior to the merger.384 “We were aware that brokers were at the
heart of that public discussion and were at the heart of a lot of the [controversial] cases,” said
Pam Flaherty, a Citigroup senior vice president with responsibility for community relations and
outreach.
The merger exposed Citigroup to enhanced regulatory scrutiny. In 2001, the Federal Trade
Commission, which regulates independent mortgage companies’ compliance with consumer
protection laws, launched an investigation into Associates First’s pre-merger business and found

381

Julia P. Forrester, Still Mortgaging the American Dream: Predatory Lending, Preemption, and Federally
Supported Lenders, 74 Univ. Cincinnati L. Rev 1303, 1304-06 (2006).

382

Citigroup Buying Trouble, supra, at 31. See also infra Part V.A (discussing the involvement of bank affiliates in
predatory lending). teachlaw.law.uc.edu/current/experiences/publications/.../082906forrester.pdf
383

Richard A. Cippel, Jr. & Patrick McGeehan, Along With a Lender, Is Citigroup Buying Trouble, Oct. 22, 2000,
http://www.nytimes.com/2000/10/22/business/along-with-a-lender-is-citigroup-buying-trouble.html.
384

Erick Bergquist, “Citi Takes Ax to Asociates’ Network,” American Banker (Aug. 31, 2001).

191

that the company had pressured borrowers to refinance into expensive mortgages and to buy
expensive mortgage insurance.385 In 2002, Citigroup settled a record $215 million civil
settlement with the FTC over “systematic and widespread deceptive and abusive lending
practices” practiced by Associates.
In 2001, the New York Fed used the occasion of Citigroup’s next proposed acquisition-European American Bank on Long Island, New York--to launch its own investigation of
CitiFinancial[ck], which now contained the unit formerly known as Associates First. “The way
[Citigroup] approached that unit invited scrutiny,” former Fed Governor Mark Olson told the
FCIC. [Check against audio] “They bought a passel of problems for themselves and it was at
least a two-year [issue].” The Fed’s charge centered in part on CitiFinancial’s practice of
converting unsecured personal loans (usually for borrowers in financial trouble) into home equity
products backed by the home without properly assessing the borrower’s ability to repay, all in an
effort to get better security for Citigroup. The Fed also accused this Citigroup unit of selling
credit insurance to borrowers without checking if they would qualify for a mortgage without it.
For these violations and for impeding the Fed’s investigation, the Fed issued a Cease and Desist
Order.386 In 2004, the Fed assessed $70 million in penalties against Citigroup.387 As the time, the

385

Federal Trade Commission release, “Citigroup Settles FTC Charges Against Associates Record-Setting $215
million for Subprime Lending Victims,” 9/12/2002, http://www.ftc.gov/opa/2002/09/associates.shtm
386

Federal Reserve’s Order to Cease and Desist.
http://www.federalreserve.gov/boarddocs/press/enforcement/2004/20040527/attachment.pdf
387

http://www.federalreserve.gov/boarddocs/press/enforcement/2004/20040527/attachment.pdf

192

company said it expected to pay another $30 million in restitution to borrowers in addition to the
penalty, but in the end, the company skirted a confession of wrong-doing.388

Fed’s HOEPA rules: “Unfair, deceptive, or designed to evade”
Just as Citigroup was buying Associates First in 2000, the Federal Reserve conducted its next
round of hearings related to HOEPA, and subsequently the staff offered two reform proposals.
The first would have barred lenders from a pattern and practice of making any mortgage -- not
just the limited set of high-cost loans defined under HOEPA -- solely on the value of the
collateral and without regard to the borrower’s ability to make the payments. For the high-cost
loans under HOEPA, the lender would have to verify and document the borrower’s income and
existing debt; for the rest, the documentation standard was weaker as the lender could rely on
other information such as knowledge of the customer or the borrower’s payment history. The
staff memo explained that this change would “affect lenders who make no-documentation
loans.” The second proposal addressed a wide set of practices, like using deceptive
advertisements, misrepresenting loan terms and having consumers sign blank documents – acts
that on their face involve “fraud, deception or misrepresentations.” Despite evidence of predatory
tactics from their own hearings and from the recently released Treasury-HUD report, Fed
officials remained divided on how aggressively to modify borrower protections. They described
the same tradeoff that the HUD-Treasury report had noted. “We want to encourage the growth
in the subprime lending market,” Fed Governor Edward Gramlich told the Financial Services
Roundtable in early 2004. “But we also don’t want to encourage the abuses; indeed, we want to
do what we can to stop these abuses.” Fed General Counsel Scott Alvarez told the FCIC, “There

388

Timothy L. O’Brien, “Fed Assesses Citigroup Unit $70 Million In Loan Abuse,” New York Times (May 28,
2004), http://www.nytimes.com/2004/05/28/business/fed-assesses-citigroup-unit-70-million-in-loan-abuse.html.

193

was this concern that if you put out a broad rule, you would stop things that were not unfair and
deceptive because you were trying to get at the bad practices and you just couldn’t think of all of
the details you would need. And if you did think of all of the details, you’d end up writing a rule
that people could get around very easily.”389 Greenspan said, “if there is egregious fraud, if there
an egregious practice, one doesn’t need supervision and regulation, what one needs is law
enforcement.”390 But, the Federal Reserve would not use the legal system to rein in predatory
lenders. From 2000 to the end of Greenspan’s tenure in 2006, the Fed only made three
mortgage-related fair lending referrals to the Justice Department: First American Bank, in
Carpentersville, Illinois, and Desert Community Bank, Victorville, California, and the New York
branch of Societe Generale.
Greenspan later argued that prohibiting certain products categorically might have harmful
effects. “These products, when made to borrowers meeting appropriate underwriting standards,
should not necessarily be regarded as improper,” he said, “and on the contrary facilitated the
national policy of making homeownership more broadly available.”391
The staff proposals in 2000 did not carry the day. So, after some wrangling, in December of
2001, the Fed did modify HOEPA, but only on the margins. Explaining its actions, the Board
highlighted compromise: “[T]he final rule is intended to curb unfair or abusive lending practices
without unduly interfering with the flow of credit, creating unnecessary creditor burden, or
narrowing consumers’ options in legitimate transactions.” All in all, however, the status quo

389

FCIC interview with Scott Alvarez, at 19-20.

390

David Faber. “And the Roof Caved In.” at page 53.

391

Alan Greenspan, written testimony to FCIC Hearing (Apr. 7, 2010), 13, http://fcic.gov/hearings/pdfs/2010-0407Greenspan.pdf.

194

would be affected in minor ways only. Fed economists estimated the revised regulations would
increase the percentage of subprime loans covered by HOEPA from 9% of all subprime under
the current regulations to as much as 38% under the newly adopted regulations.392 But quickfooted lenders eased that impact by changing the terms of mortgages to avoid the revised interest
rate and fee triggers under the Fed’s rules.393 In the end, the new regulations would cover only
about 1% of subprime loans. Nevertheless, in an FCIC interview, Greenspan contended, “We
developed a set of rules that have held up to this day.”394
This was a missed opportunity, in the view of FDIC Chairman Sheila Bair, who described for the
FCIC the “one bullet” she would have liked to have had that might have prevented the financial
crisis: “I absolutely would have been over at the Fed writing rules, prescribing mortgage lending
standards across the board for everybody, bank and nonbank, that you cannot make a mortgage
unless you have documented income that the borrower can repay the loan.”
Writing rules is only part of the supervisor’s authority, however. Enforcement and supervision
are the others. While discussing the possible HOEPA rule changes in 2000, the staff of the Fed’s
Consumer Division also proposed a pilot program to investigate predatory lending practices at
selected nonbank subsidiaries of the bank holding companies,395 like CitiFinancial and HSBC
Finance, which were becoming an increasing presence in the market, along with independent
392

“Truth in Lending,” Board of Governors of the Federal Reserve, 66 Federal Register 245 (20 Dec 2001), pp.
65608.

393

Gramlich, 2007.

394

MFR of FCIC interview with Alan Greenspan (Mar. 31, 2010), 2,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4814-3714-9189&open=Y.
395

Memo from Dolores Smith and Glenn Loney to Governor Edward Gramlich, dated Aug. 31, 2000, regarding
“Compliance Inspections of Nonbank Subsidiaries of Bank Holding Companies.” (FRB-FCIC-114823-114833, at
114824)

195

mortgage companies such as Ameriquest and New Century. The independents and the nonbank
subsidiaries were subject to enforcement actions by the Federal Trade Commission, the banks
and thrifts were regulated by the Fed, FDIC, OCC, OTS, or their state regulators. But, the Fed
had the authority to examine nonbank subsidiaries for “compliance with the [Bank Holding
Company Act] or any other Federal law that the Board has specific jurisdiction to enforce,” but
the consumer protection laws did not explicitly give the Fed authority in this area.396 But in any
event, the Fed had taken a generally hands-off, “Fed-lite” approach to routinely examining these
companies.
Despite the support of Fed Governor Gramlich, the initiative stalled. Sandra Braunstein, then a
staff member in the Fed’s Consumer Division, now its Director, recalled for the FCIC that
Greenspan and other officials were concerned that routinely examining the nonbank subsidiaries
could create an unlevel playing field, because the nonbank subsidiaries had to compete with the
independents over which the Fed had no supervisory authority.397 In his own testimony before
the FCIC, Greenspan went further, arguing that with or without a mandate, the Fed lacked
sufficient resources to examine the nonbank subsidiaries. “There is a limited amount of resources
that the Fed has in terms of examination capability,” Greenspan said. “We would always be
extraordinarily cautious about our budgets.”398 Worse, said the former Chairman, inadequate
regulation sends a misleading message to the firms and the market.399 “If you examine an
396

Government Accountability Office, “Consumer Protection: Federal and State Agencies Face Challenges in
Combating Predatory Lending “ (2004), 52-53.
397

Braunstein recalls a meeting with Governor Gramlich in which he told staff that he had discussed the idea with
Chairman Greenspan but that Chairman Greenspan was not interested.
398

FCIC MFR for Interview of Alan Greenspan, Mar. 31, 2010, at 4-5.

399

Andrews, “Fed and Regulators Shrugged” (2007); Appelbaum, “Fed Held Back” (2009); FCIC PIR on Fed
Subprime Lending Regulation, at 2-11.

196

organization incompletely, they tend to put a sign in their window that they were examined by
the Fed. . . . Partial supervision is dangerous because it creates a good housekeeping stamp.”
[include Sheila Bair’s response that she “didn’t buy” the argument]
Of course, arguing for additional resources was entirely within the prerogatives of the Federal
Reserve Chairman. The Fed drew its income from interest on the Treasury bonds it owned, so it
did not have to ask Congress for appropriations, but it was always mindful that it could be
subject to a government audit.
In an FCIC interview, Greenspan recalled that he sat in “countless” meetings on consumer
protection, but that he “couldn’t pretend to have the kind of expertise on this subject that the staff
had.”400 Later, he testified at a Commission hearing that he and his Fed colleagues “always”
looked to Gramlich to make decisions about consumer protection policy “because he had the
most knowledge.” Gramlich however, “chose not to bring those issues to the board,” Greenspan
said.401
Gramlich, who chaired the Fed’s consumer subcommittee, favored tighter supervision of all
subprime lenders – similar to what was proposed in the pilot program – including units of banks,
thrifts, bank holding companies, and state-chartered mortgage companies. He acknowledged that
because such oversight would extend Fed authority to firms – such as independent mortgage
companies – not subject to direct supervision of lending practices, it would require congressional

400

MFR of FCIC interview with Alan Greenspan (Mar. 31, 2010), 3,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4814-3714-9189&open=Y.
401

FCIC hearing April 7, 2010, transcript at page 28

197

legislation “and might antagonize the states.”402 But without such oversight, it was akin to “a
city with a murder law with no cops on the beat.”403 In an interview in 2007, Gramlich told the
Wall Street Journal that he privately urged Greenspan to direct the Fed to clamp down on
predatory lending. Greenspan demurred.[i] Lacking pivotal support on the Board, Gramlich
backed away. Gramlich told the Journal, “He was opposed to it, so I did not really pursue it.”404
(Gramlich died in 2008 of leukemia, at age 68.)
Banking regulations in the U. S. were a patchwork quilt, with responsibility divvied up among
half a dozen federal agencies and each of the 50 states, but there is no doubt that the one agency
with the broadest regulatory mandate over the mortgage market was the Federal Reserve Board
because it could set rules under HOEPA that applied to all lenders no matter who regulated them.
[ck] Its failure to shut down predatory practices infuriated consumer advocates and some
members of Congress.405 Critics charged that specific accounts of abuses in financial transactions
were brushed off as anecdotal.406 Patricia McCoy, a law professor at the University of
402

Edward M. Gramlich, “Booms and Busts: The Case of Subprime Mortgages,” Federal Reserve Bank of Kansas
City Economic Review (2007), 109.

403

2007 Article Federal Reserve Bank of Kansas City Review

[i]

“Did Greenspan Add to Subprime Woes? Gramlich Says Ex-Colleague Blocked Crackdown On Predatory
Lenders Despite Growing Concerns,” Wall Street Journal, by Greg Ip, June 9, 2007
404
“Did Greenspan Add to Subprime Woes?,” G. Ip, Wall Street Journal, Jun. 9, 2007, at B1. See also “Fed
Shrugged as Subprime Crisis Spread,” E. Andrews, N.Y. Times, Dec. 18, 2007.
405

Appelbaum, “Fed Held Back” (2009); McCoy (2009), at 1344-47; Richard Cowden, “Mortgages: Proposal to
Curb Subprime Lending Abuses Earns Some Praise; Dodd, Frank Unimpressed,” 89 Banking Report (BNA) 1057,
1058 (Dec. 24, 2007) (reporting on “harsh criticisms” of the Fed’s consumer protection record by Senate Banking
Committee chairman Christopher Dodd and House Financial Services Committee chairman Barney Frank);
Financial Crisis Inquiry Commission, “Preliminary Investigative Report on the Federal Reserve’s Regulation of
Subprime Mortgage Lending” (April 2, 2010), at 1 [hereinafter FCIC PIR on Fed Subprime Lending Regulation]
(quoting criticism of Fed and Mr. Greenspan by House Committee on Oversight and Government Reform chairman
Henry Waxman).
406

Appelbaum, “Fed Held Back” (2009).

198

Connecticut who served on the Fed’s consumer advisory council between 2002 and 2004,
recognized a familiar reaction to stories of individual consumers that do not document a
macroeconomic effect. “That is classic Fed mindset,” said McCoy. “If you cannot prove that it is
a broad-based problem that threatens systemic consequences, you will be dismissed.”407
Margot Saunders of the National Consumer Law Center, “I stood up at a Fed meeting in 2005
and said, ‘How many anecdotes makes it real? . . . How many tens of thousands of anecdotes will
it take to convince you that this is a trend?”408
As noted, the Fed did file a public enforcement action against Citigroup’s subprime mortgage
lending subsidiary in 2004 and levied a $70 million fine, but that order remained “the Fed’s only
public enforcement action against a lending affiliate.”409 This reluctance trumped strong
recommendations in favor of Fed supervision in the 2000 HUD-Treasury report, and in two
reports by the Government Accountability Office, issued in 1999 and 2004. And regarding the
mortgage-lending subsidiaries of bank holding companies, the Fed did not change its nosupervision policy until July 2007 when under new Chairman Ben Bernanke it finally began the
pilot program to examine subprime lending subsidiaries of several such companies. The Fed did
not issue another HOEPA regulation until July 2008, a year after the subprime market had shut
down. These new, comprehensive rules banned unfair and deceptive acts and practices with
respect to a much broader category of “higher-priced mortgage loans.” Among these were a
prohibition against extending those loans without regard to the borrower’s ability to pay,

407

Appelbaum, “Fed Held Back” (2009).

408

Appelbaum, “Fed Held Back” (2009).

409

Binyamin Applebaum, “As Subprime Lending Crisis Unfolded, Watchdog Fed Didn’t Bother Barking,”
Washington Post (Sept. 27, 2009).409 Id.

199

including a requirement to verify related income and assets.410 They would not take effect until
October 1, 2009,411 which was without a doubt “too little too late.”412
Looking back, Fed General Counsel Alvarez said his institution was captive to the climate of the
times. He explained to the FCIC, “[T]he mindset was that there should be no regulation; that the
market should take care of policing, unless there already is an identified problem…We were in
that reactive mode because that was the mindset of the nineties and early 2000s.”413 The strong
housing market had added reason for comfort. Alvarez noted the long history of low default
rates in home mortgages and the motive to reach people traditionally outside the banking system
with products that could help them become homeowners.414

States: “long-standing position”
As the Fed balked at expanding the HOEPA regulations regarding banks’ predatory lending and
at supervising nonbank subsidiaries of bank holding companies, many of the states proceeded on
their own, enacting “mini-HOEPA” laws and undertaking vigorous enforcement actions. In
1999, North Carolina led the way, establishing a fee trigger of 5%; that is, any mortgage for
which the total points and fees at origination totaled more than 5% of the face amount of the loan
qualified as a “high-cost mortgage” subject to the provisions of the regulations. This fee trigger
410

“Truth in Lending,” 73 Fed. Reg. 44522-23 (July 30, 2008). “Higher-priced mortgage loans” are defined in the
2008 regulations to include mortgage loans whose annual percentage rate exceeds the “average prime offer rates for
a comparable transaction” (as published by the Fed) by at least 1.5% for first-lien loans or 3.5% for subordinate-lien
loans.
411

Id. at 44523.

412

Sudeep Reddy, “Currents: Fed Faces Grilling on Consumer-Protection Lapses,” Wall Street Journal, Dec. 2,
2009, at A22. See also Senate Report No. 111-176, at 16 (2010) (stating that the Fed’s 2008 rules under HOEPA
were issued “long after the marketplace had shut down the availability of subprime and exotic mortgage credit”).
413

Transcript of FCIC Interview of Scott Alvarez and Kieran Fallon, Mar. 23, 2010, p. 15.

414

Id. at 13.

200

was considerably lower than the 8% set by the Fed’s 2001 HOEPA regulations. For a broader
class of loans, provisions also prohibited prepayment penalties for mortgage loans under
$150,000 and repeated refinancing known as loan “flipping.”
These rules did not apply to the federally-chartered thrifts. In 1996, the Office of Thrift
Supervision had promulgated rules that reasserted the agency’s “long-standing position” that its
regulations “occupied the entire field of lending regulation for federal savings associations,
leaving no room for state regulation.” Exempting states from “a hodgepodge of conflicting and
overlapping state lending requirements,” the OTS said, would allow thrifts “to deliver low-cost
credit to the public free from undue regulatory duplication and burden.” Meanwhile, “the
elaborate network of federal borrower-protection statutes” would protect the interests of
consumers.415
Nevertheless, a number of other states emulated North Carolina’s approach. In 2002 Georgia
attempted to make the mortgage purchasers—the securitizers on Wall Street—liable for
predatory terms in the mortgages they bought, and in 2004 Massachusetts followed suit. This
was an unprecedented approach. All in all, by 2007, 29 states and the District of Columbia
passed some form of anti-predatory lending legislation.416 State attorneys general launched
thousands of enforcement actions, including 3,694 in 2006 alone. [check for actions in earlier
years] In some cases, the states teamed up to produce large settlements: In 2002, a suit initiated
by Illinois, Massachusetts, and Minnesota recovered [ck] more than $50 million from First
Alliance Mortgage Company, even though it had filed for bankruptcy. That same year,

415

“Lending and Investment,” Federal Register 61, no. 190 (Sept. 30, 1996), 50965.

416

Starkman (2010) [CJR article]; “Standard & Poor’s Addresses Massachusetts’ Predatory Home Loan Practices
Act” (Sept. 20, 2004).

201

Household Finance – later acquired by HSBC, a global U.K.-based banking group – was ordered
to pay $484 million in penalties and restitution to consumers. In 2006, a coalition of 49 states
and the District of Columbia settled with Ameriquest for $325 million and required the company
to abide by specific restrictions on its lending practices.417 As we will see, these efforts would
come to an end with respect to national banks when the OCC in 2004 officially joined OTS in
forbidding states from taking such actions. ““The federal regulators’ refusal to reform
[predatory] practices and products served as an implicit endorsement of their legality,” Illinois
Attorney General Lisa Madigan testified to the Commission.

CRA Pledges: “Reaffirming commitments”
While consumer groups were lobbying the Fed for greater protections against predatory lending
practices, they also lobbied the banks to provide loans and investments to low- and moderateincome communities. The resulting promises were sometimes labeled “CRA commitments” or
“Community Development” commitments. These commitments were voluntary and were not
required under any law, including the Community Reinvestment Act of 1977, and were often
outside the scope of the CRA. For example, while the CRA does not mention lending to
minorities, these commitments often did. One of the most notable lending commitments came
when Citigroup, recently merged with Travelers in 1998, announced a $115 billion lending and
investment commitment, including issuing mortgages.
During the early years of the CRA, the Federal Reserve Board had given some weight to
commitments made to regulators when considering whether to approve merger applications. This
changed in February, 1989, when it denied Continental Bank’s application to merge with

417

Wilmarth (2004), at 316; Nalder (2008); Eggert (2009); Madigan, FCIC testimony (Jan. 14, 2010).

202

Continental Illinois [ck], explicitly stating that its commitment to the regulators to improve its
community service could not make up for its poor record of lending. In April 1989, the FDIC,
OCC, and Federal Home Loan Bank Board (precursor of the OTS) joined the Fed in announcing
that commitments to regulators for future lending would only be considered when addressing
“specific problems in an otherwise satisfactory record.”418 [check if still current]
Separate from these commitments to regulators, banks also frequently made pledges to
community groups. According to both internal Fed documents and public statements, the Fed
never considered these pledges when it evaluated mergers and acquisitions, nor did it enforce
them; the Fed recognized these pledges merely as agreements among private parties rather than
with the Fed itself.419 As former Fed official Glenn Loney told Commission staff, “[A]t the very
beginning, [we] said we’re not going to be in a posture where the Fed’s going to be sort of
coercing banks into making deals with…community groups so that they can get
their…applications through. And that was…the conclusion they came to from the very
beginning.”420
The rules implementing the 1995 changes to the CRA made it clear that the Federal Reserve
would not consider promises of future actions to third parties nor enforce prior agreements with
those parties. Under a section labeled, “Compliance with private commitments,” the rules state
“an institution’s record of fulfilling these types of agreements [with third parties] is not an

418

Federal Register 54 FR 13742 April 5, 1989 “Statement of the Federal Financial Supervisory Agencies regarding
the Community Reinvestment Act”
419

MFR, Interview with Glenn Loney, former Deputy Director, Federal Reserve Board, April 1, 2010.

420

Transcript, Interview with Glenn Loney, former Deputy Director, Federal Reserve Board, April 1, 2010.

203

appropriate CRA performance criterion.”421 Still, even without official status, the announcement
of a large merger and the requisite public scrutiny offered the banks the chance to highlight a
bank’s past acts and to offer assurances for the future. In 1998, for example, when NationsBank
announced its intention to merge with BankAmerica, it announced a 10-year, $350 billion
community investment initiative including pledges of $xxx for lending, $xxx for small business
and $xxx for community development.
This merger was perhaps the most controversial of its time, because of the size and scale of the
two banks. The Fed held four public hearings and received over 1,800 comments. Supporters of
the merger touted the community investment commitment while opponents decried its lack of
specificity. The Fed’s internal staff memorandum recommending approval reiterated the Board’s
long standing policy:422 “The Board considers CRA agreements to be agreements between
private parties and has not facilitated, monitored, judged, required, or enforced agreements or
specific portions of agreements...NationsBank remains obligated to meet the credit needs of its
entire community, including [low- and moderate-income] areas, with or without private
agreements...”423 The merger was approved. In the final order, the Federal Reserve mentioned
the commitment and then went on to state that: “an applicant must demonstrate a satisfactory
record of performance under the CRA without reliance on plans or commitments for future
action. The Board believes that the CRA plan--whether made as a plan or as an enforceable

421

Fed, FDIC, OCC, OTS, Community Reinvestment Act Regulations and Home Mortgage Disclosure: Final Rules,
Federal Register, May 4, 1995, Volume 60, Number 86.
422

Federal Reserve System Order Approving Merger, p. 65.

423

Memorandum to Board of Governors from Division of Consumer and Community Affairs, August 10, 1998,
FCIC-133121 and 133122

204

commitment--has no relevance in this case without the demonstrated record of performance of
the companies involved.”
This dance was oft-repeated during the merger mania of the late 1990s and early 2000s. At times
banks would sign agreements with specific community groups or unilaterally announce a lending
and investment pledge. JP Morgan announced commitments of $xxx and $800 billion,
respectively, in connection with its mergers with xx and Bank One. In addition to the
commitment that Citigroup made when it merged with Travelers in 1998, it committed to $120
billion when it acquired California Federal Bank in 2002. When merging with Fleet in 2004,
Bank of America announced its largest commitment to that point: $750 billion over 10 years.
The National Community Reinvestment Coalition, an advocacy group, eventually tallied over $7
trillion in commitments from 2002 to 2007, about one-third of which were aimed at mortgage
lending. Although banks would tout their fulfillment of these commitments in press releases, the
NCRC and other community groups were unable to verify if this lending actually occurred, they
told the FCIC.424 And, the language in the Fed’s orders never [ck] wavered. It insisted that these
commitments would not affect its decisions about the mergers. So what then was the purpose of
these commitments? Were they a meaningful step or only a gesture? For the banks, the idea was
to reassure community groups that the increased scale of the merged institution would not
undermine community housing and small-business needs. Lloyd Brown of Citigroup explained
to the FCIC that, in the end, most of the transactions fulfilling these agreements “would be
considered in the normal course of business.” Speaking of a recent Bank of America
commitment, Andrew Plepler, head of Global Corporate Social Responsibility at the bank, told
424

MFR of FCIC interview with Josh Silver (Jun. 16, 2010), 15,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4813-9322-6246&open=Y.

205

the FCIC: “At the time of mergers, community groups, government officials and media have
many concerns that the two institutions will not carry through on all community
lending. Institutions address these fears by ‘‘reaffirming’ commitments to community
lending. The [commitment] figure was arrived at by working closely with business partners who
project current levels of business activity which qualifies toward community lending goals into
the future to assure the community that past lending and investing practices will
continue.”425 Both Citi and BofA told the FCIC that they did not track their adherence to their
commitments on a consistent basis.426 [add information from ongoing investigation]
In essence, banks promised to keep doing what they were doing and community groups had the
assurance that they would.

Bank capital standards: ““Arbitrage”
As we have seen, the first generation of subprime lenders had put themselves at serious risk. As
discussed, Keystone Bank in March 1999 and Superior Bank in November 2001 shut down when
their subprime securitized assets held on their balance sheets at inflated values proved to be
worth much less.
In an effort to prevent this from happening again, the Federal Reserve and other regulators
reworked the capital requirements governing securitization activities by banks and thrifts. In
October 2001, they introduced the “Recourse Rule” governing how much capital a bank held
against different securitized assets. If a bank retained an interest in a residual tranche of a
425

MFR of Interview of Andrew Plepler, Global Corporate Social Responsibility, Bank of America, July 14, 2010.
NEED TO CHECK INTERVIEW RECORDING FOR PRECISE WORDING.
426

Responses to FCIC interrogatories from Citigroup (Mar. 18, 2010, from Paul Weiss) and Bank of America (no
cite). See FCIC TopIR on CRA, pp. 5, 11, https://vault.netvoyage.com/neWeb2/goId.aspx?id=4811-61349639&open=Y.

206

mortgage security, as Keystone, Superior and others had, it would have to keep a dollar in capital
for every dollar of residual interest. That made sense, since the bank, in this instance, would be
the first to take losses suffered by the loans in the pool. Under the old rules, banks held only 8%
in capital to protect against losses on residual interests and any other exposures that they retained
in securitizations; this had allowed Keystone and others to seriously understate their risks and not
hold sufficient capital. The Recourse Rule therefore increased the capital charge on residual
interests by 12.5 times. In doing so, it increased banks’ incentive to sell the residual interests in
securitizations, meaning that they were no longer the first to lose when the loans went bad.
A second element of the Recourse Rule imposed a ratings-based framework for all asset-backed
securities, including mortgage-backed securities and their various tranches. The new regime
anchored the capital requirement directly to the rating agencies’ ratings of the tranches. Those
rated AAA or AA required greatly reduced capital charges in comparison to lower-rated
investments. For example, $100 invested in AAA or AA mortgage-backed securities required
holding only $1.60 in capital (the same as for GSE-backed securities), but anything with a BB
rating required $16 in capital, a tenfold increase.
As it turned out, banks could lessen the capital they were required to hold for a pool of
mortgages simply by securitizing them, as opposed to holding them on their books as whole
loans. For example, if a bank kept $100 in mortgages on its books, it might have to set aside
about $5, including $4 in capital against unexpected losses and $1 in reserves against expected
losses. If the bank put the $100 into a mortgage-backed security, sold that security in tranches,

207

and bought all of the tranches, the capital requirement would be about $4.10 in total.427
“Regulatory capital arbitrage does play a role in bank decision making,” David Jones, a Fed
economist who wrote an article about the subject in 2000, told the FCIC in an interview, but he
added, “It is not the only thing that matters.” 428
And a final comparison: under bank regulatory capital standards, a $100 AAA corporate bond
required $8 in capital, five times as much as the AAA mortgage-backed security. Unlike the
AAA corporate bond, the AAA tranche of the mortgage-backed security was ultimately backed
by real estate. And, in the United States, it was believed, house prices would not fall.
The new requirements also put the rating agencies in the driver’s seat. How much capital a bank
held depended in part on the ratings of the securities it held. Tying capital standards to rating
agency views would come in for criticism after the crisis began. [Quote from hearing criticizing
this.] The Fed’s Jones said it was better than the alternative – “to let the banks rate their own
exposures.” That alternative “would be terrible [because] banks were coming to the Fed and
arguing rating agencies were too conservative, noting performance of securitization exposures by
rating was better than similarly rated corporate debt for example.”429
Meanwhile, banks and their regulators were not prepared for the possibility of significant losses
on triple-A mortgage-backed securities, which were, after all, supposed to be among the safest

427

Assuming 75% AAA tranche ($1.20), 10% AA tranche ($0.20), 8% A tranche ($0.30), 5% BBB tranche ($0.40),
and 2% equity tranche ($2.00). See Goldman Sachs, Effective Regulation: Part 1, Avoiding Another Meltdown,
March 2009, page 22.
428

FCIC interview with David Jones, October 19, 2010 [3:17]. See David Jones, Emerging problems with the Basel
Capital Accord: Regulatory capital arbitrage and related issues, Journal of Banking & Finance, Volume 24, Issues
1-2, January 2000, Pages 35-58.

429

FCIC interview with David Jones, October 19, 2010 [3:17].

208

investments. Nor were they prepared for the ratings downgrades due to expected losses, which
would then require banks to post more capital. And, were this to occur, at the moment that the
banks wanted to sell their securities to raise capital, there would be no buyers. All of which
came to pass within a few years.

209

CHAPTER CONCLUSIONS HERE

210

Part II, Chapter 2: The mortgage machine

Contents
Chapter 2: The mortgage machine ........................................................................................................... 211
Foreign investors: “An irresistible profit opportunity” ......................................................................... 213
Mortgages: “It just kept layering the risks” ......................................................................................... 217
OCC and OTS: “Immunity from state law is a significant benefit”...................................................... 234
MBS players: “Wall Street was very hungry for our product” ............................................................ 237
Moody’s: “Given a Blank Check” ....................................................................................................... 248
GSEs: “Less competitive in the marketplace” ...................................................................................... 258

In 2004, Wall Street – commercial banks, thrifts, and investment banks – caught up with Fannie
Mae and Freddie Mac in the securitization of residential mortgages. By 2005, they had taken the
lead. While the two GSEs maintained their monopoly securitizing prime mortgages below their
loan limits, the wave of refinancing by prime borrowers, spurred by a period of very low and
steady interest rates, petered out.. Meanwhile, Wall Street focused on the higher-yield loans that
the GSEs were unable to purchase and securitize – loans that were too large, called jumbo loans,
and the non-prime loans that didn’t meet the GSEs’ underwriting standards. Those non-prime
loans soon became the biggest part of the mortgage market. They came in two forms: the
notorious “subprime” and also “Alt-A” -- a loan made to a borrower with strong credit but has
some characteristics that make it riskier than a prime loan.430

430

For example, an Alt-A loan may have no or limited documentation of the borrower’s income, a high loan-tovalue ratio (LTV), or may be for an investor-owned property.

211

By 2005 and 2006, Wall Street securitized a third more loans that Fannie and Freddie. In just
two years, private-label mortgage-backed security issuance grew more than 30% to an annual
$1.15 trillion in volume in 2006; 71% were either subprime or Alt-A.

Many investors preferred or were restricted to buying securities with only the top credit ratings.
The credit rating agencies made possible such purchases by giving most mortgage-backed
securities the AAA stamp of approval. Meanwhile, yields on other highly-rated assets were at
low levels. As a result, investors had a huge appetite for Wall Street’s mortgage-backed
securities made from higher-yield mortgages – which tended to be those made to subprime
borrowers, those with non-traditional features, or those with limited or no documentation, “nodoc loans”, or otherwise weaker underwriting standards. “Securitization could be seen as a
factory line,” Citigroup’s ex-CEO Chuck Prince told the FCIC. “You needed raw material to put
in the front end of that… As more and more and more of these subprime mortgages were created
as raw material for the securitization process, not surprisingly in hindsight, more and more of it
was of lower and lower quality. And at the end of that process, the raw material going into it
was actually bad quality, it was toxic quality, and that is what ended up coming out the other end
of the pipeline. Wall Street obviously participated in that flow of activity.”431 Perhaps not
surprisingly, Wall Street was rewarded handsomely as long as the boom lasted.
The mortgage machine could not have worked without short-term financing provided by the
shadow banking system. Starting in the late 1990s, the shadow banking system increasingly took
command of the securitization business. Unlike depository institutions with ample cash on hand,
431

FCIC interview with Chuck Prince, March 17, 2010.

212

Wall Street relied more on money market funds and other investors to provide cash to conduct
this business, with commercial paper and repo being the main short-term financing mechanisms.
With house prices already up xx% from 1995 to 2003, the flood of money helped to boost prices
another 36% from the beginning of 2004 until the market peaked in July 2006—even as
homeownership was moving down. From 2004 to mid-2006, the highest gains were
concentrated in the “sand states”: in places like the Los Angeles suburbs 54%; Las Vegas 36%;
Orlando, 72%.432 Throughout this time, national regulators would constrain the efforts of state
regulators to impose mortgage lending rules on nationally-regulated lenders.
Foreign investors: “An irresistible profit opportunity”
From June 2003 through June 2004, the Federal Reserve kept the Federal Funds rate stable at 1%
in order to stimulate the economy following the 2001 recession. Over the next two years, as
deflation fears waned, the Fed gradually raised interest rates to 6.25% in a series of 17 quarterpoint increases.
For some, the Fed had simply acted too late and had kept rates too low for too long. John
Taylor, Stanford economist and former Under Secretary of Treasury for International Affairs,
told the FCIC that this was the primary cause of the crisis. His “Taylor Rule” describes how the
Fed has historically set the federal funds rate. If the Fed had followed its historical pattern,
Taylor said, the Fed would have set short-term interest rates much higher, discouraging
excessive investment in mortgages and other sectors of the economy. “The boom in housing
construction starts would have been much more mild, might not even call it a boom, and the bust

432

CoreLogic CSBA and National Home Price Index, Single Family Combined (SFC) Index. The national market
peaks in April 2006; urban area increases are measured over the same period. Los Angeles suburbs are an average of
Santa Anna-Anaheim-Irvine and Riverside-San Bernardino-Ontario metro areas, FCIC calculations.

213

as well would have been mild, you might not even call it a bust,” Taylor said. “The whole thing
[would have been] attenuated significantly if interest rates would have been higher.”433
Fed Chairmen Bernanke and Greenspan tell a different story. Bernanke points out that the Fed
was never very far from following the Taylor Rule, but he says that it didn’t work this time – for
reasons out of the Fed’s control. Both the current and former Fed chairman argue that the
decision to purchase a home is based on long-term interest rates on mortgages, not on the shortterm rates that the Fed controls, and that short-term and long-term rates had become de-linked:
“Between 1971 and 2002, the Fed Funds rate and the mortgage rate moved in lock-step,”
Greenspan said. With that experience, when the Fed started to raise rates in 2004, officials
expected mortgages rates to also rise, slowing growth in the housing market. Instead, mortgages
rates continued to fall for another full year.434 The construction industry continued to build new
houses, then more new houses, peaking at an annualized rate of 2.27 million starts in January
2006, a 30-year high as home prices continued to climb.435
As Chairman, Greenspan told Congress in 2005, it was a “conundrum” that mortgage rates
continued to decline despite higher short-term interest rates. One possible explanation was
money from abroad. Developing countries were experiencing strong economic growth and –
having found themselves vulnerable to financial problems in the past – encouraged their
consumers and businesses to save more. With excess cash to invest, investment funds in these
countries often found the apparently safe and high-yield investments in the U.S. appealing. Fed
433

FCIC interview with John Taylor.

434

Federal Reserve Bank of St. Louis, FRED database, 30 Yr Conventional Mortgage Rate (MORTG), available at
http://research.stlouisfed.org/fred2/series/MORTG
435

Federal Reserve Bank of St. Louis, FRED database, Housing Starts: Total: New Privately Owned Housing Unites
Started (HOUST), available at http://research.stlouisfed.org/fred2/series/HOUST

214

Chairman Ben Bernanke called it a “global savings glut.”436 Flows into the U.S., shown in the
chart, were unprecedented, and the U.S. ran huge annual current account deficits.437

Global current account surpluses and deficits, $ Billions
2,000
1,500
1,000

Annual

All other surpluses

All other deficits

Germany and Japan

UK and Spain

Top oil exporters**

USA

China and EM Asia*

$ Billions

500
0

‐500

‐1,000
‐1,500
‐2,000
1990 1991 1992 19931994 1995 1996 1997 19981999 2000 2001 2002 20032004 2005 2006 2007

The share of U.S. Treasury debt held by foreign official entities rose from $0.6 trillion to $8.51
trillion,438 representing an increase from 11% of total U.S. debt in 2000 to 15% of total U.S. debt

437

The current account deficit is the trade deficit plus interest payments made to foreigners sent abroad and transfer
payments annually. Data from Bureau of Economic Analysis, Trade in Goods and Services, avalable at
http://www.bea.gov/international/index.htm#bop
438

US Treasury, Treasury Direct: Historic Debt Outstanding
http://www.treasurydirect.gov/govt/reports/pd/histdebt/histdebt.htm and US Treasury, Major Foreign Holders of
Treasury Securities, http://www.ustreas.gov/tic/mfh.txt

215

in 2006.439 Foreigners also invested in securities backed by Fannie and Freddie, which seemed
nearly as safe with their implicit guarantee that the government would back them up in case of
trouble. As the Asian financial crisis ended in 1998, foreign holdings of GSE securities were
steady with their levels of almost 10 years earlier, about $186 billion. By 2000 – just two years
later – foreigners would own $348 billion in GSE securities.440 By 2004, they would own $875
billion. “You had a huge inflow of liquidity. A very unique kind of situation where poor
countries like China were shipping money to advanced countries because their financial systems
were so weak that they [were] better off shipping to countries like the United States rather than
keeping it in their own countries,” former Fed Governor Frederic Mishkin told the FCIC.441
“The system was awash with liquidity, which helped lower long term interest rates.” [Add
additional balancing views]
As more and more foreign cash poured into the United States, foreign investors sought other
high-grade debt assets that were almost as safe as Treasuries and GSE securities but that offered
a slightly higher return. They quickly found an affinity for the AAA assets pouring out of the
Wall Street mortgage securitization machine. As demand from overseas drove up the prices for
securitized debt, it “created an irresistible profit opportunity for the U.S. financial system: to

439

Board of Governors of the Federal Reserve System, Table L.107 Rest of the Word

441

FCIC Interview of Frederic Miskin, Memorandum for the Record available at on NetDocs at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4823-4002-6375&open=Y Net Docs ID 4823-4002-6375, Audio
is available in the 2010-10-01 FCIC Interview of Frederic Miskin at 3:40 available on NetDocs at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4847-7705-0375&open=Y NetDocs ID 4847-7705-0375

216

engineer ‘quasi’ safe debt instruments by bundling riskier assets and selling the senior tranches,”
University of California-Berkeley economist Pierre-Olivier Gourinchas told the FCIC.442
IIt was Gordon Gekko’s ocean of money.
Mortgages: “It just kept layering the risks”
In order to ride this wave of money, the mortgage securitization machine worked overtime. And
in order to ride that wave, the originators worked overtime to sign up eager borrowers for
mortgages to sell to the banks. But the refinancing boom was over and housing prices were still
rising. To supply the securitization machine, originators needed new products to sell – products
that could make expensive homes more affordable even to subprime borrowers. This new
activity brought changes to the mortgage market that would result in higher yields for investors
but, at the same time, greater risks. “Holding a subprime loan has become something of a highstakes wager,” the Center for Responsible Lending warned in 2006.443
Subprime mortgages rose from 8% of all mortgages in 2003 to 20% in 2005, continuing the trend
that had begun early in the decade. About 70% of subprime borrowers used hybrid adjustablerate mortgages (ARMs) such as 2/27s and 3/28s – that is, mortgages with a low “teaser” rate for
the first two or three years which then adjust periodically thereafter.444 As subprime borrowing
became more prominent, so did these loans.

442

Notes from hearing, February XXX, 2010.

443

Ellen Schloemer, Wei Li, Keith Ernst, and Kathleen Keest, “Losing Ground: Foreclosures in the Subprime
Market and Their Cost to Homeowners” (Dec. 2006), http://www.responsiblelending.org/mortgagelending/research-analysis/foreclosure-paper-report-2-17.pdf
444

Cite to JEP paper by Lehnert, Pence, and Sherlund??

217

More and more, prime borrowers also used alternative mortgage products. The dollar volume of
Alt-A securitization rose [XXX]% from 2003 to 2005. In general, these products made the
borrowers’ monthly mortgage payments on ever more expensive homes initially affordable.
Popular Alt-A loan products included interest-only mortgages and payment-option ARMs, or
option ARMs. Option ARMs, discussed more below, allowed borrowers to vary their monthly
payments with their ability to pay, possibly adding to the principal balance of their mortgage
over time. When the balance got big enough, the lender would increase the required monthly
payment, sometimes dramatically. Option ARMs rose from just 1%[ck] percent of mortgages in
2003 to 8% in 2005.
Among both non-prime and prime mortgages, underwriting standards weakened. Discussed
more below, the combined loan-to-value ratios – which reflect the total mortgage debt including
first, second, and possibly even third mortgages – rose. Debt–to-income ratios climbed, as did
the number of loans made for non-owner-occupied properties.
The mortgage market also saw structural changes. In 2003, Fannie and Freddie purchased or
sold mortgage-backed securities on 57% of all mortgages issued that year. By 2004, that
percentage was 42% and in 2005 and 2006, 37%.445 Taking their place were mortgages sold into
the private-label mortgage-backed securities market. To feed this market, originators competed
fiercely.
Countrywide Financial Corporation took home the biggest trophy. From 2000 to 2005, its
originations grew six-fold. In 2004, it became the number one mortgage originator and
maintained that position until the market collapsed in 2007. Even after Countrywide nearly
445

FHFA

218

failed, loaded down with a mortgage portfolio that contained the kinds of loans that co-founder
and CEO Angelo Mozilo had once described as “toxic,” Mozilo would describe his 40-year-old
company to the Commission as one that had helped 25 million people buy homes – preventing
social unrest – by adhering to federal housing policy and extending loans to minorities who had
historically been victims of discrimination. As Mozilo would tell the FCIC, “Countrywide was
one of the greatest companies in the history of this country and probably made more difference
to society, to the integrity of our society, than any company in the history of America.”446 Of
course, extending mortgages to homebuyers was only part of the business. As Countrywide’s
President and COO David Sambol told the commission, “For the most part, we were a seller of
securities to Wall Street.”447 Plainly stated, Countrywide’s essential business strategy was to
“originate what was salable in the secondary market.”448 Indeed, the company sold or securitized
86% of the $1.7 trillion in mortgages it originated between 2002 and 2005.449
To achieve its incredibly rapid growth, Mozilo announced in 2004 a “very aggressive” goal to
gain 30% of the origination market.450 At the time, his company’s market share was 12%.451
Countrywide was not unique. Ameriquest, New Century, Washington Mutual and others pursued
the same aims and as aggressively. These companies gained market share by originating
mortgages that had been created years before as niche products with a solid underwriting
rationale. Now they were transformed into riskier, mass-market versions with a very different
446

Transcript page 16

447

Sambol/Clara’s notes p.2

448

Sambol.Clara notes p.2

449

PIR p 6 figure 3 – figure 2

450

PIR p 17 citing investor’s conf footnote 30

451

IMF annual volume 1, pg 49

219

rationale. “The definition of a good loan changed from ‘one that pays’ to ‘one that could be
sold,’” Patricia Lindsay, formerly a fraud specialist at New Century, told the FCIC.452
2/28s and 3/27s: “Adjust for the affordability”
Historically, 2/28s or 3/27s had been used to provide credit-impaired borrowers an opportunity to
repair their blemished credit. During the first two or three years of the loan, a lower interest rate
offered borrowers a manageable payment schedule to demonstrate the financial wherewithal to
make timely payments. At the end of this period, borrowers would have several alternatives to
making the higher payments when the interest rate adjusted. If borrowers had established their
creditworthiness, they could refinance into a new, sustainable mortgage, with the same lender;
borrowers typically paid a 3.5% to 4% penalty if they refinanced with a different lender.453 If the
borrowers were unable to refinance, the home could be sold and the mortgage repaid. If unable
to sell or make the higher payments, the borrowers would have to default.
But as house prices rose in the 2000s, the 2/28s and 3/27s became a very useful affordability
product to help get people into homes. “As homes got less and less affordable, you would adjust
for the affordability in the mortgage because you couldn’t really adjust people’s income,”
Andrew Davidson [ck title], a long-time veteran of the mortgage markets, told the FCIC.
Borrowers were qualified at the low “teaser rates,” and little attention was paid to what might
happen when rates reset. These mortgages became the workhorses of the subprime securitization
market.

452

Written testimony of Patricia Lindsay to FCIC hearing, p. 3.

453

MFR of FCIC interview with Andrew Davidson, 3.

220

Consumer protection groups, such as the Leadership Conference on Civil Rights, railed against
2/28s and 3/27s, which, they said, neither rehabilitated credit nor turned renters into owners. As
David Berenbaum from the National Community Reinvestment Coalition testified to Congress in
the summer of 2007, “The industry has flooded the market with exotic mortgage lending such
as… 2/28 and 3/27 ARMs. These exotic subprime mortgages overwhelm borrowers when
interest rates shoot up after an introductory time period.”454 Consumer groups argued that these
mortgages were simply a way for lenders to strip equity from the homes of low-income or
otherwise marginalized borrowers. These loans came with big fees that would get rolled into the
mortgage, increasing the chances that the mortgage would be larger than the home value at the
reset date. [example of typical loan fees and interest rates (teaser and ultimate interest rates)] If
the borrower couldn’t refinance, the lender would foreclose—now owning a home in a rising real
estate market. Furthermore, the increased risks of default and foreclosure threatened to
undermine, not strengthen, the economic stability of families and neighborhoods.
Option ARMs: “Activities that are in the best interest of our Company”
Like the hybrid loans, option ARMs were originally niche products for select buyers, but by
2004 became loans of choice for the same reason: they required lower mortgage payments than
other more traditional mortgages. The new twist was that borrowers could pick their payment
each month, possibly resulting in an increase in the principal balance of their loan.
The option ARM dated to the high interest-rate environment of the early 1980s, when traditional
ARMs became popular. But, an option ARM was typically offered to financially sophisticated
borrowers who had fluctuating income, such as the self employed. This mortgage gave
454

http://banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=e012f6c1-08c5-419d-9bcfd65a22559e12

221

borrowers the option to make a range of payments each month; any shortfall on the interest
would be added to the principal – a situation called negative amortization.455 If the principal got
large enough, the mortgage would “recast” into a new fixed-rate mortgage with higher monthly
payments that would pay down the principal with interest over the remaining life of the loan.456
Borrowers who periodically made minimum payments could prevent this recasting by
periodically making larger payments. However, during the housing boom, many borrowers
systemically made minimum payments, adding to their mortgage balance every month.
One of the early sellers of option ARMs was Golden West Savings, an Oakland, Californiabased thrift founded in 1929 and acquired in 1963 by the husband-and-wife team of Marion and
Herbert Sandler. In 1975, the Sandlers merged Golden West with World Savings; Golden West
became the parent company and operated branches under the name World Savings Bank.457 The
thrift issued [$XXX] in option ARMs between 1981 and 2006. Unlike other mortgage
companies, Golden West held all of these loans in portfolio. It did not sell or securitize any of
them.458

455

The option-ARM provides borrowers several monthly payment options such as the traditional payment of
principal and interest, interest-only payment and the minimum payment option that is described in the text. The
traditional payment of principal and interest is based on the term of the loan (15, 30, or 40 year). This option is
amortizing because it reduces the amount the borrower owes on the mortgage. Another option is the interest-only
payment, in which a borrower pays only the interest on the loan. With the minimum payment option, the monthly
payment may be less than the amount of interest due that month. This is considered a negatively amortizing loan
since borrowers end up underpaying their loan and the difference between the minimum payment and the actual
interest on the loan that is due each month is added to the principal of the loan, thereby increasing a borrower’s loan
balance.
456

http://www.goldenwestworld.com/wpcontent/uploads/historyoptionarmandstructuralfeaturesgwoptionarm.pdf

457

Source: www.worldsavings.com, from http://web.archive.org.

458

http://www.goldenwestworld.com/lending-operations/#3

222

Sandler told the FCIC that Golden West’s option ARMs – marketed under the brand, “Pick-aPay” loans – had the lowest losses in the industry for that product.459 At the time that Wachovia
acquired Golden West, losses were low industry-wide, held down by years of strong house price
gains. [cite ck] Sandler attributed Golden West’s performance to the fact that the company ran
simulations about what would happen to its loans under various scenarios – for example, if
interest rates went up or down or if house prices collapsed 5%, even 10%. After 10 years, or in
the event that the principal balance grew to 125% of its original size, the Pick-a-Pay mortgage
would “recast” into a new fixed-rate mortgage.460 461

“For a quarter of a century, it worked

exactly as the simulations showed that it would,” Sandler said. “And we have never been able to
identify a single loan that was delinquent because of the structure of the loan, much less a loss or
foreclosure.” By 2007, after it was acquired by Wachovia Corporation and the housing market
turned, Golden West’s losses would suddenly jump from under 0.10% of loans to over [XXX%].
And, foreclosures among option ARM borrowers would be rampant.
By the early 2000s, banks and thrifts like Washington Mutual and Countrywide increased their
activity in the option ARMs market, with changes that made payment shocks more likely. For
example, these option ARMs would recast in as little as 5 years, or when the loan balance hit just

459

http://www.goldenwestworld.com/lending-operations/#5; “Throughout its history, Golden West originated
ARMS with the lowest delinquencies, foreclosures and losses of any major financial company in the country,
including fixed-rate lenders. For example, in its final eight years of operation as an independent company (19982005), Golden West’s losses were zero.” [An OCC review of loan performance through 200# corroborated that
claim.]
460

http://www.goldenwestworld.com/wpcontent/uploads/historyoptionarmandstructuralfeaturesgwoptionarm.pdf

461

According to Golden West the mimimum payment rate ranged 1.95%-2.95% or higher:
http://www.goldenwestworld.com/wp-content/themes/goldenwest/docs/DifferencesAmongARMs.pdf

223

110% of its original size.462 These option ARMs also offered low initial “teaser” rates, as low as
1% and loan-to-value ratios as high as 100%.
In 2002, Washington Mutual was the second largest mortgage originator, right behind Wells
Fargo, ahead of Countrywide.463 Washington Mutual had offered the option ARM since 1986,
and in 2003, it conducted a study “to explore what Washington Mutual could do to increase sales
of Option ARMs, our most profitable mortgage loan.” [cite] A focus group made clear that few
customers requested a option ARM; instead “they need to be ‘sold’ to customers.”464 The study
found “the best selling point for the Option Arm” was showing consumers “how much lower
their monthly payment would be by choosing the Option Arm versus a fixed-rate loan.”465
The study also revealed that many WaMu brokers “felt these loans were ‘bad’ for customers.”466
A member of the focus group stated, “A lot of (WaMu Loan) Consultants don’t believe in it …
and don’t think [it’s] good for the customer. You’re going to have to change the mindset for a lot
of the consultants that are on board.”467
Despite these issues, the volume of option ARM originations at WaMu soared from $30 billion
in 2003 to $68 billion in 2004, when they comprised more than half of WaMu’s originations and

462

Need to cite – examples like countrywide and wamu

463

Inside Mortgage Finance

464

a WMI August 14, 2003, market study entitled, “Option Arm Focus Groups – Phase I” a research study to
explore ways to increase sales of option ARMs it was
465

JPM-WM03241849, April 13, 2010 PSI Hearing Exhibit #35

466

a WMI August 14, 2003, market study entitled, “Option Arm Focus Groups – Phase I” a research study to
explore ways to increase sales of option ARMs it was
467

a WMI August 14, 2003, market study entitled, “Option Arm Focus Groups – Phase I” a research study to
explore ways to increase sales of option ARMs it was

224

had become the thrift’s “signature” adjustable-rate home loan product.468

The average FICO

score for these mortgages was around 700, well into the range considered “prime,” and about
two-thirds were jumbo loans─ mortgage loans which exceeded the maximum dollar amount
Fannie Mae and Freddie Mac were allowed to guarantee.469 More than one-half were in
California. In 2006, WaMu estimated that option ARM, home-equity, and subprime mortgages
generated returns from 7 to 11.5 times as large as loans that Fannie or Freddie guaranteed.470
Countrywide’s option ARM business peaked at $14.5 billion in originations in the second quarter
of 2005, about 25% of all the loans that Countrywide originated during that quarter. But it had to
relax underwriting standards to get there. In July 2004, Countrywide decided it would lend up to
90% of a home’s appraised value, up from 80%. It also reduced the qualifying FICO scores to as
low as 620 in 2004.471 In early 2005, Countrywide loosened its standards again, increasing the
allowable combined loan-to-value ratio (including second liens) to 95%.
For option ARMs originated by Countrywide and WaMu, the average loan-to-value ratio had
risen from just under [will swap out for percentage above 90% LTV 70% to 73%; the combined
loan-to-value ratio had risen from 70% to 75%], and debt-to-income ratios had risen from 34% to
38%, meaning that more of a borrower’s income would have to go to mortgage payments. And,
68% of these two originators’ option ARMs had low documentation in 2005, up from to 64%

468

From a 2006 Board of Directors presentation, PSI docs, p366 (numbers are diff on diff pages).

469

As set by the Office of Federal Housing Enterprise Oversight (OFHEO).

470

PSI docs, p366 (numbers are diff on diff pages).

471

Countrywide PIR pg. 26[] “Countrywide loosened underwriting guidelines for payment option ARM loans by
increasing allowable CLTV ratios and reducing FICO scores to 660 and 620 .” From table: loan amount $400,000
from 680 to 620; $500,000, from 680to 660; $650,000, from 680 to 660.)

225

[look for earlier data] in 2003. The percentage of these loans made to investors – that is,
borrowers who did not plan to use the home as their primary residence – also rose.
These changes worried lenders even as they continued to make the loans. In August 2005,
Countrywide CEO Angelo Mozilo emailed senior management expressing concern that making
all these loans could bring “catastrophic consequences.” In particular, Mozilo said, Countrywide
should not market the option ARMs to investors. “Pay option loans being used by investors is a
pure commercial spec[ulation] loan and not the traditional home loan that we have successfully
managed throughout our history,” Mozilo wrote in an email to Countrywide Bank CEO Carlos
Garcia. Speculative investors “should go to Chase or Wells not us. It is also important for you
and your team to understand from my point of view that there is nothing intrinsically wrong with
pay options loans themselves, the problem is the quality of borrowers who are being offered the
product and the abuse by third party originators… if you are unable to find sufficient product
then slow down the growth of the Bank for the time being.” [cite] However, Countrywide’s
growth did not slow. The dollar value of its retained option ARMs increased from $5 billion in
2004 to $26 billion in 2005, peaking in 2006 at $33 billion. In the same period, WaMu also
increased the proportion of option ARM mortgages retained on its balance sheet, the bulk from
California, followed by Florida. The option ARMs on the books of these thrifts would be a
source of significant losses during the crisis.
Citing Countrywide and Wamu as “in our face” as competitors, John Stumpf, CEO, Chairman,
and President of Wells Fargo, described his company’s decision not to write option ARMs, even
as it originated many other high-risk mortgages. These were “hard decisions to make at the
time,” he said further noting that “we did lose revenue, and we did lose volume.”

226

Across the market, the volume of option ARMs had risen five-fold from 2003 to 2005, from
[$XXX] billion to over [$XXX] billion. By then, WaMu and Countrywide already had plenty of
evidence that more borrowers were making the minimum payments, and their mortgages were
negatively amortizing—so that equity was being eaten away. The percentage of Countrywide’s
option ARMs negatively amortizing grew from just 1% in 2004 to 53% in 2005 and then over
90% by 2007. At WaMu, these percentages were 2% in 2003, 30% in 2004, and then 82% in
2007. House price declines added to borrowers’ problems. Any equity left after the negative
amortization would be eroded. Increasingly, borrowers would owe more on their mortgage than
their home was worth on the market. If the house were to be sold, the borrower would owe the
bank money, maybe a lot of money, at closing. If the borrower didn’t have this money, a sale
could be impossible. This would create an incentive to walk away from the home and the
mortgage.
Consumer advocates testified to the FCIC about the inherent dangers in option ARMs. Mr. Stein
from the California Reinvestment Coalition, testified to the FCIC about option ARMs being
inappropriately issued to borrowers, stating, “Nowhere was this dynamic more clearly on display
than in the summer of 2006 when the Federal Reserve convened HOEPA hearings in San
Francisco. At the hearing, consumers testified to being sold option ARM loans in their primary
non-English language, only to be pressured to sign English-only documents with significantly
worse terms. Some consumers testified to being unable to make even their initial payments
because they had been lied to so completely by their brokers.” 472 Ms. Tawatao, regional counsel
with Legal Services of Northern California, described the borrowers she was currently assisting
as “people who got steered or defrauded into entering option ARMs with teaser rates or pick-a472

Sacramento hearing

227

pay loans forcing them to pay into -- pay loans that they could never pay off. Prevalent among
these clients are seniors, people of color, people with disabilities, and limited English speakers
and seniors who are African-American and Latino.”473
Changing Underwriting Standards
For decades, the traditional down payment for a prime mortgage had been 20% (in other words,
the loan-to-value ratio had been 80%), even for hybrid loans [ck]. As home prices continued to
rise, finding the cash for 20% down became harder, and lenders began accepting smaller and
smaller down payments over the course of the 2000s.
There had always been a place for lower down payment mortgages. Typically, lenders who
allowed customers to make low down payments required borrowers to purchase private mortgage
insurance, for which the borrower paid a monthly fee. If a mortgage ended in foreclosure, and
the lender took a loss, the mortgage insurance company would pay the lender. Worried about
losses from defaults, the GSEs would not buy or guarantee mortgages with down payments
below 20% unless the borrower paid for private mortgage insurance. Luckily – or unluckily, as
it would turn out for many individual homeowners, for the housing industry, and for financial
system as a whole – lenders came up with a way to get rid of these monthly fees that added to the
cost of homeownership: lower down payments that didn’t require insurance.
Lenders had latitude in setting down payment requirements. Back in 1991, Congress had
directed federal regulators to adopt regulations prescribing standards for real estate lending rules
that would have applied to banks and thrifts. The goal was to “curtail abusive real estate lending
practices in order to reduce risk to the deposit insurance funds and enhance the safety and

473

Sacramento hearing

228

soundness of insured depository institutions.” While Congress had itself debated including
explicit loan-to-value standards in the statute, it chose not to, leaving that decision to the
regulators. In the end, regulators declined to introduce any standards for loan-to-value ratios or
documentation for home mortgages.474 Discussing the final rule, the regulatory agencies
observed: “A significant number of commenters expressed concern that rigid application of a
regulation implementing [loan-to-value] ratios would constrict credit, impose additional lending
costs, reduce lending flexibility, impede economic growth, and cause other undesirable
consequences…[T]he agencies have decided against adopting specific [loan-to-value] ratios or
ranges in the final regulation.”475
In 1999, the regulatory agencies revisited the issue with new guidance discussing the risks of
high loan-to-value mortgages. They noted that high loan-to-value lending was becoming more
common and that “[c]onsumers are increasingly using the equity in their homes to refinance and
consolidate other debts or finance purchases.” Still, the regulators in the 1999 guidance once
again did not impose any requirements, and only reminded the banks and thrifts that they should
establish and observe internal guidelines to manage the risk of these loans.476
By the 2000s, high LTV lending was made more common by the so-called piggyback mortgage.
The lender would offer the borrower a first mortgage for 80% of the home’s value and a second

474

Congress directed regulators to create these standards in the 1991 FDIC Improvement Act. (3) FDICIA,
Codified to 12 U.S.C. 1831p--1(a), formerly 1831s(a)]
475

Real Estate Lending Standards, Final Rule, OCC, Fed, FDIC, OTS. Federal Reserve Board of Governors, SR 931, January 11, 1993, Real Estate Lending Standards. www.federalreserve.gov/boarddocs/srletters/1993/SR9301.htm
476

Interagency Guidance on High LTV Residential Real Estate Lending, October 8, 1999, OCC, Fed, FDIC, OTS

www.federalreserve.gov/boarddocs/SRLetters/1999/sr9926a2.pdf

229

mortgage for the missing 10% (if they had a 10% down payment) or 20% (if not).477 Borrowers
liked these piggybacks as the monthly payments were often cheaper than mortgage insurance and
the interest payments were tax deductable [will add info re costs]. Lenders liked them because
the first mortgage – even without mortgage insurance – could potentially be sold to the GSEs.
But, the increasingly common piggybacks added risks. With the higher combined loan-to-value
ratio, the borrower had less equity in the home. In a rising market, should payments become
unmanageable, the borrower could always sell the home and come out ahead. However, should
the payments become unmanageable in a falling market, the borrower could owe more than the
home was worth. Piggyback loans – essentially nothing down – made it inevitable that many
borrowers would end up with negative equity if house prices fell, especially if the appraisal had
overstated the initial value.
Nevertheless, piggyback lending helped address a significant challenge for companies like New
Century. By [XXX], the firm had a three-month backlog of orders for new mortgages from its
securitizing banks. Meeting production goals meant finding new borrowers, and home
purchasers who lacked down payments were a relatively untapped source. Yet, among
mortgages originated in 2004, those with piggybacks had four times the 60 day plus delinquency
of other mortgages. When senior management at New Century was made aware of these
numbers, the head of the Secondary Marketing Department asked for "thoughts on what to do
with this information ... pretty compelling." The Corporate Credit Officer assessed the analysis
as "very compelling." Nonetheless, the number of mortgages originated with piggybacks
477

Piggyback mortgages were done with the knowledge of the first-lien lender. [ I don’t agree with this decrip of
silent second – seconds are recorded so first lender knows. I think silent seconds are ones that don’t require any
payment – they accrue and are paid on sale or some outside date]More nefarious cases, where this second mortgage
was not disclosed, were referred to as silent-seconds.

230

increased to 35% of overall loan production at New Century by the end of 2005, up from only
8% a couple years earlier. [check how much held and how much securitized] 478
They were not alone in taking on the risk of higher loan-to-value ratios. Across all securitized
subprime mortgages, the average combined-loan-to-value rose from 78% to 85 [add data re
percent above 90%, if available] between 2000 and 2006. Along with the banks and the GSEs,
the American consumer was leveraging up. But to buy a home, they were willing to take the
risk.
Another way to get people into houses – and quickly – was to ask for less information from the
borrower. Again, so-called “stated income” or “low-documentation” (or sometimes “nodocumentation”) loans had emerged years before to help people with fluctuating or hard-toverify incomes, such as the self-employed or for long-time customers with strong credit histories.
Or, perhaps the lender would waive information requirements if the loan was deemed safe in
other respects. “If I’m making a 65%, 75%, 70% loan-to-value, I’m not going to get all of the
documentation,” Herb Sandler of Golden West explained to the FCIC. It was too cumbersome
and unnecessary. He already had a good idea how much money teachers, accountants, and
engineers were paid in a given area—and if he didn’t, he could easily look it up. All he needed
to do was verify that his borrowers worked where they said they did. If he guessed wrong, the
loan-to-value ratio still protected his investment.479
In the mid-2000s, however, low- and no-documentation loans took on an entirely different
character. Non-prime lenders now advertised the fact that they could offer borrowers quicker

478

New Century bankruptcy report, pg 128.

479

Transcript of FCIC interview with Herb Sandler, 13-14.

231

decisions about their mortgage applications along with the convenience of not having to provide
tons of paperwork.480 In return, they charged a higher interest rate, and they had a faster
turnaround. The idea caught on: from [200X] to [200X], the percentage of low- and no-doc
loans skyrocketed from an estimated [XXX%] to [XXX%]. Within the Alt-A securitizations,
80% of 2006 loans had limited or no documentation. As Bill Black, a veteran supervisor,
testified before the FCIC, the mortgage industry’s own fraud specialists described stated income
loans as “an open ‘invitation to fraud’ that justified the industry term ‘liar’s loans.’” Speaking of
lending at Citigroup, Richard Bowen said, “A decision was made that ‘We’re going to have to
hold our nose and start buying the stated product if we want to stay in business.’”481 Jamie
Dimon, CEO of JP Morgan testified to the commission, “In mortgage underwriting, somehow we
just missed, you know, that home prices don’t go up forever and that it’s not sufficient to have
stated income.”
In the end, market participants in subprime and Alt-A mortgages had, in essence, placed all of
their chips on black: They were betting that home prices would never stop rising. This was the
only scenario that would keep the mortgage machine humming. To see this, we return to our
case-study mortgage-backed security, CMLTI 2006-NC2.
On their face, the 4,499 loans bundled in this deal were adjustable-rate and fixed-rate residential
mortgage loans originated by New Century. The loans had a 30-year maturity and an average
principal balance of $210,478, just under the median US home price of $221,900 in

480

http://www.jchs.harvard.edu/publications/finance/mm07-1_mortgage_market_behavior.pdf, pg 52

481

Richard Bowen, MFR

232

2006.[1] Nearly 60% of loans in the deal were originated in May and June 2006, just as national
home prices were peaking. About 90% of loans in the pool were reportedly for primary
residences, with 43% for home purchases and 48% for cash-out refinancings. The loans came
from all 50 states and the District of Columbia [ck] and were in 288 different metropolitan areas
or counties across the country. But, despite efforts at geographic diversification, nearly a third
came from California and over 10% from Florida; this concentration was typical for mortgagebacked securities during the boom.
The loans within this deal also had many of the characteristics described in this chapter. About
75% of these loans were ARMs, and most of these were 2/28s or 3/27s. In a twist, many of these
hybrid ARMs had other “affordability features” as well. For example, [XXX%] were interest
only – during the first two or three years, not only would borrowers pay a lower fixed rate, they
would not have to pay any principal. Another [XXX%] were “2/28 hybrid balloon” loans where
the principal would amortize over 40 years to lower the monthly payments even further.
Whatever it took to make the loan. Among the roughly 25% of loans that were fixed rate, some
had maturities of more than 30 years.
The majority of the mortgage pool was secured by first mortgages and approximately 5% by
second mortgages. Of the first mortgages, 32% had a piggyback mortgage on the same property.
As reported above, these piggyback loans were a specialty at New Century. As a result, more
than one-third of the mortgages in CMLTI 2006-NC2 had a combined loan-to-value ratio
between 95% and 100%.

[1]

This particular deal would be described as an excess-spread over-collateralized based credit enhancement
structure; see “The Panic of 2007,” Gary Gorton, paper prepared for the Federal Reserve Bank of Kansas City’s
Jackson Hole Conference, August 2008, p. 23)

233

And to compound matters a bit more, approximately 42% of the pool were no-doc loans for
which income or assets were simply “stated.” The rest were “full-doc” loans, although this full
documentation was fuller in some cases than in others.482
The loans in CMLTI 2006-NC2 mirrored the overall market at the time: complex products with
high LTVs and little documentation. And, even as many warned that this toxic mix demanded
serious attention, the regulators as we will see were not on that page.
OCC and OTS: “Immunity from state law is a significant benefit”
For years, some states had tried to regulate the mortgage business, especially clamping down on
the predatory mortgages proliferating in the subprime market. The national thrifts and banks and
their federal regulators—the Office of Thrift Supervision and the Office of the Comptroller of
the Currency, respectively—resisted. The regulators agreed with these companies that they
needed a uniform set of rules that preempted the states or they would wind up with too many
different rules to follow across the country. In August 2003, as the market for riskier subprime
and Alt-A loans was growing, as lenders were piling on more risk with smaller down-payments,
reduced documentation requirements, interest-only loans, and payment-option loans, the OCC,
which regulates national banks, fired another salvo in the preemption wars. The rules the OCC
proposed were nearly identical to rules the OTS issued in 1996 governing real estate lending by
nationally chartered thrifts and their subsidiaries, which empowered the thrifts to disregard state
consumer laws in making residential mortgages.483

482

For a quarter of these loans, the borrower supplied two years of W-2 tax statements and tax returns; others were
backed by only one year’s worth of information, or by business bank statements.
483

Bank Activities and Operations: Real Estate Lending and Appraisals, 69 Federal Register 1904 (Jan. 7, 2004).
The rules were issued in proposed form at 68 Federal Register 46, 119 (Aug. 5, 2003). For a description of the
OCC’s 2004 rules and their similarity to the OTS’s rules, see Wilmarth (2004), at 227-36, 298-99.

234

Asserting its authority, OTS had issued a series of orders declaring that federal law preempted
state fair lending laws with regard to federally regulated thrifts. In 2003, for example, referring to
these orders the OTS chief counsel issued four opinion letters declaring laws passed by Georgia,
New York, New Jersey and New Mexico didn’t apply to national thrifts.64 In the New Mexico
opinion, the regulator declared invalid New Mexico’s prohibitions against balloon payments,
negative amortization, prepayment penalties, loan flipping, and lending without regard to the
borrower’s ability to repay.65
The Comptroller of the Currency took the same line regarding the national banks it regulated. In
a 2002 speech, before the final OCC rules were passed, Comptroller John D. Hawke Jr. said,
“national banks’ immunity from state law is a significant benefit of the national charter – a
benefit that the OCC has fought hard over the years to preserve…The ability of national banks to
conduct a multistate business subject to a single, uniform set of federal laws, under the
supervision of a single regulator, free from visitorial powers of various state authorities, is a
major advantage of the national charter.”484 In an interview that year, Hawke explained that the
potential loss of regulatory market share “was a matter of concern.”
With this rationale, in August 2003, the OCC issued its first preemptive order aimed at Georgia’s
mini-HOEPA statute. In January 2004, the OCC adopted [ck] sweeping preemption rules that
would apply to all state laws that interfered with or placed conditions on the ability of national
banks to lend. “[S]tate laws that obstruct, impair, or condition a national bank’s ability to fully
exercise its powers to conduct activities authorized under Federal law do not apply to national
banks,” the OCC said in the rule. The states challenged the rule but the U.S. Supreme Court
484

Remarks by Comptroller of the Currency Hawke before Women in Housing and Finance (Feb. 12, 2002),
attached to OCC News Release 2002-10, at 2, available at http://www.occ.treas.gov/speeches.htm.

235

upheld it in 2007. Shortly after the rule change, three large banks with combined assets of more
than $1 trillion announced their intention to convert from state charters to national charters,
yielding a 15% increase in the OCC’s annual budget.485
With OCC and OTS preemption in place, the two federal agencies were the only regulators with
the power to prohibit abusive lending practices by national banks and thrifts and their direct
subsidiaries. Comptroller Dugan defended preemption noting that “72 percent of all non-prime
mortgages were made by lenders that were subject to state law. Well over half were made by
mortgage lenders that were exclusively subject to state law.” Lisa Madigan, Attorney General of
Illinois, flipped the argument around, noting that national banks and thrifts, and their
subsidiaries, were heavily involved in subprime lending. Using different data sources, she noted
the fact that “national banks and federal thrifts and… their subsidiaries … were responsible for
almost 32 percent of subprime mortgage loans, 41 percent of the Alt-A loans, and 51 percent of
the pay-option and interest-only ARMs that were sold” was evidence of the effects of
preemption. And, she noted that national banks were otherwise associated with subprime
lending. Referring to warehouse lines of credit issued by banks, she stated “in fact, national
banks funded 21 of the 25 largest subprime issuers that were doing business in the lead-up to the
crisis.” In addition, fifteen of the 25 largest subprime lenders from 2005 to 2007 were affiliated
with national banks or thrifts.486
Madigan told the FCIC,

485

Bar-Gill & Warren (2008), at 82-83, 92-94, describing conversions of JP Morgan Chase Bank, HSBC Bank
USA and Harris Bank from state to national charters and the impact of those conversions on the OCC’s budget.
Smaller banks switch charters every year.

236

Even as the Fed was doing little to protect consumers and our financial system from the
effects of predatory lending, the OCC and OTS were actively engaged in a campaign to
thwart state efforts to avert the coming crisis…In the wake of the federal regulators' push
to curtail state authority, many of the largest mortgage-lenders shed their state licenses
and sought shelter behind the shield of a national charter. And I think that it is no
coincidence that the era of expanded federal preemption gave rise to the worst lending
abuses in our nation's history487
Comptroller Hawke told the FCIC that he sees it differently: “While some critics have suggested
that the OCC’s actions on preemption have been a grab for power, the fact is that the agency has
simply responded to increasingly aggressive initiatives at the state level to control the banking
activities of federally chartered institutions.” [add info re enforcement actions taken]
MBS players: “Wall Street was very hungry for our product”
The production of subprime and Alt-A mortgage-backed securities depended on a complex
supply chain. The shadow banking system provided much of the money, largely through shortterm lending in the commercial paper and repo market – a fact that would become critical as the
financial crisis began to unfold in 2007. And, much more than in earlier years, these loans were
not collateralized by Treasuries and GSE securities but by highly-rated mortgage securities
backed by increasingly risky loans. Vertically integrated firms like Lehman, Bear, and
Countrywide could take care of every step of the process: originating mortgages, packaging
them into securities, and selling those securities to their clients. Independent mortgage
originators like Ameriquest and New Century—without access to deposits—typically relied on

487

FCIC hearing. Three examples of such mortgage-lenders include JPMC, Harris Bank and HSBC.

237

financing to originate mortgages from warehouse lines of credit extended by the banks, their own
commercial paper programs, or money borrowed in the repo market. These originators put
together their own mortgage pools but then relied on securitizers, including investment banks
and commercial banks, to create the mortgage-backed securities.
Warehouse lending was a multi-billion dollar business for commercial banks such as Citigroup.
From 2000 to 2010, Citigroup made available at any one time as much as $7 billion in warehouse
lines of credit to mortgage originators, including $950 million to New Century and over $3.5
billion to Ameriquest. Citigroup CEO Chuck Prince would tell the FCIC that he wouldn’t have
approved of this business, had he known about it. “I found out at the end of my tenure, I did not
know it before, that we had some warehouse lines out to some originators. And I think getting
that close to the origination function—being that involved in the origination of some of these
products—is something that I wasn’t comfortable with and that I did not view as consistent with
the prescription I had laid down for the company not to be involved in originating these
products.”488
As early as 1998, Moody’s called the new asset-backed commercial paper or ABCP programs “a
whole new ball game.”489 As asset-backed commercial paper became a popular method to fund
the mortgage business, it grew from about one-quarter to about one-half of commercial paper
sold between 1997 and 2001.490 In 2001, only five mortgage companies borrowed a total $4
billion through asset-backed commercial paper; by 2006, 19 entities borrowed $43 billion.491

488

Transcript of FCIC interview of Charles O. Prince, former Chairman and CEO of Citigroup, March 17, 2010.

489

Moody’s Special Report: The ABCP Market in the Third Quarter of 1998.

490

491

Source: Moody’s 2007 Review and 2008 Outlook: US Asset-backed Commercial Paper, Feb. 27, 2008.

238

Companies would use this borrowing to finance their mortgage inventory on its way to being
securitized. For example, Countrywide created commercial paper programs Park Granada
(launched in 2003) and Park Sienna (launched in 2004). By May, 2007, Countrywide was
borrowing $13 billion through Park Granada, which stored prime mortgages and $5.3 billion
through Park Sienna, which stored subprime and other mortgages until they were sold.492,493
Commercial banks used these commercial paper programs partly for the purpose of regulatory
arbitrage. When banks held mortgages on their balance sheets, regulators required them to hold
4% in capital to protect against the possibility of loss. In contrast, when banks put mortgages
into off -balance sheet entities such as commercial paper programs, there was no capital charge,
at least until 2004. To make the deals work for investors, banks provided liquidity support to
these programs, earning a fee for doing so. This liquidity support meant that the bank would
have to take the commercial paper, and the mortgages backing the paper, on to their balance
sheets or pay up if the commercial paper could not be sold to investors at previously agreed upon
prices. These liquidity supports would be triggered during the financial crisis, bringing billions
in mortgage assets – all declining in value – on to banks’ balance sheets, meaning that the banks
would now have to raise capital.
The Enron scandal put these capital rules in jeopardy, when the accounting standards-setting
body, the Financial Accounting Standards Board, made it harder for companies to get offbalance sheet treatment for these programs. The asset-backed commercial paper market stalled
for more than a year. Meanwhile, banks protested that these programs were different from the
off-balance sheet practices at Enron and should be excluded from the new standards. In 2003,
492

Moody’s ABCP Program Review: Park Granada, July 16, 2007

493

Moody’s ABCP Program Review: Park Sienna, July 16, 2007

239

bank regulators responded with a proposal that would allow banks to remove these assets from
their balance sheets for purposes of calculating regulatory capital. The proposal would also
introduce, for the first time, a capital charge amounting to, at most, 1.6% of the liquidity support
that banks provided to asset backed commercial paper programs.494 However, after strong
pushback from the industry – the American Securitization Forum, an industry association, called
that modest proposed charge “arbitrary;”495 State Street Bank complained it was “too
conservative”496 – regulators in 2004 announced a final rule with a capital charge of up to 0.8%
for these liquidity supports – half of their initial proposed charge.497,498 With that regulatory
decision lifting the regulatory cloud, growth in ABCP markets resumed.
Growth in the repo market was also supported by regulatory changes – in this case, changes in
the bankruptcy laws – which helped to transform the types of repo collateral.499 Prior to 2005,
repo lenders only had clear and immediate rights to their collateral in the event of the bankruptcy
of the borrower if they lent using Treasury or GSE securities as collateral. Now, in 2005,
Congress expanded that provision to many other assets, including mortgage loans, mortgage-

494

Interim Capital Treatment of Consolidated Asset-Backed Commercial Paper Program Assets, 68 Fed. Reg.
56,568, 56,571 (Oct. 1, 2003).
495

Letter from the Am. Sec. Forum to Office of Thrift Supervision (Nov. 17, 2003) (available at
http://www.ots.treas.gov/_files/comments/9d9fb65c-670d-45a4-8616-b629ad4c29bb.pdf).
496

Letter from State St. Bank to Office of Thrift Supervision (Nov. 14, 2003) (available at
http://www.ots.treas.gov/_files/comments/ba249202-7305-427f-9fe8-d2f6ba2445da.pdf).
497 497

Consolidation of Asset-Backed Commercial Paper Programs and Other Related Issues, 60 Fed. Reg. 44,908,
44,911 (July 28, 2004).

498

Regulators specifically allowed asset-backed commercial paper programs to function with limited capital because
the collateral was usually high quality, primarily rated AAA or AAA by the rating agencies; because the commercial
paper itself was usually rated A1 or P1; and because of the perceived low probability that investors would fail to roll
their investment when the commercial paper matured.

499

http://w4.stern.nyu.edu/blogs/regulatingwallstreet/2010/07/the-doddfrank-wall-street-refo.html#more

240

backed securities, and collateralized debt obligations.500 There were now, according to an
industry expert, “very strong incentives to securitize anything you could get your hands on,
including subprime mortgages, so then the big investment banks like Lehman could use it for
their overnight borrowing needs.”501 The short-term repo market, now increasingly relying on
risky but highly-rated mortgage-backed securities, would prove an unstable source of funding
beginning in mid-2007 when banks and investors became skittish about the mortgage market
generally. “There were certainly asset types that were being financed by [repo] that were in
retrospect not as liquid as you would want. The illiquid, hard-to-value securities were a greater
fear than people would like them to be,” Darryll Hendricks, a UBS executive and chair of a New
York Fed task force examining the repo market after the crisis, told the FCIC.502,503

500

Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.

501

http://rortybomb.wordpress.com/2010/05/06/an-interview-about-the-end-user-exemption-with-stephen-lubben/

502

FCIC Interview with Darryll Hendricks, August 6, 2010.
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4826-7731-5335&open=Y
503

FCIC Interview with Darryll Hendricks, August 6, 2010.
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4826-7731-5335&open=Y

241

$ Billions

Net Repo Borrowing by Securities Firms
1500
1300

Quarterly

1100
900
700
500
300

‐100

1980‐Q1
1981‐Q1
1982‐Q1
1983‐Q1
1984‐Q1
1985‐Q1
1986‐Q1
1987‐Q1
1988‐Q1
1989‐Q1
1990‐Q1
1991‐Q1
1992‐Q1
1993‐Q1
1994‐Q1
1995‐Q1
1996‐Q1
1997‐Q1
1998‐Q1
1999‐Q1
2000‐Q1
2001‐Q1
2002‐Q1
2003‐Q1
2004‐Q1
2005‐Q1
2006‐Q1
2007‐Q1
2008‐Q1
2009‐Q1

100

Source: Federal Reserve Board of Governors Flow of Funds release, table L.129

To see how the mortgage securitization machine worked in practice, look again at our case-study
deal from the fall of 2006, CMLTI 2006-NC2. New Century needed money to originate the
4,499 mortgages that it would eventually sell to Citigroup. Eight banks and securities firms
provided the bulk of the money, mostly through repo loans – most prominently, Morgan Stanley
($424 million), Barclays Capital, a division of a U.K.-based bank ($221 million), Bank of
America ($147 million), and Bear Stearns ($64 million). The balance was provided by New
Century, which borrowed $3 million through its own commercial paper program and by a unit of
Citigroup, Salomon Brothers Realty Corp, which extended less than $500,000 in a warehouse
line of credit. The banks provided this financing as New Century originated these mortgages,
mostly in the month or two before the pool was sold to Citigroup on August 29, 2006. As a
result, for a time, New Century owed these banks nearly $1 billion, mostly in the form of repo
loans secured by specific mortgages. Citigroup paid New Century $979 million for the

242

mortgages, and New Century paid the repo lenders back – but only after keeping a $24 million
(2.5%) fee.
Investors in the case-study deal
Investors for mortgage-backed securities came from all corners of the global economy; as
discussed earlier, the key to making securitization work was a structure with tranches that would
appeal to the specific requirements of each and every one of them. CMLTI 2006-NC2, for
example, had 19 tranches. The investors in these tranches are shown in the table below. Fannie
Mae bought the entire $155 million top AAA rated tranche, which paid a better return than
super-safe U.S. Treasuries. The next AAA rated tranches, $582 million worth, went to 29
institutional investors around the world, globally spreading the risk. Notable among these
investors were foreign banks and funds in China, Italy, France, and Germany; the Federal Home
Loan Bank of Chicago, a government-sponsored enterprise that provides financing to the
mortgage industry; the Kentucky Retirement Systems; a hospital; and JP Morgan, which
purchased part of the tranche using cash from its securities lending operation. In other words, JP
Morgan lent securities held by its clients to other financial institutions in exchange for cash
collateral, and then put that cash collateral to work by investing in the case-study deal. As we
will see, securities lending operations were a large, but ultimately unstable, source of cash
fueling this market.

243

Orig Bal
$154,577

Orig
Rating
AAA

Yield
0.14%

$281,749

AAA

0.04%

A2-B

$282,356

AAA

0.06%

A2-C
M-1
M-1

$18,266
$39,285

AAA
AA+

0.24%
0.29%

M-1
M-2

$44,018

0.31%

M-2
M-2
M-2
M-3
M-4
M-5
M-6
M-7
M-8
M-9
M-10
M-11
CE
P
R
Rx

$14,199
$16,093
$16,566
$10,886
$9,940
$8,520
$11,833
$13,726
$10,886
$13,276
0*
$0
$0

AAA+
A
AABBB+
BBB
BBBBB
NR
NR
NR
NR

0.34%
0.39%
0.40%
0.46%
0.70%
0.80%
1.50%
2.50%
2.50%

Tranche
A1
A2-A

Senior

Mezzanin
e
Tranches

Residual
Tranches

PURCHASER
Fannie Mae
Chase Security Lendings Asset
Management
1 Investment fund in China
6 Investment funds
Federal Home Loan Bank of Chicago
3 Banks in Germany, Italy and France
11 Investment funds
3 Retail investors
2 Banks in the US and Germany
1 Investment fund and 2 banks in Italy
Cheyne Finance Limited
3 Asset Managers, including
FINCEECF
Parvest ABS Eurobor
4 Asset managers incl FAH,
FINCEECF and KOIL
1 Bank in China
1 CDO
3 CDOs
2 CDOs
2 CDOs
3 CDOs
3 CDOs
3 CDOs
7 CDOs
3 CDOs and Multistrat Cust Trust
not verified
Citi and Capmark Financial Group Inc
Citi and Capmark Financial Group Inc

The yield is the rate on the one-month LIBOR contract plus the rate listed. At the time the deal was issued, Fannie Mae, for example,
would have received the LIBOR rate of 5.32% plus 0.14% to give a total yield of 5.46%.

Collateralized debt obligations or CDOs, which will be explained more in the next chapter,
bought most of the tranches rated below AAA and nearly all of those rated below AA-, a
phenomenon explored more fully in the next chapter. In the case-study deal, these tranches
represented about 22% of the total value of the security and presented the real salesmanship
challenge, because they bore most of the risk of unexpected loss. If losses rose above 2.6% –
wiping out the investors in the residual and BB tranches – the mezzanine investors would start to
lose money. Only a couple of the highest-rated mezzanine tranches were not purchased by

244

CDOs. For example, Cheyne Finance Limited purchased $7 million of the top mezzanine
tranche. Cheyne – technically, a Structured Investment Vehicle or SIV – would be one of the
first causalities of the crisis, sparking panic during the summer of 2007. Parvest ABS Euribor
also purchased $20 million of the third mezzanine tranche; it would also be noteworthy as one of
the BNP Paribas funds whose problems helped ignite the financial crisis in the summer of
2007.504
Citigroup retained part of the equity or “first-loss” tranche of the case-study deal, earning an
interest rate of [XXX%]. Typically, investors such as hedge funds, seeking high returns, would
buy the equity tranches of mortgage-backed securities; as losses started to come in on the
underlying pool of mortgages, these investors would be the first to experience losses. This was
the expected loss on the pool. These investors knew they had a risky asset, and in return,
expected to receive interest rates of 15%, 20%, even 30%. As we will see later, equity investors
often were engaged in trading strategies in which they would benefit if other tranches failed.
Fees: “Pushed as much as we could”
Structuring, selling, and distributing the case-study deal, and the thousands like it, was lucrative
for the banks involved. The mortgage originators would make a profit when it sold loans for
securitization.505 Across originators, some of this profit flowed down to the employees—
particularly those who generated significant mortgage volume.
The fees drove the process. Part of the $24 million that New Century received for the case-study
deal went to pay the many employees who participated. “The originators, the loan officers,
504

http://www.marketwatch.com/story/bnp-suspends-fund-valuations-amid-credit-market-turmoil

505

Staff estimates from prospectus and Citigroup production dated 11/4/1010

245

account executives, basically the salespeople [who] were the reason our loans came in . . . were
compensated very well,” New Century’s Patricia Lindsay told the FCIC. “They were
commission-driven, the salespeople.” And, volume mattered more than quality. “Wall Street
was very hungry for our product. We had our loans sold three months in advance, before they
were even made at one point…. But basically, I know that, you know, we needed to create more
product to get more volume.” 506
Similarly, an Ameriquest mortgage originator, Mark Bomchill, told FCIC that as the market
heated up, compensation at Ameriquest “shot up at a 90 degree angle…By the time I left, the
threshold for getting a bonus went from five loans to eight loans to ten loans.”507 The incentive
was to make the lower-quality loans that had higher fees; Bomchill told the FCIC that he steered
borrowers away from prime loans and focused on “subprime and Alt-A and a lot of stated
income loans,” saying “we were pushed as much as we could to get the loan as high as we
could.” The compensation incentives created an “an environment where we would do anything
or say anything to close the loan. [We were] pitching [not to] CPAs and accountants and
lawyers. We were pitching more of the blue collar workers – construction workers and janitors.”
At Long Beach Mortgage, the subprime division of Washington Mutual, the 2004 Incentive Plan
was organized strictly by mortgage volume. Account executives received bonuses depending on
whether they were “gold,” “silver,” or “bronze” in terms of volume rankings among
executives.508 As WaMu made clear in a 2007 strategic plan titled “Home Loans Product
Strategy,” the goals were also product specific namely to “drive growth in higher margin
506

FCIC interview

507

Mark Bomchill MFR at __.

508

Long Beach Mortgage Production. Incentive Plan 2004

246

products (Option ARM, Alt A, Home Equity, Subprime), recruit and leverage seasoned Option
ARM sales force, and maintain a compensation structure that supports the high margin product
strategy.”509
After structuring the deal, an underwriter, often an investment bank, would market and sell the
securities to investors. For this, it collected a percentage of the proceeds (on average, between
0.2% and 1.5%), either in the form of discounts, concessions, or commissions.510 For a $1 billion
deal like CMLTI 2006-NC2, a 1% fee would give Citi $10 million. In this case though, Citi did
not receive a commission: instead, it was compensated in a different way – it kept parts of the
residual tranches; if the deal did well it stood to capture profits.
Options Group, a company that compiles compensation figures for investment banks, reported
that mortgage-related professionals at the five largest investment banks received the lion share of
bonuses from 2004 to 2007. 511 Options Group examined compensation for employees in the
mortgage-backed securities sales and trading desks at 11 banks from 2005 to 2007. 512 It found
that associates had average base salaries of $65,000 to $90,000 from 2005 through 2007, but
received bonuses that at least – on average – matched their salaries. The next up the ladder, vice
509

Permanent Subcommittee on Investigations – Exhibit 59a: Long Beach Mortgage Production - Incentive Plan
2004 and Incentive Plan 2007. Page 11 WaMu Home Loans Product Strategy

510

The Options Group gathers compensation figures for Investment Banks based on their database of 250,000
industry professionals, senior executive interviews and media sources. It is a company which offers executive
search, market intelligence and strategic consulting to financial services companies. Their research and intelligence
gathering culminates in an annual report which contains market trends and average compensation paid to various
financial industry professionals.

Barclays Capital, Bear Stearns, BNP Paribas, Citigroup, Deutsche Bank, Goldman Sachs,
HSBC, JPMorgan, Lehman Brothers, Morgan Stanley, and UBS.

512

247

presidents had average base salaries and bonuses that ranged from a combined total of $500,000
to $1,150,000 in these years. And, further up, directors had total average compensation of
$1,000,000 to $1,600,000. Then, managing directors had total average compensation of
$3,200,000. At the top of this ladder was the head of the unit. In 2006, the Merrill head of
fixed-income and mortgage units, Dow Kim, had a base salary of $350,000 and got a bonus of
$35 million, on par with Merrill Lynch’s CEO.513 [will put in additional information on relative
compensation]
Moody’s: “Given a blank check”
The ratings agencies played an essential role in Wall Street’s mortgage-backed securities
machine. Issuers needed them to approve the structure of their deals; investors often needed
their AAA rating to buy securities; banks needed them to determine the amount of capital they
held; repo markets needed them to determine loan terms; and the rating agencies’ judgment was
baked into any number of collateral agreements and other financial contracts.514 The eventual
mass downgrades by the rating agencies of thousands of mortgage-related securities is a big part
of the story of the financial crisis.
While there are three major rating agencies – Fitch, Moody’s, and S&P – the Commission
focused its case study investigation on Moody’s Investors Service, the largest of the three. From
2000 through 2007, Moody’s rated nearly 45,000 of those securities AAA, compared to just four
companies that Moody’s rated AAA across the world as of summer 2010.

513

Proxy statement

514

Securities and Exchange Commission, “Report on the Role and Function of Credit Rating Agencies in the
Operation of the Securities Markets” (Jan. 2003), 29.

248

The rating process involved inherent conflicts. Issuers, rather than investors, had paid for ratings
since the early 1970s. In addition, incentives were affected by the increasing profitability of
rating securities, and from the fierce competition among the three rating agencies for business –
especially in rating structured finance products such as mortgage-backed securities, which
comprised more than half of Moody’s revenues in 2005, 2006 and 2007. From 1998 to 2007,
Moody’s revenues from rating financial instruments like mortgage securities increased six-fold.
When Moody’s Corporation was spun off from Dun & Bradstreet in September 2000 employees
noticed a pronounced shift in office culture – described by Eric Kolchinsky, a former managing
director, as a change “from one [culture] resembling a university academic department to one
which values revenues at all costs,”515 a subject we will return to in later chapters.
Meanwhile, the models Moody’s used to rate mortgage-backed securities were designed under
difficult circumstances with poor data. In designing the models, Moody’s did not adequately
account for the deterioration in underwriting standards or sufficiently account for a possible
dramatic decline in national home prices. And, Moody’s did not even develop a model to rate
subprime securities until late 2006, after Moody’s had already rated nearly 24,000 subprime
securities.
Congress “put them in the business forevermore”
Credit ratings have been baked into regulations for three-quarters of century.516 In 1931, the
Office of the Comptroller of the Currency (OCC) permitted banks to report publicly traded bonds

515

Eric Kolchinsky, testimony to the FCIC, hearing on “The Credibility of Credit Ratings, the Investment Decisions
Made Based on those Ratings, and the Financial Crisis,” Session 1: The Ratings Process, June 2, 2010, p. 20-21
(ID# 4818-8776-0390)
516

The ratings from the three agencies measure slightly different credit risk characteristics. S&P and Fitch base
their ratings on the probability that a borrower will default; Moody’s bases its ratings on the expected loss to the

249

with a rating of BBB or better at book value, meaning the price they paid for the bonds. Other
bonds had to be reported at potentially lower market prices. In 1951, the National Association of
Insurance Commissioners imposed higher capital requirements on lower-rated bonds held by
insurers. But, the watershed event in federal regulation occurred in 1975 when the SEC
modified its minimum capital requirements for broker-dealers based on credit ratings issued by a
“nationally recognized statistical rating organization” (NRSRO) which at the time only included
Moody’s, S&P and Fitch. And, ratings are also built into banking capital regulations which,
since 2001, have permitted banks to hold less capital for higher rated securities. For example,
BBB securities require five times more capital than AAA and AA rated securities and BB
securities require ten times more capital.517 The Basel II international banking regulations
included similar requirements.518
Credit ratings also determined whether certain investments could be held. The SEC restricts
investment by money market funds to “securities that have received credit ratings from any two
NRSROs… in one of the two highest short-term rating categories or comparable unrated
securities.” The Department of Labor restricts pension fund securities investments to those rated
A or higher. Credit ratings even affect private transactions. Ratings triggers were included in
contracts that required the posting of collateral or immediate repayment if a security or entity
was downgraded. Indeed, such triggers played an important role in the financial crisis and
contributed to the demise of AIG.
investor. Despite such differences, investors and regulators tend to view the ratings as roughly equivalent. Ratings
are divided into two categories – investment grade securities are rated BBB- to AAA while securities rated below
BBB- are considered speculative and also referred to as junk (for S&P; similar levels for Moodys are Baa to AAA).
517
12 C.F.R. Part 325, Appendix A, Table II.—Summary of Risk Weights and Risk Categories.
518

BIS, Basel Committee on Bank Supervision, No. 3, August 2000, CREDIT RATINGS AND
COMPLEMENTARY SOURCES OF CREDIT QUALITY INFORMATION, located at
http://www.bis.org/publ/bcbs_wp3.pdf.

250

Importantly for the mortgage market, the 1984 Secondary Mortgage Market Enhancement Act
permitted federal and state chartered financial institutions to invest in mortgage-related securities
if they had high ratings from at least one rating agency.519 “Look at the language of the original
bill,” Lewis Ranieri, the securitization pioneer, told the FCIC. “It requires a rating…. It put them
in the business forevermore. It became one of the biggest, if not the biggest, business.”520 As
Kolchinsky would summarize the situation, “the mandated outsourcing of credit analysis [by the

government] without any associated mandated standards of highly complex and flexible
structured finance instruments” led to a situation where the rating agencies “were given a blank
check.”521
The rating agencies themselves were able to avoid regulation for decades. Beginning in 1975,
the SEC had to approve a company’s application to become an NRSRO but there was no
regulation of the NRSROs after the application was approved.522 Thirty years later, Congress
gave the SEC limited authority to oversee the agencies in the Credit Rating Agency Reform Act
of 2006.523 That law became effective in June 2007 and focused on mandatory disclosure of

519

Secondary Mortgage Market Enhancement Act of 1984 bill summary and status (S. 2040), the Library of
Congress THOMAS, http://thomas.loc.gov/cgi-bin/bdquery/z?d098:SN02040:@@@L&summ2=m&; see also 15
U.S.C. 78c(a)(41), http://www.law.cornell.edu/uscode/15/usc_sec_15_00000078---c000-.html.
520

Lewis Ranieri, interview with the FCIC, July 30, 2010, p. 27 (ID# 4843-7826-6375).

521

Eric Kolchinsky, testimony to the FCIC, hearing on “The Credibility of Credit Ratings, the Investment
Decisions Made Based on those Ratings, and the Financial Crisis,” Session 1: The Ratings Process, June
2, 2010, p. 19-20 (ID# 4818-8776-0390)

522

Securities and Exchange Commission, “Definition of a Nationally Recognized Statistical Rating Organization,”
Proposed Rule 33-8570, April 19, 2005, pp. 5-6, 9, available at http://www.sec.gov/rules/proposed/33-8570.pdf.
523

Credit Rating Agency Reform Act of 2006, P.L. 109-291, 15 U.S.C. 78o-7(c)(1), September 29, 2006,
http://www.sec.gov/divisions/marketreg/ratingagency/cra-reform-act-2006.pdf.

251

their methodologies; however, the SEC was expressly prohibited from regulating “the substance
of the credit ratings or the procedures and methodologies.”524
Investors across the financial system relied on credit ratings. Many institutional investors such
as pension funds and university endowments did by necessity because they did not have access
to the same data as the rating agencies, nor did they have the capacity or analytical ability. As
Moody’s former managing director Jerome Fons told the FCIC, “subprime RMBS and their
offshoots offer little transparency around composition and characteristics of the loan collateral
…. Loan-by-loan data, the highest level of detail, is generally not available to investors.” Large
financial institutions also were influenced by ratings. As Lloyd Blankfein, CEO of Goldman
Sachs, testified to the FCIC, “I would say I would be more complacent when I saw something
had AAA than if it had a AA or a AA then had a single A. So to that extent, I also must have
been deferring to a rating agency.”525
Still, some investors were skeptical of these products despite their ratings. Arnold Cattani,
Chairman of Mission Bank in Bakersfield, California, described his decision to sell his bank’s
holdings of MBS and CDOs: “At one meeting, when things started getting difficult, maybe in
2006, I asked the CFO what the mechanical steps were in an MBS, mortgage-backed securities,
if a borrower in Des Moines, Iowa defaulted. I know what it is if a borrower in Bakersfield
defaults, and somebody has that mortgage. But as a package security, what happens? And he
couldn’t answer the question. And I told him to sell them, sell all of them, then, because we
didn’t understand it, and I don’t know that we had the capability to understand the financial
complexities; didn’t want any part of it.”
524

See 15 U.S.C.78o-7(c)(2).

525

Hearing 1

252

Also, rating agencies were not liable for misstatements in securities registrations.526 In court
challenges, the agencies were able to avoid culpability by[successfully] invoking the First
Amendment protection of journalistic services or by maintaining that ratings are merely
opinions.527 Moody’s standard disclaimer at the end of its publications emphasized this stance:
“The credit ratings… are, and must be construed solely as, statements of opinion and not
statements of fact or recommendations to purchase, sell, or hold any securities.”528 Gary Witt, a
former team managing director at Moody’s, told the FCIC, “People expect too much from
ratings…investment decisions should always be based on much more than just a rating.”529
Rating methodology: “Everything but the elephant sitting on the table”
The ratings were intended to provide a means of comparing risks across asset classes and time.
In other words, the risk of a AAA-rated mortgage security was similar to the risk of a AAA-rated
corporate bond. As Moody’s reported in its “Ratings Symbols and Definitions,” “[i]t is
Moody’s intention that the expected loss rate associated with a given rating symbol and time
horizon be the same across obligations and issuers rated.”530

526

Rule 436(g)(1) of the Securities Act of 1933

527

See Jefferson County School District No. R-1 v. Moody’s Investor’s Services, Inc., 175 F.3d 848, 856 (10th Cir.
1999), dismissing claims for tortious interference, injurious falsehood, and antitrust violations because Moody’s
credit ratings are “protected expressions of opinion”. See also, County of Orange v. McGraw-Hill Cos., 245 B.R.
151, 157 (C.D. Cal. 1999): “The First Amendment protects S&P’s preparation and publication of its ratings.” See
also Quinn v. McGraw-Hill, 168 F3rd 331 (7th Cir., 1999).

528

See, for example, “Moody's Revisits its Assumptions Regarding Structured Finance Default (and Asset)
Correlations for CDOs,” June 27, 2005, p. 16, http://www.fcic.gov/hearings/pdfs/2010-0602-exhibit-financedefault.pdf.
529

Gary Witt, testimony to the FCIC, hearing on “The Credibility of Credit Ratings, the Investment Decisions Made
Based on those Ratings, and the Financial Crisis,” Session 1: The Ratings Process, June 2, 2010, p. 41 (ID# 48188776-0390)
530

“Moody’s Rating Symbols and Definitions,” May 2010, p. 4 (ID# 4817-6499-3286).

253

Since the mid-1990s, Moody’s used three different models to rate the various tranches of
mortgage-backed securities. The first model, developed in 1996, rated all residential mortgagebacked securities. In 2003, Moody’s created a new model, M3 Prime, to rate prime, jumbo, and
Alt-A deals.531 Moody’s did not develop a model for specifically rating subprime deals, called
M3 Subprime, until fall 2006 when the housing market had already peaked.532
To determine the creditworthiness of a given debt security, the models incorporated a number of
factors, including firm- and security-specific factors, market factors, regulatory and legal factors,
and macroeconomic trends. The M3 Prime model allowed Moody’s to automate more of the
ratings process.533 While Moody’s did not sample or review individual loans, the company used
loan level information provided by the originator [ck]. The model relied on loan-to-value ratios,
borrower credit scores, originator quality, loan terms and other information, and simulated the
performance of each loan in 1,250 economic scenarios that included variations in interest rates
and state-level unemployment and home price changes. On average across the model’s
scenarios, the national home prices trended upward at approximately 4% per year. The model put
little weight on the possibility that prices would fall sharply nationwide.534 Jay Siegel, a former
Moody’s team managing director involved in the development of the model, told the FCIC that
“there may have been [state-level] components of this real-estate drop that the statistics would

531

“Moody’s Approach to Rating Residential Mortgage Pass-Through Securities,” November 8, 1996, MOODYSFCIC-0013453 – 0013464; “Moody’s Mortgage Metrics: A Model Analysis of Residential Mortgage Pools,” April
1, 2003, ID#4836-9749-6328.
532

“Introducing Moody’s Mortgage Metrics: Subprime Just Became More Transparent,” Moody’s Investors Service,
September 7, 2009, MOODYS-FCIC-0011496 – 0011558 (ID# 4828-5176-7558).
533

“Moody’s Mortgage Metrics: A Model Analysis of Residential Mortgage Pools,” April 1, 2003, p.2. ID# 48369749-6328.
534

Jay Siegel, interview with the FCIC, May 26, 2010, pp. 66-67 (ID# 4812-9405-9014).

254

have covered, but the 38 percent national drop, staying down over this short, but multiple-year
period, is more stressful than the statistics call for.”535 Even as housing prices rose to
unprecedented levels, Moody’s never adjusted the scenarios to put greater weight on the
possibility of a national housing price decline.536 “Moody’s position was that there was not a…
national housing bubble,” Siegel told the FCIC.537
When the initial quantitative analysis was complete, the lead analyst on the deal convened a
rating committee composed of other analysts and managers to assess the analysis and determine
the overall ratings for the bonds within the securities.538 Former Moody’s team managing
director Jay Siegel, who helped to develop the M3 Prime model, told the FCIC that qualitative
analysis was also integral to the ratings process. “One common misperception is that Moody’s
credit ratings are derived solely from the application of a mathematical process or model. This is
not the case.… The credit rating process involves much more – most importantly, the exercise of
independent judgment by members of the rating committee,” Siegel said. “Ultimately, ratings are
subjective opinions that reflect the majority view of the committee’s members.”539As Roger
Stein, a Moody’s managing director, noted, “overall, the model has to contemplate events for
which there is no data.”540

535

Jay Siegel, interview with the FCIC, May 26, 2010, pp. 66-67 (ID# 4812-9405-9014).

536

Jay Siegel, interview with the FCIC, May 26, 2010, pp. 59 (ID# 4812-9405-9014).

537

Jay Siegel, interview with the FCIC, May 26, 2010, pp. 59 (ID# 4812-9405-9014).

539

Jay Siegel, testimony to the FCIC, hearing on “The Credibility of Credit Ratings, the Investment Decisions Made
Based on those Ratings, and the Financial Crisis,” Session 1: The Ratings Process, June 2, 2010, p. 29 (ID# 48188776-0390)
540

Roger Stein, interview with the FCIC, May 26, 2010, p. 19 (ID# 4844-0976-5382).

255

After rating subprime deals with the 1996-era model for years, Moody’s finally introduced a
parallel model for the rating of subprime mortgage-backed securities in 2006.541 Like M3 Prime,
the subprime model determined credit enhancement levels by running the underlying subprime
mortgages through 1,250 different scenarios involving varying interest rates, unemployment
levels, and shifts in home prices.542 Moody’s officials told the FCIC that they recognized the
subprime model did not include sufficiently stressful scenarios and therefore applied additional
weight to the most stressful scenario, which reduced the amount of the security rated AAA. 543
Stein, who helped to develop the subprime model, said that the output from the model was
manually “calibrated” to be more conservative to make sure that predicted losses were consistent
with analysts’ “expert views.”544 As one step in the process, Stein explained that Moody’s took
the “single worst case” from the M3 Subprime model simulations and multiplied it by a factor of
greater than two to generate a “stress” scenario.545
Moody’s did not sufficiently account for the deteriorating quality of the loans being securitized.
Former managing director of credit policy, Jerome Fons, described this problem to the FCIC: “I
sat on this high-level Structured Credit committee, which you’d think would be dealing with
such issues [of declining mortgage underwriting standards], and never once was it raised to this
group or put on our agenda that the decline in quality that was going into pools, the impact
541

“Introducing Moody’s Mortgage Metrics: Subprime Just Became More Transparent,” Moody’s Investors Service,
September 7, 2009, MOODYS-FCIC-0011496 – 0011558 (ID# 4828-5176-7558), p. MOODYS-FCIC 0011504,
0011547.
542

Roger Stein, interview with the FCIC, May 26, 2010, p. 18 (ID# 4844-0976-5382).

544

Roger Stein, interview with the FCIC, May 26, 2010, p. 9-10 (ID# 4844-0976-5382).

545

Roger Stein, interview with the FCIC, May 26, 2010, p. 18 (ID# 4844-0976-5382).

256

possibly on ratings, other things…. We talked about everything but, you know, the elephant
sitting on the table.”546
To illustrate how the agencies rated a mortgage-backed security, turn again to our case-study
deal, CMLTI 2006-NC2. Moody’s used its model to simulate losses in the mortgage pool. Those
loss estimates, in turn, would determine how big the junior tranches of the deal would have to be
to protect the senior tranches from losses. In analyzing the deal, the lead analyst noted that the
deal was similar to another Citigroup deal of New Century loans that Moody’s had rated earlier:
“[T]his collateral is substantially of the same credit risk. I recommend the same levels” of
tranche support.547 Once the size of the junior tranches was determined, the deal was tweaked
based on the presence of certain riskier loan types, including interest-only mortgages.
Approximately 78% of the dollar amount [ck] of the deal was rated triple A. For its efforts,
Moody’s was paid an estimated $208,000.548 (S&P also rated this deal and received
$135,000.)549 As we explain ahead, 3 tranches of CMLTI 2006-NC2 would be downgraded less
than a year later – part of Moody’s downgrade of 399 tranches of 2006 RMBS on July 10,
2007.550 In October 2007, the M4-M10 tranches were downgraded. By 2008, all of the tranches
were downgraded.551 Indeed, of mortgage assets it rated AAA in 2006, Moody’s downgraded
546

Jerome Fons, interview with the FCIC, April 22, 2010, p. 56 (ID# 4842-7212-1862).

547

MOODYS-FCIC-0008597 Moody’s Rating Committee Memorandum, August 29, 2006 (ID# 4813-4149-9654).

548

MOODYS-FCIC-0394813 – 0394814, Invoice from Moody’s Investors Service to Susan Mills, Citigroup Global
Markets Inc., October 12, 2006 [ID# 4812-6493-3640].
549

cite

550

“Moody’s Downgrades 399 Subprime RMBS Issued in 2006; 32 Additional Securities Placed on Review for
Possible Downgrade,” July 10, 2007 [ID# 4812-6205-2872].

551

“2006 Vintage First-Lien Subprime RMBS Rating Activity,” October 11, 2007, p. 9 [ID# 4825-5422-6184];
“Moody's Downgrades Certain Citigroup Subprime RMBS,” April 21, 2008, p. 2 [ID# 4835-1065-8568]; “Moody's
Downgrades Certain Citigroup Subprime RMBS,” October 15, 2008, p. 2 [ID# 4835-7776-7432].

257

86% to junk. In 2007, just shy of 90% became junk. Massive downgrades began in July 2007
when housing prices had declined by only 4%.552 The consequences of such downgrades would
reverberate throughout the system.
GSEs: “Less competitive in the marketplace”
In 2004, Fannie and Freddie faced problems on multiple fronts. They had violated accounting
rules and now faced corrective actions and fines. And, they were losing market share to Wall
Street, which was beginning to take over the securitization market. Struggling to remain a
dominant presence, they purchased increasing amounts of non-GSE, private-label mortgagebacked securities – that is, those mostly backed by subprime and Alt-A loans being bundled and
sold by securitizers like Wall Street firms and lenders like Countrywide. Indeed, at one point in
2004, Fannie and Freddie purchased 40% of all subprime mortgage-backed securities that were
issued and 27% of all Alt-A mortgage-backed securities. The GSEs almost exclusively
purchased the safest, AAA rated tranches of those securities. They also loosened their own
underwriting standards, purchasing and guaranteeing riskier loans than they had previously – a
subject we will return to later. Their regulator, the Office of Federal Housing Enterprise
Oversight (OFHEO), focused more on the accounting and other operational issues, and less on
Fannie and Freddie’s growing investments in risky mortgages and securities.553
In 2002, Freddie changed accounting firms. The company had been using Arthur Andersen for
many years, but when Andersen got into trouble in the Enron debacle (with both going out of
business), Freddie switched to PricewaterhouseCoopers. The new accountant found that the
company had understated its earnings by $5 billion from 2000 through the third quarter of 2002,
552

These details are from Chairman’s notes on Moody’s prior to hearing

553

Preliminary Investigative Report on Fannie Mae, p. 58.

258

in an effort to smooth reported earnings and promote itself as “Steady Freddie,” a company of
strong and steady growth.554 Bonuses were tied to the reported earnings and OFHEO found that
this structure contributed to the accounting manipulations.555 Its board ousted most of the top
management, including the chairman and chief executive officer Leland Brendsel, President and
COO David Glenn and Chief Financial Officer Vaughn Clarke,.556 In December 2003, Freddie
entered into a consent order with OFHEO that required it to pay a $125 million penalty and to
implement numerous corrective actions to the company’s corporate governance, internal
controls, accounting, and risk management.557 The following month, OFHEO directed Freddie
to maintain a capital surplus of 30 percent over its minimum capital requirement to ensure
adequate capital until operational risk was reduced and the GSE was able to produce timely,
certified financial statements.558 Before the dust settled, Freddie Mac would settle shareholder
lawsuits for $410 million and pay $50 million in penalties to the SEC.
Fannie was next. In September 2004, OFHEO discovered violations of accounting rules calling
into question previous company filings. Eventually, in 2006, OFHEO reported that Fannie had
overstated earnings from 1998 through 2002 by $11 billion, and like Freddie, the accounting
554

December 2003 OFHEO Special Examination Report at
http://www.fhfa.gov/webfiles/749/specialreport122003.pdf.
555

December 2003 OFHEO Special Examination Report at
http://www.fhfa.gov/webfiles/749/specialreport122003.pdf
556

In December, 2003, OFHEO publicly described the company’s accounting irregularities in a Report on the
Special Examination of Freddie Mac. It said that the size of the bonus pool for Freddie Mac’s senior executives was
tied, in part, to meeting or exceeding annual specified earnings-per-share (EPS) targets. The actions to shift extra
earnings to future periods helped ensure achievement of future EPS goals and the related bonuses. OFHEO also said
management committed insufficient resources for accounting and internal controls, treating those functions as
“second class citizens,” and circumvented prevailing public disclosure standards in order to obfuscate specific
capital market and accounting transactions.
557
December 10, 2003 OFHEO press release and consent agreement at
http://www.fhfa.gov/webfiles/2268/121003CorrectiveActionsand125MPenalty.pdf.
558

January 29, 2004 OFHEO press release at http://www.fhfa.gov/webfiles/2158/12904MandatoryTarget.pdf.

259

manipulations were motivated by compensation plans tied to reported results [ck consistency
with 1.3].559 OFHEO would require Fannie to improve accounting controls, maintain the same
30 percent capital surplus imposed on Freddie and implement corrective actions to Fannie’s
governance and internal controls.560,561 Fannie’s board soon ousted CEO Franklin Raines and
other top officials, and the SEC required Fannie Mae to restate its financial results for 2002
through mid-2004. Fannie settled related SEC and OFHEO enforcement actions for $400
million in penalties.562 Executives at both Fannie and Freddie told the FCIC that the accounting
issues distracted management from their mortgage business.[cites] For example, Donald
Bisenius, an executive vice president at Freddie Mac, said, “I believe that the focus we needed to
place on the restatement and the remediation took a tremendous amount of management’s time
and attention and probably led to us being less aggressive or less competitive in the marketplace
as we otherwise might have been.”563
While the GSE’s executives and regulators focused on their accounting woes, they lost market
share. From 2000 to 2003, Fannie’s and Freddie’s combined market share had increased from
559

In 2006, OFHEO issued its final Report of the Special Examination of Fannie Mae. OFHEO said that
management engaged in numerous acts of misconduct, involving well over a dozen different forms of accounting
manipulation and violations of generally accepted accounting principles. As in the case of Freddie, OFHEO said
Fannie’s management sought to hit ambitious earnings-per-share targets that were linked to their own compensation.
Fannie CEO Franklin Raines received compensation of $90 million over 1998-2003; of that amount, over $52
million was directly linked to achieving EPS targets.
560
September 20 , 2004 OFHEO press release at http://www.fhfa.gov/webfiles/1563/92004ltrtoFNMboard.pdf;
September 27, 2004 OFHEO press release at
http://www.fhfa.gov/webfiles/2242/92704FNMDirsAgreetoCorrect.pdf. March 8, 2005 OFHEP press release and
supplemental agreement at http://www.fhfa.gov/webfiles/2160/030805agreementrelease.pdf; May 23, 2006 OFHEO
press release at http://www.fhfa.gov/webfiles/2095/52306fnmserelease.pdf; May 23, 2006 OFHEO press release and
consent order at http://www.fhfa.gov/webfiles/2204/settlementrelease52306.pdf.
561

July 17, 2003 Falcon testimony at http://www.fhfa.gov/webfiles/1481/falcon71703.pdf

562

OFHEO, 2006 Report to Congress, p. 1

563

FCIC interview with Donald Bisenius, Executive Vice President, Freddie Mac, September 29, 2010 (1 hr. 11
min. 30 sec.)

260

45% of originations in 2000 to 57% in 2003, representing $2.2 trillion of the $3.9 trillion of
mortgages originated in 2003. But in 2004, total originations declined to $2.9 trillion and the
GSEs share of the market declined to 42% or $1.2 trillion. The decline continued over the next
two years.
The securitization of riskier loans purchased by Wall Street firms increased substantially. As
shown in the figures below, subprime mortgage-backed securities increased from $87 billion in
2001 to $465 billion in 2005 and Alt-A mortgage-backed securities increased from $11 billion to
$332 billion. Starting in 2001 for Freddie and 2002 for Fannie, the GSEs – particularly Freddie
– became buyers in this market. While private investors always remained the majority of buyers,
at their peak the GSEs purchased 40% of the subprime mortgage-backed securities and 27% of
Alt-A mortgage-backed securities. As noted, the GSEs’ purchases were limited to only the most
highly-rated tranches. From 2005 through 2008, the GSEs combined purchases of these
securities declined, both in dollar amount and as a percentage of subprime and Alt-A mortgagebacked securities issued during each year.

Subprime PLS Purchases
Billions of $

$500
$400
$300

Freddie Mac

$200

Fannie Mae

$100

Other

$0
2001

2002

2003

2004

2005

2006

2007

2008

261

Alt‐A PLS Purchases
$400
$350
Billions of $

$300
$250

Freddie Mac

$200

Fannie Mae

$150

Other

$100
$50
$0
2001

2002

2003

2004

2005

2006

2007

2008

These investments were profitable at first, but, as delinquencies increased in 2007 and 2008, both
GSEs began to take significant losses on their holdings of private-label mortgage-backed
securities—disproportionately from their purchases of Alt-A securities. By the second quarter of
2010, total losses on the securities totaled $45 billion at the two companies—enough to wipe out
nearly 60% of their capital.564
OFHEO knew about the GSEs purchases of the subprime and Alt-A mortgage-backed securities.
In the 2004 report of examination, the regulator noted Freddie’s purchases of the subprime
mortgage-backed securities and that Freddie’s outstanding balance of all mortgage-backed
securities increased 60% during the year to $133 billion.565 Additionally, it noted that Freddie
was purchasing whole mortgages with “higher risk attributes which exceeded the Enterprise’s
modeling and costing capabilities,”566 including “No Income/No Asset loans” that introduced

564

Fannie Mae had $56 billion of total capital in mid-2008; Freddie Mac had $43 billion. Federal Housing Finance
Agency, 2008 Annual Report to Congress, revised edition. Pp 121 and 138.
565

2004 exam report at 10.

566

2004 Exam report at 9-10.

262

“considerable risk.”567 Indeed, OFHEO reported that mortgage insurers were already seeing
abuses with these loans.568 But OFHEO concluded that the purchases of mortgage-backed
securities and riskier mortgages were not a “significant supervisory concern,” and the
examination was more focused on Freddie’s efforts to address the matters in the consent order.569
OFHEO included nothing in Fannie’s report about the GSE’s purchases of subprime and Alt-A
mortgage-backed securities and credit risk management was deemed satisfactory.570
The reasons for the GSEs’ purchases of subprime and Alt-A mortgage-backed securities have
been debated. Some observers, including Fed Chairman Greenspan, have linked the GSEs’
purchases of private mortgage-backed securities to the GSEs’ push to fulfill their rising
affordable housing goals. As Greenspan wrote of the GSEs in a working paper, pressed to
“expand ‘affordable housing commitments,’ they chose to meet them by investing heavily in
subprime securities.”571 Since 1992, the Department of Housing and Urban Development (HUD)
required a certain amount of the GSEs’ loan purchases to be mortgages for low- and moderateincome families and underserved communities. And, a change in 19xx had made purchases of
private label securities qualify for the GSEs’ affordable housing goals depending on the
characteristics of the securities. Still, prior to 2005, 50 percent or less of the GSEs’ loan

567

2004 Exam report at 10.

568

2004 Exam report at 10.

569

2004 Exam report at 10; Id at 2 (“Our examinatio9n activities focused heavily on the Enterprise’s compliance
with the extensive requirements of the Consent Order the Board of Directors executed on December 9, 2003.”).
570

2004 Exam report (no page numbers; report in binder in Seefer’s office).

571

Page 13 of April 7 hearing http://fcic.gov/hearings/pdfs/2010-0407-Transcript.pdf (“the search and
demand for mortgage-backed securities was heavily driven by Fannie Mae and Freddie Mac, which were
pressed by the Department of Housing and Urban Development and the Congress to expand affordable
housing commitments.”).
263

purchases had to satisfy the affordable housing goals, and, according to Fannie CEO Dan Mudd,
they were easy to meet in the normal course of business [put in Mudd MFR statement].572 In
2005 the goals would be increased above 50%, a subject for a later chapter.
Suggesting that the affordable housing goals were not the driving force behind the GSEs’
purchases of mortgage-backed securities, a 2006 consultant survey of Freddie’s purchases found
that only 34% of its total Wall Street securities purchases qualified for “goals” purposes, and
only 23% of Fannie’s did.573 [more data to be added]
Robert Levin, former Chief Business Officer of Fannie Mae, told the FCIC that buying privatelabel mortgage-backed securities “was a money-making activity - it was all positive
economics...there was no tradeoff [between making money and hitting goals], it was a very
broad-brushed effort” that could be characterized as “win-win-win: money, goals, and share.”574
Mark Winer, the head of Fannie’s Business, Analysis and Development Group stated that the
purchase of AAA tranches of mortgage-backed securities backed by subprime was viewed as an
attractive business opportunity with good returns. He said the mortgage-backed securities
satisfied housing goals but that it was not the reason for acquiring them.575 [add in Mudd and
others].

572

Mudd MFR at __.

573

BlackRock Solutions, “Fannie Mae's Strategy and Business Model, Supplementary Exhibits,” December 2007,
FMAC-FCIC 000049050-069, at FMAC-FCIC 000049059.

574

Levin MFR

575

Winer MFR

264

Overall, while the mortgages backing the subprime mortgage-backed securities were often to
borrowers that could help Fannie and Freddie to fulfill the goals, the mortgages backing the AltA securities were not. Alt-A mortgages were not generally extended to lower-income borrowers
and the regulations prohibited counting mortgages to borrowers with unstated income levels—a
hallmark of Alt-A loans.576 Officials told the FCIC that the Alt-A securities actually detracted
from the goals—the low- and moderate-income and special affordable housing goals specifically
— every year from 2001 to 2007. These purchases “did not have a net positive effect on Fannie
Mae's housing goals,” Fannie Executive Vice President Robert Levin told the FCIC.577 In order
to fulfill the affordable housing goals, purchases of Alt-A mortgage-backed securities had to be
offset with increases in purchases of mortgages for low-and moderate-income borrowers.
As we will see, Fannie and Freddie continued to purchase subprime and Alt-A mortgage-backed
securities from 2005 to 2008 and also increased their purchase and securitization of riskier
mortgages. The results of their efforts would be disastrous for the companies, their shareholders,
and the taxpayer.

576

FCIC interview with John Weicher, former FHA Commissioner.

265

CHAPTER CONCLUSIONS HERE

266

Part II, Chapter 3. The CDO machine

Contents
Chapter 3. The CDO machine .................................................................................................................. 267
CDOs: “We created the investor” ........................................................................................................ 270
BSAM: “We used the CDO as a funding source”................................................................................ 281
Citigroup’s liquidity puts: “A potential conflict of interest” ............................................................... 287
AIG: “Golden Goose for the Entire Street” .......................................................................................... 293
Goldman Sachs: “Synthetics mean it has a greater impact” ................................................................. 297
Moodys: “Achieved through some alchemy” ....................................................................................... 304
SEC: “Voluntary supervision” ............................................................................................................. 315

In the 2000s, a previously obscure financial product called the collateralized debt obligation, or
CDO, solved a key problem for the mortgage securities market: who would purchase the
mortgage-backed securities that few investors seemed to want?
As we have seen, Wall Street in the 1990s had developed a clever way of distributing to
investors the monthly payments from borrowers: mortgage-backed securities featuring a
waterfall of payouts to investors. Cash would flow first to risk-averse investors at the top of the
waterfall at a low interest rate, and last to risk-seeking investors at a high interest rate. If
borrowers were delinquent or defaulted, the bottom investors were out of luck.
But who would want to be at the bottom of the waterfall? At the very bottom were the equity
investors, often hedge funds (who liked the high interest rates) or mortgage servicers (who would
have an interest in collecting if the loans went bad).

267

The next rungs up from the bottom, the lowest investment-grade tranches, were always the
hardest to sell. Wall Street came up with a solution: in the words of one banker, they “created
the investor.”578 That is, they built new securities that would buy the tranches few wanted to
buy. Bankers would take those low investment-grade tranches, largely rated BBB or A, from
many mortgage-backed securities and re-package them into the new securities – the CDOs.
Those securities would be sold with their own waterfalls, with the risk-averse investors, again,
paid first and the risk-seeking investors paid last. As in the case of mortgage-backed securities,
the rating agencies would give their highest, AAA ratings to the securities at the top of the CDO
waterfall.
Still, it’s not obvious that you should be able to transform the risky part of a bunch of mortgagebacked securities rated BBB into a new security that is mostly rated AAA. But math made it so.
The securities firms argued – and the rating agencies agreed – that if you pooled many BBB
rated mortgage-backed securities, you would get additional diversification benefits, because they
wouldn’t necessarily all go bad at the same time. The rating agencies believed those
diversification benefits were significant – in simple terms, if one security went bad, the second
had only a very small chance of going bad at the same time. And, so long as losses were limited,
only those investors at the bottom of the waterfall would be wiped out. They would absorb the
blow and the other investors would continue to get paid.
[insert CDO chart]
Based on that logic, the CDO machine gobbled up the BBB and other low-rated tranches of
mortgage-backed securities, growing from a bit player to a multi-hundred billion dollar industry.
578

Joe Donovan, Credit Suisse, quoted in Michael Gregory, The “What if’s” in ABS CDOs, Asset Securitization
Report, February 18, 2002.

268

Between 2003 and 2007, as house prices rose xx% nationally and $xx billion in mortgagebacked securities were created, Wall Street issued nearly $700 billion in CDOs that included
mortgage-backed securities. By 2004, in fact, Wall Street firms such as Citigroup, Merrill
Lynch, and Goldman Sachs were packing most of the below-AAA tranches of subprime and AltA mortgage-backed securities into CDOs.579 Thanks to this seemingly limitless appetite on the
part of the CDOs, sellers of mortgage-backed securities now always had ready buyers for their
riskiest tranches. As a result, securitizers continued to demand loans for their pools and
hundreds of billions of dollars flooded the mortgage world. In effect, the CDO became the
engine that powered the mortgage supply chain. “There is a machine going,” Scott Eichel, a
senior managing director at Bears Stearns, an investment bank, told a financial journalist in May
2005. “There is a lot of brain power to keep this going.”580

Everyone involved in keeping this machine humming – the CDO managers and underwriters
who packaged and sold the securities, the rating agencies that gave most of them sterling ratings,
and the guarantors who wrote protection against them defaulting – collected fees based on the
dollar volume of securities sold. As demand for these securities grew and quality plunged, risk
was simply passed down the supply chain. For the traders who had put these deals together, as
for the executives of their companies, volume equaled fees equaled bonuses. And those fees
were in the billions of dollars, market-wide. Regulators stood aside; banks were earning high
579

Industry experts agree the percentage of BBB tranches of residential mortgage-backed securities that were
purchased by CDOs was over 90%. The FCIC, in analyzing Moody’s data, was unable to put an exact figure on this
phenomenon because the available collateral information about CDOs does not distinguish cash positions (positions
in actual securities) from synthetic positions (positions through derivatives).
580

Allison Pyburn, CDO machine? Managers, mortgage companies, happy to keep fuel coming, Asset
Securitization Report, May 23, 2005.

269

profits, housing markets were booming, and the whole process seemed to be spreading risk
among investors the way it was supposed to.
But when the housing market went south, the models proved tragically wrong. One mortgagebacked security turned out to be not so different from another; in other words, they were highly
correlated. Mortgages across the country would default at the same time, particularly in regions
where subprime and Alt-A mortgages were heavily concentrated. This was not how it was
supposed to work. Losses in one region were supposed to be offset by successful loans in
another region. In the end, CDOs turned out to be some of the most toxic assets in the financial
crisis. The greatest losses would be experienced by big CDO arrangers such as Citigroup,
Merrill Lynch, and UBS, and by big guarantors such as AIG. These players had believed their
own models and retained what were supposed to be the least risky tranches of the CDOs: those
rated AAA or even “super-senior,” better than AAA.
“The whole concept of [mortgage-backed] CDOs had been an abomination,” Pat Parkinson,
currently head of banking supervision and regulation at the Federal Reserve Board, told the
FCIC. “The point is, the only sort of [economic] environment in which one mortgage-backed
security is in trouble is one in which most of them are going to be in trouble. So that you’re not
going to get much diversification effect. So maybe that was a financial innovation too far or… a
poor implementation of what started out as a reasonably sound idea.”581

CDOs: “We created the investor”
Michael Milken at Drexel Burnham Lambert assembled the first collateralized debt obligation in
1987 out of different companies’ junk bonds. The strategy made sense – pooling many bonds
581

FCIC interview with Pat Parkinson, [Transcript of 3-30-10 interview, pp. 70-71], 2010. Netdocs ID: 4826-8172-

6727

270

reduced investors’ exposure to the failure of any one bond, and tranching the securities allowed
investors to pick their risk and return.
For the CDO managers who created CDOs, the key to profitability was the profit margin or
spread – the difference between the interest that the CDO received on the bonds or loans that it
held and the interest that the CDO paid to investors. Throughout the 1990s, CDOs managers
generally purchased corporate and emerging market bonds and bank loans. When the liquidity
crisis of 1998 drove up returns on asset-backed securities, Prudential Securities saw an
opportunity and launched a series of “multi-sector CDOs” that combined different kinds of assetbacked securities into one CDO. These securities were backed by mortgages, mobile home
loans, airplane leases, mutual fund fees, intellectual property rights, and other asset classes with
predictable income streams. The diversity was supposed to provide yet another layer of safety
for investors.
Multi-sector CDOs went through a tough patch when some of the asset-backed securities in
which they invested started to perform poorly in 2002 – particularly those backed by mobile
home loans (after borrowers defaulted in large numbers), airplane leases (after 9/11) and mutual
fund fees (after the dot-com bust). The accepted wisdom among many investment banks,
investors, and rating agencies was that the diversity among assets had actually contributed to the
problem; in that view, the asset managers who selected the portfolios could not be experts in
sectors as diverse as airplane leases and mutual funds.
So, the CDO industry turned to nonprime mortgage-backed securities, which CDO managers
believed they understood, which they thought had a long record of good performance, and which
paid relatively high returns for what was considered a safe investment.

271

“Everyone looked at the sector and said, the CDO construct works, but we just need to find more
stable collateral,” said Wing Chau, who ran two firms, Maxim Advisory and Harding Advisory,
that managed CDOs mostly underwritten by Merrill Lynch. “And the industry looked at
residential mortgage-backed securities, Alt-A, subprime, and non-agency mortgages, and saw the
relative stability.”582
That “relative stability” would not last long, but for the time being these securities could be
billed as safe; they also paid higher interest rates than identically rated tranches of mortgagebacked securities. CDOs quickly became ubiquitous in the mortgage business.583 Investors liked
the mix of safety and high returns, and investment bankers liked having a way to sell off those
problematic lower tranches of their mortgage-backed securities.
“We told you these [BBB rated mortgage-backed securities] were a great deal, and priced at
great spreads, but nobody stepped up,” Credit Suisse banker Joe Donovan told a Phoenix
conference of securitization bankers in February 2002. “So we created the investor.”584
By 2004, CDOs were the biggest buyers of the BBB and other mezzanine tranches of mortgagebacked securities. Just as mortgage-backed securities provided the cash to originate mortgages,
now, in the mid-2000s, CDOs would provide the cash to fund mortgage-backed securities. Also
by 2004, mortgage-backed securities accounted for more than half of the collateral in CDOs, up
from less than one-fifth in 2002.585 Sales of mortgage CDOs more than doubled every year,

582

FCIC interview with Wing Chau, November 11, 2010. [13:00]

583

CDOs that bought relatively senior tranches of mortgage-backed securities were known as high-grade, those that
bought the BBB rated and other junior tranches were known as mezzanine.
584
Michael Gregory, The “What if’s” in ABS CDOs, Asset Securitization Report, February 18, 2002.
585

JP Morgan, Structured Finance CDO Handbook, February 19, 2004, page 9.

272

jumping from $22 billion in 2003 to $217 billion in 2006.586 Filling this pipeline would require
hundreds of billions of dollars of subprime and Alt-A mortgages.
CDO players: “It was a lot of effort”
Five types of players were involved in the CDO pipeline: securities firms, CDO managers, rating
agencies, investors, and financial guarantors. Each took varying degrees of risk and, for a time,
profited handsomely.
Securities firms underwrote (that is, created and sold) the CDOs and generally determined how
they were tranched. Three firms, Merrill Lynch, Goldman Sachs, and the securities arm of
Citigroup, accounted for more than [40%] of CDOs sold from 2004 to 2007. Deutsche Bank and
UBS were also major participants. What made these firms so competitive was their extensive
network of salespeople. “It was every salesman’s job to sell structured products,” Nestor
Dominguez, co-head of Citigroup’s CDO desk, told the FCIC. “We spent a lot of effort to have
people in place to educate, to pitch structured products. It was a lot of effort, about 100
people. And I think our competitors did the same.”587
The underwriters’ focus was on generating fees and structuring deals that they could sell, and not
much else. Underwriting did entail risks, however: the securities firm had to buy the assets,
such as the BBB rated tranches of mortgage-backed securities, and hold them during the six to
nine months that it took to create a CDO; during that period, the firm took the risk the assets
would lose value. “Our business was to make new issue fees, [and to] make sure that if the

586

Issuance then dropped in 2007 to $162 billion and virtually disappeared in 2008. Source: FCIC estimates, based
on data provided by Citigroup and Moody’s.
587

FCIC interview with Nestor Dominguez, [XXXX], 2010.

273

market did have a downturn that we were somehow hedged,”588 Michael Lamont, co-head for
CDOs at Deutsche Bank, told the FCIC. Chris Ricciardi, formerly head of the CDO desk at
Merrill Lynch, told the FCIC that he did not track the performance of CDOs after underwriting
them. Lamont said it was not his job to decide whether the rating agencies’ models had the
correct underlying assumptions. That “was not what we brought to the table,” he said. In many
cases, though, underwriters helped CDO managers select collateral, leading to potential conflicts;
more on that later.
In marketing their CDOs, underwriters touted the benefit of having a supposedly expert CDO
manager select the mortgage-backed securities underlying the CDOs. Managers ranged from
small independent investment firms such as Chau’s to units of large asset-management
companies such as PIMCO and Blackrock.
CDO managers received annual fees based on the dollar amount of assets in the CDO and on the
structure of the tranches. On a percentage basis, these may have looked small—they could be
measured in tenths of a percentage point—but the amounts were not trivial. For CDOs that
focused on the relatively senior tranches of mortgage-backed securities, annual manager fees
tended to be in the range of $600,000 to a million dollars per year for a $1 billion dollar deal.
For CDOs that focused on the more junior tranches, which were often smaller, fees would be
$750,000 to $1.5 million per year for a $500 million deal. As managers did larger deals and
subsequent deals, they generated more fees without much additional cost.589 “You’d hear
statements like, ‘Everyone and his uncle wants to be a CDO manager,’” Mark Adelson, then a
CDO analyst at Nomura Securities and currently chief credit risk officer at S&P, told the FCIC.
588

FCIC interview with Michael Lamont.

589

JP Morgan, Structured Finance CDO Handbook, February 19, 2004, page 2.

274

“That was an observation voiced repeatedly at industry conferences around those times. It was
very lucrative.”590 Using the bottom range of industry fees, CDO managers industry-wide
earned at least $1.5 billion in management fees between 2003 and 2007, and probably a lot
more.591 The rating agencies blessed the structure of the CDOs – that is, the size and number of
tranches – in close consultation with the underwriters. Rating agencies were willing to give their
highest AAA ratings to most of the securities that CDOs issued, as they were for mortgagebacked securities, because they believed these CDOs had similar pooling and tranching benefits;
according to the rating agencies’ models, discussed below, the below-AAA investors would
suffer any losses, protecting the AAA investors in most likely scenarios. The AAA rating made
those products market-ready for many investors. Underwriters and CDO managers such as Chau
used the ratings to market the securities. Rating agency fees were capped at $500,000 for the
typical CDO. For most deals, there would be two rating agencies each receiving those fees,
because investors ostensibly preferred two points of view – although the views tended to be in
sync.592
The CDO investors, like investors in mortgage-backed securities, focused on different tranches
based on their perceived risks and returns. CDO underwriters such as Citigroup, Merrill Lynch,
and UBS often retained the super-senior (better than AAA) tranches. They also sold them to
asset-backed commercial paper programs that invested in these CDOs and other highly-rated

590

FCIC interview with Mark Adelson.

591

That assumes an annual management fee of 0.10% of the total value of the deal, based on the mortgage-focused
multi-sector 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 management fees ranging from
as low as 0.10% to as high as 0.40%.
592

Rating agencies would also receive a small ongoing monitoring fee of [$XXX] to monitor the performance of
CDOs after issuance.

275

assets, particularly a set of such programs known as structured investment vehicles or SIVs.
Hedge funds bought most of the equity tranches.
Eventually, other CDOs became the most important class of investor. By 2005, CDO
underwriters sold most of the mezzanine tranches – including those rated A and, especially, those
rated BBB, the lowest and riskiest investment grade rating – to other CDO managers, to be
packaged into other CDOs.593 It was common for CDOs to invest 10% or 15% of their cash in
other CDOs; CDOs that invested 80% to 100% of their cash in other CDOs were known as
“CDO-squareds.”
Finally, the financial guarantors, most notably American International Group, or AIG, played a
central role by selling CDO investors protection against default, making the deals more attractive
but creating huge risks for the guarantors in the event of significant losses. At the time, when
few people worried about the amount of risk piling up in the mortgage market, it seemed to be a
lucrative and relatively safe business for AIG and others.
Profit from the creation of CDOs, as is customary on Wall Street, was shared with the
employees. Bonuses accounted for a large part of compensation for investment bank
employees, overshadowing their base salary and longer-term incentives such as employee stock
options.
Pretax profit for the five largest investment banks doubled between 2003 and 2006, from [$20]
billion to [$44] billion; total compensation rose from [$33] billion to [$59] billion. A large part
of the growth was in mortgage-backed securities, including CDOs, and derivatives, and thus
employees in those areas could be expected to be compensated accordingly. “Credit derivatives
593

FCIC estimates based on Moody’s CDO Enhanced Monitoring Service.

276

traders as well as mortgage and asset backed securities salespeople should especially enjoy
bonus season,” the Options Group, which compiles compensation figures for investment banks,
reported in 2005. [will update with additional figures]
To see in more detail how the mortgage-backed CDO pipeline worked, we revisit the Citigroup
deal, our case-study mortgage-backed security, also known as CMLTI 2006-NC2. Earlier, we
described how CDOs bought most of the below-AAA bonds issued in this deal. One example
was Kleros Real Estate Funding III, which was underwritten by UBS, the Swiss bank. The CDO
manager was Strategos Capital Management, a subsidiary of Cohen & Company, an investment
company headed by Chris Ricciardi, who had earlier built Merrill’s CDO business. Kleros III,
launched in 2006, purchased and held $9.6 million in securities from the A rated M5 tranche of
CMLTI 2006-NC2, along with 187 junior tranches of other mortgage-backed securities. In total,
it owned [$975 million] of mortgage-related securities, of which 45% were rated A or lower,
16% A-, and the rest higher. According to the rating agencies’ models, Kleros III would achieve
diversification benefits because these securities would not be expected to default at the same
time.
To fund those purchases, Kleros III sold [$1 billion][check] of its own bonds to investors. The
bonds, as in all CDOs and private-label mortgage-backed securities, were sold in tranches. And,
as was typical for CDOs at the time, roughly 88% of the Kleros III bonds were AAA rated —
remarkable given that all of the assets backing these bonds were below AAA.

277

The super-senior and AAA tranches of Kleros were retained by UBS [check]. At least half of the
below-AAA tranches issued by Kleros III were purchased by other CDOs.594
“Mother’s milk to the CDO market”
The growth of CDOs had important impacts on the mortgage market itself. CDO managers who
were eager to expand their assets under management – on which their income was based – were
willing to pay high prices to accumulate BBB tranches of mortgage-backed securities. This
“CDO bid” pushed up market prices on those tranches, pricing out of the market traditional
investors in mortgage-backed securities who had been more knowledgeable about mortgage
credit risk.
Informed institutional investors such as insurance companies had purchased the relatively simple
private-label mortgage-backed securities issued in the 1990s. These securities were typically
protected from losses by bond insurers, who had analyzed the deals as well. Beginning in the
late 1990s, the more complex mortgage-backed securities – deals that used six or more tranches
and other devices to protect the AAA investors – became more common, replacing the earlier
structures that had relied on bond insurance to protect investors. The more complicated
structures depended upon CDOs to buy various tranches, particularly the low-investment-grade
tranches for which traditional investors had less enthusiasm. By 2004, the earlier forms of
mortgage-backed securities had essentially vanished, leaving the market to the multi-tranche
structures and their CDO investors.595

594

For example, Kleros III tranches were in Buckingham CDO, Buckingham CDO II, and Buckingham CDO III,
which were all deals underwritten by Barclays.
595

The portion of asset-backed securities covered by bond insurers fell from just under 40% in 2002 to just over
10% in 2003. Mark Adelson and David Jacob, The Sub-prime Problem: Causes and Lessons, January 8, 2008.

278

This was a critical development. Unlike the traditional investors who worried about the risk in
the deal, CDO managers focused more on whether the mortgage-backed securities they were
buying fit the criteria needed to get rating agency endorsement of the CDOs they were
building.596 “The CDO manager and the CDO investor are not the same kind of folks who just
backed away,” Adelson said. “They’re not mortgage professionals; they’re not real estate folks.
They’re derivatives folks.”597
Indeed, Chau, the CDO manager, described his job as creating structures that rating agencies
would approve and investors would buy, and making sure the mortgage-backed securities that he
bought “met industry standards.” He said he relied on the rating agencies. “Unfortunately, what
lulled a lot of investors, and I’m in that camp as well, what lulled us into that sense of comfort
was that the rating stability was so solid and that it was so consistent. I mean, the rating agencies
did a very good job of making everything consistent.”598 With many CDO managers driven by
ratings and structures and not at all focused on the underlying mortgages, CDO production was
on autopilot. “Mortgage traders speak lovingly of ‘the CDO bid.’ It is mother’s milk to
the…market,” James Grant, a market commentator, wrote in 2006. “Without it, fewer assetbacked securities could be built, and those that were would have to meet a much more
conservative standard of design. The resulting pangs of credit withdrawal would certainly be felt
in the residential real-estate market.”599

596

FCIC interview with Michael Lamont, Deutsche Bank, September 21, 2010.

597

FCIC interview with Mark Adelson, October 22, 2010.

598

FCIC interview with Wing Chau, November 11, 2010. [52:16].

599

James Grant, “Up the Capital Structure,” December 15, 2006, from Mr. Market Miscalculates.

279

UBS’s Global CDO Group agreed, noting that CDOs “have now become bullies in their
respective collateral markets.” The bid from CDOs had promoted an increase in both the volume
and the price of mortgage-backed securities, and had “an impact on the overall U.S. economy
that goes well beyond the CDO market.”600 Without the demand from CDOs, lenders would
have been able to sell fewer mortgages, and thus they wouldn’t have pushed so hard to make the
loans in the first place.
“Leverage is inherent in CDOs”
The mortgage pipeline also introduced leverage at every step. Most financial institutions thrive
on leverage, in other words, investing borrowed money. Leverage increases profits in good
times, but also potentially increases losses in bad times. The mortgage itself creates leverage –
particularly, in the case of low-down payment, high loan-to-value loans. Mortgage-backed
securities and CDOs created further leverage. And the CDOs were often purchased as collateral
by other CDOs with yet another round of debt. CDOs using credit default swaps, as described
below, were leveraged by design. For that reason, the CDO, backed by securities that were
themselves backed by mortgages, created leverage on leverage, Dan Sparks, mortgage
department head at Goldman Sachs, told the FCIC.601 “Lots of folks [were] looking for leverage
– leverage as an institution, or leverage in the structure, different leverage methodologies for
different investors,” Citigroup’s Dominguez told the FCIC.602

600

UBS Global CDO Group, Presentation on Product Series (POPS), January 2007. UBSSFCIC00063885,
UBSSFCIC00063889.

601

FCIC interview with Dan Sparks, June 15, 2010.

602

FCIC interview with Nestor Dominguez, [XXX], 2010.

280

Even the investor that bought the CDOs could use leverage. Structured investment vehicles – a
type of commercial paper programs that invested mostly in AAA rated securities – were
leveraged between 12-to-1 to 15-to-1, in other words these structured investment vehicles would
hold $15 in assets for every dollar of capital.603 The assets would be financed with debt. Hedge
funds, which were common purchasers, were also often highly leveraged in the repo market, as
we will see. But, it would become clear during the crisis that some of the highest leverage was
created by companies like Merrill, Citigroup, and AIG when they retained or purchased the AAA
super-senior tranches of CDOs with little or no capital backing.
Thus, with the homeownership rate peaking in 2004, and new mortgages being driven more and
more by serial refinancings, investors, and second home purchases, the value of trillions of
dollars of securities rested on just two things: whether millions of homeowners could make the
payments on their subprime and Alt-A mortgages; and whether the market value of homes
whose mortgages were the basis of these securities would not fall. Those dangers were
understood all along by some market participants. “Leverage is inherent in [mortgage] CDOs,”
Mark Klipsch, a banker with Orix Capital Markets, an asset management firm, told a Boca Raton
conference of securitization bankers in October 2004.604 While that was good for short-term
profits, Klipsch said losses could be large later on. “We’ll see some problems down the road.”

BSAM: “We used the CDO as a funding source”
Bear Stearns Asset Management, or BSAM, played a prominent role in the CDO business as
both a CDO manager and a hedge fund investor. At BSAM, Ralph Cioffi managed [seven]
CDOs with $18.3 billion in assets and three hedge funds with as much as [$19 billion] in assets
603
604

Moody’s Special Report: Moody’s Update on Structured Investment Vehicles, 16 January 2008. Page 13.
Drought of CDO collateral tops concerns, Asset Securitization Report, October 18, 2004.

281

at the end of 2006. Although Bear Stearns owned BSAM605, Bear’s management exercised little
supervision over its business.606 The eventual failure of Cioffi’s two large mortgage-focused
hedge funds would be an important event in 2007, early in the financial crisis.
In 2003, Cioffi launched his first fund at BSAM, the High Grade Structured Credit Strategies
Fund, which totaled $8.6 billion by the end of 2006.607 By that time, Cioffi had added the High
Grade Structured Credit Strategies Enhanced Leverage Fund, which would total $[XXX] billion
at the end of 2006.
The funds purchased mostly mortgage-backed securities or CDOs, and used leverage (mostly by
borrowing in the repo market) to enhance the returns.608 The target was for 90% of assets to be
rated either AAA or AA.609 As Cioffi told the FCIC, “[T]he thesis behind the fund was that the
structured credit markets offered yield over and above what their ratings suggested they should
offer.”610
Cioffi targeted a leverage ratio of [10] to 1 for the High Grade fund. For Enhanced Leverage,
Cioffi upped the ante, with a target leverage ratio of [12] to 1. At the end of 2006, the two funds

605

Financial Crisis Inquiry Commission, Hearing on the Shadow Banking System, May 5, 2010, written testimony
of James Cayne at 2, http://fcic.gov/hearings/05-05-2010.php (checked)
606

Warren Spector, interview by FCIC, March 30, 2010, Memorandum for the Record at 2, NetDocuments ID 48441109-0695. (checked)
607

Bear Stearns Asset Management Collateral Manager Presentation. BSAMFCIC 00000671 - . BSAMFCIC
00000740 at . BSAMFCIC 00000672.
608

Bear Stearns Asset Management Collateral Manager Presentation BSAMFCIC 0000671 at BSAMFCIC 0000672.

609

Interview of Cioffi. Unofficial transcript at 8.

610

Interview of Cioffi. Unofficial transcript at 2.

282

had [$18 billion] in securities – using [$2 billion] of his hedge fund investors’ money and [$16
billion] of borrowed money.
Borrowing in the repo market was typical for hedge funds. A survey conducted by the FCIC
identified at least $275 billion of repo borrowing by the 168 hedge funds that responded, as of
June 30, 2008.611 Of that amount, the surveyed hedge funds invested at least $45 billion in
mortgage-backed securities or CDOs. The ability to borrow using the AAA and AA tranches of
CDOs as repo collateral was an important driver of the demand for those tranches.
But repo borrowing carried risks for hedge fund investors: it created significant leverage and it
had to be renewed frequently. With respect to leverage, repo borrowers such as hedge funds
faced no regulatory margin requirements when they bought bonds.612 An investor buying a stock
on margin—meaning with borrowed money—might have to put up 50 cents on the dollar,
implying a leverage ratio of 2 to 1: he puts up 50 cents, his stock broker lends him the other 50
cents. In the repo market, these margins were determined by securities firms based on the
perceived riskiness of the assets used as collateral and were much looser. To borrow using a
Treasury bond as collateral, a securities firm would lend 99.75 cents against a dollar’s worth of
Treasuries, allowing the borrower 400 to 1 leverage.613 As a result, the borrower has 25 cents in
equity. This structure would make sense because Treasuries could be expected to retain their

611

The hedge funds responding to the survey had a total $1.2 trillion in investments, including leverage.

612

Under Regulation T and Regulation U, the Federal Reserve is empowered to set margin requirements on traded
securities, and it has set a margin requirement of [50%] on purchases of stock. [These regulations date to the Great
Depression.] However, in 1996, Congress amended the Securities Exchange Act of 1934 to eliminate the Board’s
authority to set margin requirements for credit extended to broker-dealers who maintain a public customer business.
This exclusion applies to all lenders. Therefore, broker-dealers may pledge both debt and equity securities in the
repo market and the counterparty is not required to apply the margin requirements of Regulation T or Regulation U.
613

UK FSA, The Turner Review, page 24.

283

value; in case of a default by the borrower, the lender could always sell the collateral to pay off
the loan.
For a mortgage-backed security, a securities firm would lend a hedge fund, say, 95 cents on the
dollar, still allowing 20 to 1 leverage, or 100 divided by 5. With this leverage, a 5% change in
the value of that mortgage-backed security can double the fund’s money – or lose all the initial
investment. Again, the structure assumed that the underlying collateral could be sold easily in
case of default. But, mortgage-backed securities would prove to be very different from U.S.
Treasuries – and proved much more risky than the slight difference in margins would suggest.
The short-term nature of repo money also makes it risky – funding today could be gone
tomorrow. To the degree the funding was overnight, Cioffi’s funds, for example, took the risk
that its repo lenders would decide not to extend, or “roll,” the repo lines another day. So, more
and more, repo lenders were loaning money to funds like Cioffi’s, rolling the debt nightly, and
not worrying very much about the real quality of the collateral.
The firms, mostly investment banks, lending money to hedge fund managers such as Cioffi were
often also selling him mortgage-related securities, with the same securities posted as collateral
for the loan.614 If the market value of the collateral fell, the repo lenders could and would
demand more collateral from the hedge fund to back the repo loan. This would play a pivotal
role in the fate of many hedge funds in 2007 – but most spectacularly in the fate of Cioffi’s

614

A broker, for example, might lend $95,000 to purchase $100,000 of residential mortgage-backed securities. The
fund would contribute $5,000 of its own money (the margin or haircut) and then post the $100,000 of assets as
collateral for the loan.

284

funds. “The repo market, I mean it functioned fine up until one day it just didn’t function,”
Cioffi told the FCIC.615
Cioffi’s hedge funds could buy billions of dollars of CDOs on borrowed money because of the
market’s bullishness about mortgage assets, he told the FCIC. “It became… a more and more
acceptable asset class, [with] more traders, more repo lenders, more investors obviously. [It had
a] much broader footprint domestically as well as internationally. So the market just really
exploded.”
BSAM touted its CDO holdings to investors, telling them CDOs were a market opportunity
because they were complex and therefore undervalued in the general marketplace.616 In 2003,
this was a promising market with seemingly manageable risks. Cioffi and his team not only
bought CDOs, they also created and managed other CDOs. Cioffi would purchase mortgagebacked securities, CDOs, and other securities for his hedge funds. When he had reached his
firm’s internal investment limits, he would re-package those securities into CDOs to tranche and
sell to other customers.617 With the proceeds, Cioffi would pay off his repo lenders but in the
meantime he would end up with the equity tranche of a new CDO.
For Cioffi, retaining the equity tranches represented the same financial risk as owning the assets
that went into the CDO outright – because the equity tranche would be the first to suffer losses if
the underlying assets did not perform – but without the additional risk that short-term repo

615

Unofficial transcript of October 19, 2010 interview of Ralph Cioffi at 29.

616

Bear Stearns High-Grade Structured Credit Strategies Marketing Presentation, BSAMFCIC 0000706-37 at
BSAMFCIC 0000709 NetDocuments ID 4838-7883-0856 (NOT cleared). FCIC Interview of Ralph Cioffi.
Unofficial transcript at 3. NetDocuments ID 4852-9362-1512
617

Interview of Cioffi. Unofficial transcript at 7.

285

funding posed.618 Those equity positions would never be a large portion of the hedge funds’
total assets.619 “For … the hedge funds I managed for BSAM, we used the CDO as a funding
source,” Cioffi said.620
Because Cioffi managed these newly created CDOs and selected the collateral621 from his own
hedge funds,622 he was positioned on both sides of the transaction. The structure created a clear
conflict of interest between Cioffi’s obligation to his hedge fund investors and his obligation to
his CDO investors; this was not unique on Wall Street, and BSAM disclosed the structure to
potential CDO investors. For example, a critical question was at what price the assets should be
transferred between the two types of investor: if the CDO paid above-market prices for a
security, for example, that would advantage the hedge fund investors and disadvantage the CDO
investors.
BSAM’s flagship CDOs – dubbed Klio I, II, and III – were created in rapid succession over 2004
and 2005, with Citigroup as the underwriter. Klio II, issued in October 2004, was a large CDO,
with $5 billion in assets, funded in great part by issuing short-term asset backed commercial
paper. All three deals were composed predominantly of mortgage-backed securities, with
BSAM retaining the equity position in all three. Typical for the industry at the time, the CDO’s
expected return on each one – including both the yield on the investment and the CDO

621

Interview of Cioffi. Unofficial transcript at 36.

622

Interview of Cioffi. Unofficial transcript at 36.

286

management fee – was between 15% and 23% annually.623 Thanks to the combination of
mortgage-backed securities, CDOs and leverage, Cioffi’s funds earned healthy returns for a time
– the High Grade fund had returns of 17% in 2004, 10% in 2005 and 9% in 2006 after fees.624
But when house prices fell and investors started to question the value of mortgage-backed
securities in 2007, the same short-term leverage that had inflated Cioffi’s returns would amplify
losses and quickly put his two hedge funds out of business.

Citigroup’s liquidity puts: “A potential conflict of interest”
By the mid-2000s, Citigroup was a market leader in selling CDOs, often using its depositorbased commercial bank to guarantee big parts of the deals. For much of this period, the
company was in various types of trouble with its regulators, which then-CEO Chuck Prince told
the FCIC took up more than half his time. In addition to the problems with CitiFinancial’s
mortgage origination, which resulted in the unprecedented $70 million fine in 2004, as discussed
earlier, Citigroup got into trouble for helping Enron – before that company filed for bankruptcy
in 2001 – use structured finance transactions to manipulate its financial statements. In July 2003,
Citigroup agreed to pay the SEC $120 million to settle these allegations and agreed, under formal
Fed and OCC enforcement actions, to overhaul its risk management.625,626

623

Source: Everquest filings.

624

Bear Stearns Asset Management Collateral Manager Presentation. BSAMFCIC 00000671 - . BSAMFCIC
00000740 at . BSAMFCIC 00000675.
625

JP Morgan agreed to pay $135 million to settle SEC charges that it helped Enron manipulate its financial
statements, and signed analogous agreements to revamp its risk management systems. Federal Reserve Board, Press
Release, July 28, 2003.
626

Regulators in the Japan and the U.K. also came down on the company in 2004 and 2005. In September 2004, the
Financial Services Agency of Japan suspended Citibank’s ability to operate branches in Japan due to the bank’s
participation in alleged illegal activity in that country, and in the following year the Financial Services Agency of

287

By March 2005, the Fed had seen enough and banned Citigroup from making any more
acquisitions until it got better control of its empire. Prince had already decided to turn “the
company’s focus from an acquisition-driven strategy to more of a balanced strategy involving
organic growth.”627 Robert Rubin, a former Treasury Secretary and Goldman Sachs co-chairman
who was now chairman of the executive committee of Citigroup’s board of directors,
recommended Citigroup increase its risk-taking – assuming, he told the FCIC, that the firm
managed the risks properly.628
The investment bank subsidiary was a natural place to grow after the Fed and then Congress had
done away with restrictions on activities that investment banks affiliated with commercial banks
could pursue. One opportunity among many was the CDO business, which was just then taking
off amidst the booming mortgage market.
In 2005, Citi’s CDO desk was a tiny unit in the company’s investment banking arm, accounting
for less than 1% of revenues – “eight guys and a Bloomberg” terminal, in the words of Nestor
Dominguez, co-head of the desk.629 Nevertheless, over the previous two years, this tiny
operation under the command of Tom Maheras, co-CEO of the investment bank, had become a
leader in the nascent market for mortgage-backed CDOs, selling more than $18 billion in 2003
and 2004, close to one-fifth of the market in those years.

the U.K. fined Citigroup $25 million for engaging in a bond trading scheme labeled “Dr. Evil” by Citigroup bond
traders.
627

Transcript of FCIC staff interview of Chuck Prince, March 17, 2010, p. 22.

628

FCIC staff interview of Robert Rubin, March 11, 2010.

629

FCIC interview with Nestor Dominguez, March 2, 2010. The CDO desk earned revenues of $367 million in
2005. Letter from Brad Karp (Paul, Weiss) on behalf of Citigroup to Bradley J. Bondi in re the FCIC’s second and
third supplement requests, March 31, 2010, “Response to Interrogatory No. 21.”

288

The eight guys had picked up on a novel structure pioneered by Goldman Sachs and WestLB, a
German bank. Instead of selling the super-senior tranches of the CDOs as long-term debt,
Citigroup sold them as short-term commercial paper. Of course, using commercial paper
introduced liquidity risk, which was not present when the tranches were sold as long-term debt,
because the CDO manager would have to re-sell the paper to investors regularly – usually at least
once every three months – until the CDO was retired.630 But, commercial paper was cheap at the
time, thanks to very low short-term interest rates, and it had a large base of potential investors,
particularly among money-market mutual funds. To back the commercial paper and to ensure
the rating agencies would give it their top ratings, Citibank – Citigroup’s national bank
subsidiary – sold liquidity puts, which are contracts guaranteeing investors that a bank would
step in and buy the commercial paper if there were no buyers when it matured or if interest rates
rose a predetermined amount.
In the 1990s, securitization had driven the growth in commercial paper. For example, credit card
issuers would package credit card debt into securities and sell most of the securities in tranches,
with the senior tranches taking the form of short-term commercial paper rather than long-term
bonds. Issuers tended to keep the most junior or equity tranches, which took the first losses; this
aligned their interests with their investors’ interests. Investors would not buy this commercial
paper – nor would the rating agencies grant it their top ratings – unless a bank or other financial
institution provided a liquidity put.631
The CDO team at Citigroup had jumped into the market in July 2003 with a $1.5 billion CDO,
Grenadier Funding, that included a $1.3 billion super-senior tranche with a liquidity put from
630

Moody’s Investor Service, Grenadier Funding, Ltd. New Issue Report, July 14, 2003.

631

Banks also sometimes offered credit support to commercial paper programs.

289

Citibank. Over the next three years, Citi would write $25 billion of liquidity puts on CDO
commercial paper, more than any other company.632 BSAM’s three Klio CDOs, which Citigroup
had underwritten, accounted for just over $10 billion of this total,633 a large number that would
not bode well for the bank. But, for the time being – for the fees, the bonuses, the careers – this
“strategic initiative,” as Dominguez called it, was very profitable for Citigroup. The CDO desk
earned roughly 1% of the total deal value in fees for Citigroup’s investment banking arm – about
$10 million for a $1 billion deal.[cite] In addition, Citigroup would generally charge buyers
0.10% to 0.20% in premiums annually for the liquidity puts. In other words, for a typical $1
billion deal, Citibank would receive $1 to $2 million annually on the liquidity puts alone –
practically free money, it seemed, because the trading desk believed that these puts would never
be triggered.634
And the liquidity put was yet another highly leveraged bet. Prior to the 2004 change in the
capital rules regarding liquidity puts, Citigroup did not have to hold any capital against the
possibility of losses. Rather, it was permitted to use its own risk models to determine the
appropriate capital charge. Because Citigroup’s computer models estimated that the possibility
that defaults would trigger the puts was remote, the puts were recorded as zero liability. The
regulators concurred. Following the 2004 rule change, Citibank was required to hold 0.16% in
capital against the amount of the liquidity put, or $1.6 million for a $1 billion liquidity
put. Assuming a $1 to $2 million annual fee for the put, the annual return on that capital still
could be more than 100%. No doubt about it, Dominguez told the FCIC, the AAA or similar
632

Citigroup issued and wrote liquidity puts on $10.3 billion of deals in 2004 (60% of the market) and $9.8 billion in
2005 (47%), according to Moody’s data. Moody’s, CDOs with Short-Term Tranches: Moody’s Approach to Rating
Prime-1 CDO Notes, February 3, 2006.
633 [1]
634

Everquest Financial Ltd., Form S-1, May 9, 2007, page 93. At http://www.secinfo.com/dsvr4.u6U3.htm
FCIC interview with Nestor Dominguez, March 2, 2010.

290

ratings, the multiple fees, and the low capital requirements made the liquidity puts “a much
better trade” than the typical CDOs at the time.635 The events of 2007 would reveal the
miscalculations in those assumptions and catapult the entire $25 billion in CDO assets straight
onto the bank’s balance sheet, requiring it to come up with $25 billion in cash and more capital
to satisfy bank regulators.
The liquidity puts were reviewed and approved by Citigroup’s Capital Markets Approval
Committee, which was charged with reviewing all new financial products. The committee
deemed them an income source with very remote risk of being triggered. The company based its
opinions on the credit risk of the underlying collateral, but failed to consider the liquidity risk of
a general market disruption. The OCC was aware of that Citibank had introduced the liquidity
puts, but the regulator only assessed whether Citibank had a process in place to review the new
product. The regulator did not assess the risks of the puts to Citibank.
Besides Citigroup, only WestLB of Germany and Société Générale of France wrote significant
amounts of liquidity puts on commercial paper issued by CDOs. Bank of America, the biggest
commercial bank in the United States, wrote only small deals through 2006 but did $6 billion
worth in 2007, just before the market crashed.636 When asked why few other American financial
institutions wrote liquidity puts on CDOs, Dominguez pointed to the size of Citibank’s balance
sheet. “It only works if you are a big bank,” he told the FCIC. “It’s a complicated product and it

635

FCIC interview with Nestor Dominguez, March 2, 2010.

636

Moody’s, CDOs with Short-Term Tranches: Moody’s Approach to Rating Prime-1 CDO Notes, February 3,
2006.

291

requires a lot of structuring and expertise. You needed to be a bank with a strong balance sheet,
access to collateral, and existing relationships with collateral managers.”637
The CDO desk stopped writing liquidity puts in early 2006 when it reached internal limits.
Citibank’s treasury function had set a $23 billion limit on liquidity puts; it gave one final
exception, bringing the total to $25 billion. Risk management had also set a$25 billion risk limit
on top rated asset-backed securities, which included the liquidity puts. But, in stopping, the firm
decided not to hedge its risks on the puts that it had already written. Later, in an October 2006
memo, Citigroup’s Financial Control Group criticized the firm’s pricing of the puts, which failed
to consider the risk that all of the commercial paper funding protected by the liquidity puts would
not roll at favorable rates all at the same time, creating a $25 billion cash demand on Citibank.
Presciently, the memo found that the liquidity puts were priced solely for credit risk and not
liquidity risk. An undated and unattributed internal document (believed to have been drafted in
2006) also suggested that there was a conflict of interest because Citigroup’s investment bank
paid traders on its CDO desk for generating the deals without regard to later losses. “There is a
potential conflict of interest in pricing the liquidity put cheap so that more CDO equities can be
sold and more structuring fee to be generated,” the memo said.638 The resulting losses would
help bring the huge financial conglomerate to the brink of failure, as we will see.

637

FCIC interview with Nestor Dominguez, March 2, 2010. Quote needs to be checked

638

CITI 00004244, Citigroup liquidity put discussion.

292

AIG: “Golden Goose for the Entire Street”
In 2004, American International Group was the largest insurance company in the world by stock
market value, a massive conglomerate with $850 billion in assets, 116,000 employees in 130
countries, and 223 subsidiaries.639
But to Wall Street, AIG’s most valuable asset was its credit rating: Aaa by Moody’s since 1986,
AAA by S&P since 1983, both as high as possible, and crucial because these sterling ratings let
it borrow cheaply and deploy the money in lucrative investments. Only [XXX] companies in the
United States in 2004 carried those ratings, of which only [XXX] were insurance companies.
Starting in 1998, AIG Financial Products, a Connecticut-based unit with major operations in
London, figured out a new way to make money off those ratings. Because the solid parent
company backed AIG Financial Products’ obligations, the unit could guarantee any number of
assets, ostensibly saving banks and other financial institutions billions of dollars in capital,
interest, and, potentially, losses should the value of those assets decline. The unit issued these
guarantees in the form of credit default swaps. The credit default swap is often compared to
insurance, but when an insurance company sells a policy, regulations require that it set aside a
reserve in case of a loss. In this case, the unit predicted with 99.85% confidence that there would
be no realized loss – as opposed to an unrealized loss, a distinction that would prove fatal to AIG
in 2008.
AIG Financial Products had a huge business selling credit default swaps to European banks on a
variety of financial assets, including bonds, mortgage-backed securities, CDOs, and other debt
securities. For AIG, the fee for selling protection via the swap appeared well worth the risk. For
639

Source: Bloomberg, Lp, Top 500 Global Companies by Market Cap (EQS) Function, Fiscal Year 2004, accessed
December 3, 2010; St Denis interview p 3

293

the banks purchasing protection, the swap allowed them to hold much less capital, freeing up
capital for investment. Under the regulatory capital rules instituted in 2001, purchasing credit
default swaps from AIG could reduce the amount of regulatory capital that the bank needed to
hold against that asset from 8% to 1.6%.640 By 2005, AIG had written $107 billion in credit
default swaps for such regulatory capital benefits with mostly European banks for a variety of
asset types. That number would rise to $379 billion by 2007.
In the United States, as we have reported, regulators had introduced similar capital standards for
banks’ holdings of mortgage-backed securities and other investments in 2001. So, a credit swap
with AIG also lowered American banks’ capital requirements.
In 2004 and 2005, AIG sold protection on approximately 33% of all super-senior tranches issued
by ABS CDOs,641 with a value of $54 billion, up from $2 billion in 2003.642 In an interview with
the FCIC, one AIG executive described AIG Financial Products’ principal swap salesman, Alan
Frost, as “the golden goose for the entire Street.”643
AIG’s biggest customer in guaranteeing CDOs was always Goldman Sachs, consistently a
leading CDO underwriter. It also wrote billions of dollars of protection for Merrill Lynch,
Société Générale, and others. “[AIG] looked like the perfect customer for this,” Craig Broderick,
Goldman’s chief risk officer, told the FCIC. “They really ticked all the boxes. They were

640

AIG 2008 Form 10-K, pg 133; 12 CFR, Part 325 Appendix A, II. Procedures for Computing Risk-Weighted
Assets; April 1994 OCC - FRB Interpretive Letter #988. Assets are assigned a “risk weighting” or percentage that is
then multiplied by 8% capital requirement to determine the amount of risk based capital.
641

Based on data provided by Moody’s and AIG.

642

The total would reach $78 billion by 2007

643

FCIC interview with Gene Park at page 60. Transcript available here:
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4845-7976-0902&open=Y

294

among the highest-rated [corporations] around. They had what appeared to be unquestioned
expertise. They had tremendous financial strength. They had huge, appropriate interest in this
space, backed by a long history of trading in it.””644
AIG also bestowed the imprimatur of its pristine credit rating on asset-backed commercial paper
programs by providing liquidity puts, similar to the ones that Citigroup’s bank wrote for many of
its own deals, guaranteeing it would buy paper if no one else wanted it.645 It started this business
in 2002 and by 2005, it had written more than $6 billion of liquidity puts on CDO commercial
paper. AIG also wrote more than $7 billion in credit default swaps to protect Société Générale
against the risks on liquidity puts that the French bank itself wrote on CDO commercial paper.646
“What we would always try to do is to structure a transaction where the transaction was virtually
riskless, and get paid a small premium,” Gene Park, a managing director at AIG Financial
Products, told the FCIC. “And we’re one of the few guys who can do that. Because if you think
about it, no one wants to buy disaster protection from someone who is not going to be
around...That was AIGFP’s sales pitch to the street or to banks, saying that, you know, ‘We’re
one of the largest capitalized AAA companies. We can provide you this protection.’ ”647

644

Craig Broderick, FCIC hearing, June 30, 2010.

645

For example, for the Putnam Structured Product CDO 2002-1, a $1.76 billion CDO issued by Goldman in
December 2002, AIG Financial Products provided a liquidity put on the $880 million medium-term notes. Moody’s
wrote at the time that the top P-1 rating for those tranches was “based primarily on the rating of the Put
Counterparty, AIG Financial Products, Corp., and will change as the short-term rating of the Put Counterparty
changes.”Moody’s, Moody’s assigns ratings to 3 classes of notes issued by Putnam Structured Product CDO 2002-1
Ltd, January 14, 2003. This was typical language in a Moody’s report on commercial paper.
646

Moody’s, CDOs with Short-Term Tranches: Moody’s Approach to Rating Prime-1 CDO Notes, February 3,
2006, MOODYS-FCIC-0010418; AIG, Information Pertaining to the Multi-Sector CDS Portfolio, AIGFCIC00336717-9.

647

FCIC interview with Gene Park at page 15. Transcript available here:
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4845-7976-0902&open=Y

295

In just four years, the business of offering protection on assets of many sorts, including
mortgage-backed securities, had grown six-fold and AIG’s Financial Services business, which
housed Financial Products, generated operating income of $4.4 billion, or 29% of the parent
AIG’s consolidated total operating income.648 To achieve those results, AIG had sold, circa
2005, protection on all kinds of assets [ck] worth some $211 billion including all credit default
swaps. This would rise to $533 billion by 2007.
AIG did not post one dollar in collateral upon writing these contracts, but unlike its primary
competitors AIG Financial Products usually agreed with the counterparties buying the swap
contracts that it would post collateral if the value of the underlying mortgage-backed securities
dropped, or if the rating agencies downgraded AIG’s long-term debt ratings. Its competitors, the
monolines – insurance companies such as MBIA and Ambac that focused on guaranteeing
financial contracts – did not agree to post collateral under these conditions. They only had
financial obligations in case of default. Unlike the monolines, AIG had to put up more cash and
securities to prove it could reimburse the customer if the value of the assets dropped. This would
have an enormous impact on the crisis about to unfold.
But during the boom, no matter. The investors got their AAA rated protection, AIG got its fees
for providing that insurance – about 0.12% of the amount of the swap per year 649 – and the
managers got their bonuses. In the case of the London subsidiary that ran the operation, the
bonus pool was 30% of new earnings. Financial Products CEO Joseph J. Cassano made the
allocations at the end of the year. Between 2002 and 2007, the least Cassano paid himself in a

648

AIG 2007, Form 10-K pg, 4

649

AIG 2007 Form 10-K at 91

296

year was $37 million. In the later years, his compensation was sometimes double that of the
parent company’s CEO.650
In the spring of 2005, disaster struck: AIG lost its AAA rating when auditors discovered it had
manipulated earnings. By November 2005, the company had reduced its reported earnings over
the five-year period by $3.9 billion.651 The board forced out [ck] Maurice “Hank” Greenberg,
who had been CEO for 38 years. New York Attorney General Eliot Spitzer prepared to bring
fraud charges against him.
Greenberg told the FCIC, “When the AAA rating disappeared in spring 2005, it would have been
logical for AIG to have exited or reduced its business of writing credit default swaps.”652 But it
didn’t happen. Instead, AIG Financial Products wrote another $36 billion in credit default swaps
on super senior tranches of CDOs in 2005. The company wouldn’t make the decision to stop
writing these contracts until 2006.

Goldman Sachs: “Synthetics mean it has a greater impact”
Henry Paulson, CEO of Goldman Sachs from 1999 until he became Secretary of the Treasury in
2006, testified to the FCIC that when he became Secretary, his “number one concern was the
likelihood of a financial crisis,” that he was “convinced we were due for another disruption.”653
He also testified that many bad loans already had been issued – “most of the toothpaste was out
650

PIR p 93-96

651

Gretchen Morgenson. “A.I.G. to Restate Its Earnings for 3rd Time This Year” The New York Times. 11/10/2005.
http://query.nytimes.com/gst/fullpage.html?res=9D0CE6DE123EF933A25752C1A9639C8B63&sec=&spon=&page
wanted=all
652

“Fact Sheet on AIGFP” provided by Hank Greenberg, at 4. No bates.

653

5/6/10 FCIC hearing transcript at 19.

297

of the tube” – and that “there really wasn’t the proper regulatory apparatus to deal with it.”654
Paulson provided examples: “Subprime mortgages went from accounting for 5 percent of total
mortgages in 1994 to 20 percent by 2006… Securitization separated originators from the risk of
the products they originated.”655 The result, Paulson testified, “was a housing bubble that
eventually burst in far more spectacular fashion than most previous bubbles.”656

Under Paulson’s leadership, Goldman Sachs had played a central role in the creation and sale of
mortgage securities. From 2004 through 2006, when Paulson left, the company provided $34
billion in loans to mortgage lenders, with more than half of this going to subprime lenders
Ameriquest, Long Beach, Fremont, New Century and Countrywide through warehouse lines of
credit, often in the form of repos.657 During the same period, Goldman acquired $53 billion of
loans from these and other subprime loan originators that it securitized and sold to investors.658
From 2004 to 2006, Goldman issued 318 mortgage securitizations totaling $184 billion (about a
quarter were subprime), and 63 CDOs totaling $32 billion; Goldman also issued 22 synthetic or
hybrid CDOs with a face value of $35 billion between 2004 and June 2006.659
Goldman pioneered [ck] the synthetic CDO, which, unlike the traditional CDO, would not
contain actual tranches of mortgage-backed securities, or even tranches of other CDOs. Instead,

654

5/6/10 FCIC hearing transcript at 22.

655

Paulson written testimony at 2.

656

Paulson written testimony at 2.

657

Appendix 5a to Goldman’s March 8, 2010 letter to the FCIC, GS_FCIC_000000179-173 NATIVE.xlsx. .

658

Appendix 5c to Goldman’s March 8, 2010 letter to the FCIC, GS_FCIC_000000174-214 NATIVE.xlsx. .

659

March 8, 2010 Letter to the FCIC at 28 (subprime securities); GS-MBS0000027965.xls (synthetic and hybrid
CDOs).

298

they would simply reference these mortgage securities. In a traditional CDO, money came in
from monthly mortgage payments and went out to investors. Synthetics were side bets between
investors that did not finance a single home purchase. Investors on the “long” side – those who
would make money when the securities performed – were paid by the investors on the “short”
side when in fact the set of referenced mortgage securities made timely payments. Those
payments would be reversed if the referenced mortgage securities failed. In additional to
traditional CDOs and synthetic CDOs, a third kind, hybrid CDOs, were a combination of the first
two.
Firms like Goldman found synthetic CDOs cheaper and easier to create than traditional CDOs.
With no mortgage assets to collect and finance, creating synthetic CDOs took a fraction of the
time. They also were easier to customize, because CDO managers and underwriters could
reference any mortgage-backed security – they were not limited to the universe of available
securities that they could buy.
Synthetic CDOs were complex paper transactions involving credit default swaps. On each side
of the bet, there were always two types of investors. Some investors (called funded investors)
would put up cash upfront; the CDO manager would invest this cash in highly rated securities,
such as Treasuries, that were not related to the referenced securities. If all went well, the funded
investors would receive interest, funded by cash flows from the interest on the highly rated
securities and by the protection payments from the CDS buyers. If the reference securities began
to lose money, the highly rated securities would be liquidated to pay the protection purchaser.
Other investors (called unfunded investors) weren’t investors at all, in the traditional sense:
rather, they were sellers of protection via credit default swaps. These swaps mirrored the
performance of tranches of a CDO. These investors would receive regular premiums, similar to
299

interest payments, as long as the referenced securities successfully made payments. If the
referenced securities didn’t successfully make payments, the unfunded investors would have to
pay up.
[ABACUS 2004-1 Chart]
AIG provided the credit protection for Goldman Sachs’s first synthetic CDO deal,660 and
Goldman Sachs was AIG’s biggest business partner in the CDO business. By 2007, AIG would
provide $21 billion in protection on 33 deals with Goldman, including seven of Goldman’s 24
Abacus deals.661 In 2004, Goldman launched the $1.9 billion Abacus 2004-1 deal, the first major
synthetic CDO. For Abacus 2004-1, about one-third of the swaps referenced residential
mortgage-backed securities, another third existing CDOs, and the rest commercial mortgagebacked securities (securities made up of bundled commercial real estate loans) and other
securities.
Conceptually, it is easier to think of the funded and unfunded tranches as separate parts. For the
funded tranches, IKB (a German bank), TCW, and Wachovia (the fourth-largest U.S.
commercial bank) put up a total of $195 million to purchase mezzanine tranches of the
deal.662,663 These investors were paid off if the referenced assets performed. If the referenced
assets defaulted, Goldman received the $195 million – a wager for which Goldman paid [$$ in]
660

Goldman was the largest buyer of credit default swaps from AIG Financial Products against super senior tranches
of multi-sector CDOs (“SSCDS”), purchasing 33 SSCDS which totaled $21 billion, or 27% of AIG’s $78 billion
portfolio as of 12/31/07. See Exhibit 1.
661

GS MS 0000027965.

662

See GS MBS0000021129-133.

663

Specifically, IKB purchased $30 million of Class A notes, $40 million of Class B notes, and $30 million of Class
C notes on June 9, 2004. TCW purchased $50 million of Class A Notes in January 2005, and Wachovia purchased
$45 million of Class A Notes in March 2005. See GS MBS0000021129-133; Exhibit 1.

300

premiums. In this sense, IKB, TCW, and Wachovia were “long” investors, betting on the
referenced assets performing, and Goldman was a “short” investor, betting that the referenced
assets would fail. In addition, TCW and GSC – two asset management firms that managed both
hedge funds and CDOs – were unfunded investors, receiving annual premiums from Goldman in
return for the promise that they would pay Goldman if the referenced assets failed.664 The
tranches of Abacus 2004-1 soon found their way into other funds and CDOs; for example, at one
point in 2007, TCW purchased tranches of Abacus 2004-1 for three of its own CDOs.
AIG was also an unfunded investor, in the super-senior tranches of the deal. Goldman purchased
from AIG Financial Products $1.8 billion of protection in case the referenced assets failed, in
return for an annual payment of $2.2 million.665
All told, investors in Abacus stood to receive millions of dollars if the referenced assets
performed, (just as a bond investor makes money when a bond performs). On the other hand,
Goldman stood to gain nearly $2 billion if the assets failed, while only having to pay $11 million
in CDS premiums over five years.666
Between July 1, 2004 and May 31, 2007, Goldman packaged and sold 48 synthetic CDOs, with
an aggregate face value of $73 billion. Its underwriting fee was 0.50% to 1.50% of the deal

665

In June 2009, Goldman received $806 million from CDS it purchased from AIG Financial Products on the super
senior tranche of Abacus 2004-1. GS-MBS-0000027966 and GS-MBS 0000021129-21133.

666

GS-MBS 0000021129-21133.

301

totals, Goldman’s Sparks told the FCIC.667 For the first Abacus deal, the fee revenue for
Goldman would have been approximately [$XXX million.]668 Goldman would earn profits from
shorting these deals, but it would also lose money from selling credit protection to other short
investors.669
As we will see, these new instruments would yield substantial profits for investors that held a
short position in the synthetic CDOs—that is, investors betting that the boom was a bubble about
to burst. They also would multiply losses when housing prices collapsed. When borrowers
defaulted on their mortgages, the investors expecting cash from the mortgage payments lost.
Now, investors betting on these mortgages also lost (while those betting against the mortgages
would gain).670
To see this, we can return to our case-study deal, CMLTI 2006-NC2. It wasn’t a synthetic CDO,
but it was inextricably tied to them. There were about $11 million worth of bonds in the M9
(BBB rated) tranche – one of the “mezzanine” tranches of the security. Synthetic CDOs such as
Auriga, Volans, and Neptune CDO IV all contained credit default swaps in which the M9
tranche was referenced. As long as the tranche performed, investors betting the tranche would
fail (short investors) would make regular payments into the CDO, and those payments would be
paid out to other investors banking on it to succeed (long investors). If the M9 bonds defaulted,
then the long investors would make large payments to the short investors. That is the bet – and

Sparks MFR at __.
According to the SEC, Goldman received $15 million from Paulson for structuring and marketing the Abacus
2007-AC1 deal. See 4/16/10 SEC Press Release, “SEC Charges Goldman Sachs with Fraud in Structuring and
Marketing of CDO Tied to Subprime Mortgages.”
669
We have asked Goldman to provide information about the profitability of Abacus and other synthetic CDOs.
667
668

670

Of course, the net impact on the financial system is, in theory, not greater, because there is a winner for every
loser in the derivatives market.

302

there were more than $50 million in such bets in early 2007 on the M9 tranche of the case-study
deal. That means more than $60 million would change hands based on the performance of $11
million in bonds. Dan Sparks, mortgage salesman for Goldman Sachs, put it succinctly to the
FCIC.671 “If there is a problem with a product, then synthetics mean it has a greater impact.”
The amplification on the M9 tranche was not unique. A $15 million tranche of the Glacier
Funding CDO 2006-4A, rated A, was referenced in $85 million worth of synthetic CDOs. A $28
million tranche of the Soundview Home Equity Loan Trust 2006-EQ1, also rated A, was
referenced in $79 million worth of synthetic CDOs. A $13 million tranche of the Soundview
Home Equity Loan Trust 2006-EQ1, rated BBB, was referenced in $49 million worth of
synthetic CDOs.672
In total, synthetic CDOs created by Goldman referenced 3,408 mortgage securities, and some
multiple times. For example, 610 securities were referenced twice. Indeed, one single
mortgage-related security was referenced in nine different synthetic CDOs created by Goldman
Sachs. Because of such deals, when the housing bubble burst, tens of billions of dollars changed
hands.
Although Goldman executives agreed that synthetic CDOs were “bets” that magnified overall
risk, they also maintained their creation had “social utility” because it added liquidity to the
market and allowed investors to customize the exposures they wanted in their portfolios.673 In
testimony before the Commission, Goldman’s President and Chief Operating Officer Gary Cohn

671

FCIC interview with Dan Sparks,

672

From Goldman Sachs data provided to the FCIC, quoted in FCIC’s hearing on Derivatives, handout entitled
“Amplification.”

673

Blankfein MFR at 2; Egol MFR at ___; Sparks MFR at __.

303

argued: “This is no different than the thousands of swaps written every day on the U.S. dollar
versus another currency. Or, more importantly, on U.S. Treasuries. It is one reference point that
is involved in tens of thousands of securities. This is the way that the financial markets work.
People choose a specific security that they want exposure to, whether it’s pooled or un-pooled,
and they aggregate it.”674
Others, however, criticized these deals. Pat Parkinson, current director of the Division of
Banking Supervision and Regulation at the Federal Reserve Board noted that synthetic CDOs
“multiplied the effects of the collapse in subprime.” Other observers were even more critical. “I
don’t think they have social value,” Michael Greenberger, a professor at the University of
Maryland School of Law and former Director of the Division of Trading and Markets at the
CFTC, told the FCIC.675 He characterized the credit default swap market as a “casino”.

Moodys: “Achieved through some alchemy”
The RMBS and CDO machine would not have worked without the stamp of approval these deals
received from the three leading rating agencies, Moody’s, S&P, and Fitch. Many investors could
buy only securities rated by at least one of the three agencies – in fact, under securities laws,
money market funds and many other investors could not buy securities that did not carry the
agencies’ top ratings.676 These investors often used the rating agencies’ views rather than

674

Testimony of Gary Cohn.

675

Michael Greenberger, 6-30-10 FCIC hearing on The Role of Derivatives in the Financial Crisis, p. 109 of
transcript.
676
AAA is the highest rating for long-term debt securities, and A-1 is the highest rating for short-term debt securities
under S&P’s rating scale. Under the Investment Company Act of 1940 (17 CFR § 270.2a-7(c)(3)(i)), “The money
market fund shall limit its portfolio investments to those United States Dollar-Denominated securities that the fund’s
board of directors determines present minimal credit risks (which determination must be based on factors
pertaining to credit quality in addition to any rating assigned to such securities by an NRSRO) and that are at the
time of Acquisition Eligible Securities.” Eligible Securities include rated securities “with a remaining maturity of
397 calendar days or less that has received a rating from the Requisite NRSROs in one of the two highest short-term

304

conduct their own credit analysis.677 Moody’s was paid based on the size of each deal, with caps
set at a half million dollars for a “standard” CDO in 2006 and 2007 and as much as $850,000 for
a “complex” CDO.678
In rating both synthetic and cash CDOs,679 Moody’s faced two key challenges: first, estimating
the probability of default for the mortgage-backed securities that the CDO purchased (or their
synthetic equivalents), and second, the correlation among those defaults – that is, the likelihood
that the securities would default at the same time.680 Imagine seeing how many coin flips come
up heads. Each flip is unrelated to the others; that is, the flips are uncorrelated. Now, imagine a
loaf of sliced bread. When there is one moldy slice, there are likely other moldy slices. The
freshness of each slice is highly correlated with the other slices. As investors now understand,
the mortgage-backed securities that CDOs bought were less like coins and more like slices of
bread.

rating categories (within which there may be sub-categories or gradations indicating relative standing)” (17 CFR §
270.2a-7(a)(10)(i)). Rule 2a-7 was modified by the Securities and Exchange Commission on February 23, 2010 (see
http://www.sec.gov/rules/final/2010/ic-29132.pdf and http://www.sec.gov/rules/final/2010/rule2a7amendments.pdf).
677

Investment Company Institute, “Report of the Money Market Working Group,” March 17, 2009, p. 81, available
at http://www.ici.org/pdf/ppr_09_mmwg.pdf.
678

MOODYS-FCIC-0394732, “Summary of Key Provisions for Cash CDOs as of January 2000-2010” [ID# 48361988-4039].
679

See, for example, “Moody’s Approach to Rating Synthetic CDOs,” July 29, 2003 [ID# 4816-9805-9528] and
“Moody’s Modeling Approach to Rating Structured Finance Cash Flow CDO Transactions,” September 26, 2005
[ID# 4818-0658-7912].
680

Gary Witt, written statement to the Financial Crisis Inquiry Commission, hearing on “Credibility of Credit
Ratings, the Investment Decisions Made Based on those Ratings, and the Financial Crisis,” June 2, 2010, p. 12, 15,
http://www.fcic.gov/hearings/pdfs/2010-0602-Witt.pdf.

305

To estimate the probability of default, Moody’s relied almost exclusively on its own ratings of
the mortgage-backed securities that the CDOs would purchase.681 At no time did the agencies
“look through” the securities to the underlying subprime mortgages, as Gary Witt, formerly one
of Moody’s team managing directors for the CDO unit, told the FCIC.682 “[W]e took the rating
that had already been assigned by the [mortgage-backed securities] group.”683 This decision
would lead to problems for Moody’s – and for investors. Witt testified that the underlying
collateral “just completely disintegrated below us and we didn’t react and we should have….
[W]e had to be looking for a problem. And we weren’t looking.”684
To determine the likelihood that any given security in the CDO would default, Moody’s plugged
in assumptions based on those original ratings. This was no simple task. “The rating process for
CDOs became the crucible in which the agencies had to confront the fact that similarly rated
bonds from different sectors had markedly different track records,” one market analyst wrote.685
Meanwhile, if the initial ratings turned out to poorly reflect the quality of the mortgages in the
bonds, due to poor underwriting, fraud, or other variants, the error was blindly compounded
when mortgage-backed securities were packaged into CDOs.
681

Gary Witt, written statement to the Financial Crisis Inquiry Commission, hearing on “Credibility of Credit
Ratings, the Investment Decisions Made Based on those Ratings, and the Financial Crisis,” June 2, 2010, p. 12,
http://www.fcic.gov/hearings/pdfs/2010-0602-Witt.pdf.
682

Gary Witt, testimony to the FCIC, hearing on “The Credibility of Credit Ratings, the Investment Decisions Made
Based on those Ratings, and the Financial Crisis,” Session 3: The Credit Rating Agency Business Model, June 2,
2010, p. 436 (ID# 4818-8776-0390)
685

Mark Adelson, Nomura Securities, Bond Rating Confusion, June 29, 2006.

306

Even more difficult was the estimation of correlation—always tricky, but particularly so in the
case of CDOs full of mortgage-backed securities with only a short performance history. So its
approach would explicitly rely on the judgment of its analysts. “In the absence of meaningful
default data, it is impossible to develop empirical default correlation measures based on actual
observations of defaults. Our default correlation assumptions instead reflect extensive
discussions with Moody’s analysts who have expertise with the various types of [asset-backed
and mortgage-backed securities], as well as a considerable degree of common sense,” Moody’s
acknowledged in one early explanation of its process.686
In plainer English, Witt said, Moody’s didn’t have a good model on which to estimate
correlations among mortgage-backed securities – so they “made them up.” He said, “They went
to the analyst in each of the group and they said, ‘Well, you know, how related do you think
these types of [mortgage-backed securities] are?’”687 This would become a more serious problem
as multi-sector CDOs became increasingly concentrated in mortgage-backed securities in the
mid-2000s.688,689 Witt felt strongly that Moody’s needed to update its CDO rating model to
explicitly address the increasing concentration of risky mortgage related securities in the
collateral underlying CDOs.690 He undertook two initiatives to address this issue. First, in mid2004, he developed a new rating methodology that explicitly incorporated correlation into the

686

“Moody’s Approach to Rating Multisector CDOs,” Moody’s Investors Service, September 15, 2000, p. 5.

687

Gary Witt, interview with the FCIC, April 21, 2010, p. 39 (ID# 4818-7724-2630).

690

Gary Witt, written testimony to the FCIC, June 2, 2010, p. 17, http://www.fcic.gov/hearings/pdfs/2010-0602Witt.pdf

307

model.691 However, the technique he devised was not incorporated into CDO ratings for another
year.692 Second, he proposed a research initiative in early 2005 to “look through” a few CDO
deals at the underlying mortgage-backed securities and see if “the assumptions that we’re
making for [mortgage-backed] AAA CDOs are consistent… with the correlation assumptions
that we’re making for AAA [mortgage-backed securities].”693 Although Witt received approval
from his superiors to conduct this analysis, he was unable to buy the necessary software product
because of contractual disagreements.694
In June 2005, Moody’s updated its approach for estimating default correlation695 but based the
new model on trends from the previous 20 years, a period when housing prices were rising and
mortgage delinquencies were very low. Then, Moody’s modified this optimistic set of
“empirical” assumptions with ad-hoc adjustments based on factors such as region, year of
origination, and institutional factors. For example, if two mortgage-backed securities were
issued in the same region—say, southern California—Moody’s boosted the correlation; if they
shared a common mortgage servicer, Moody’s boosted it further.696 But, on the other hand, they
would also make other technical choices that lowered the estimated correlation of default, which
would improve the ratings for these securities. Using these methods, Moody’s estimated that

695

“Moody’s Revisits its Assumptions Regarding Structured Finance Default (and Asset) Correlations for CDOs,”
June 27, 2006, http://www.fcic.gov/hearings/pdfs/2010-0602-exhibit-finance-default.pdf.
696

“Moody’s Revisits its Assumptions Regarding Structured Finance Default (and Asset) Correlations for CDOs,”
June 27, 2006, p. 5 7, 9, http://www.fcic.gov/hearings/pdfs/2010-0602-exhibit-finance-default.pdf.

308

two mortgage-backed securities would be less correlated than two consumer asset-backed
securities (containing credit card or auto loans).697,698,699
The other major rating agencies followed a similar approach.700 The correlation assumptions
were always controversial. One investment bank published a study of the different assumptions
and concluded, “The rating agencies will continue to update and improve their correlation
assumptions based on more empirical evidence, although we would never know whatever new
estimates are “right”…. The truth must lie somewhere in between historical estimates and
forward-looking market expectations.”701
Academics, including some who worked at regulatory agencies, cautioned investors that
assumption-heavy CDO credit ratings could be dangerous. “The complexity of structured
finance transactions may lead to situations where investors tend to rely more heavily on ratings
than for other types of rated securities. On this basis, the transformation of risk involved in
structured finance gives rise to a number of questions with important potential implications. One

697

“Moody’s Revisits its Assumptions Regarding Structured Finance Default (and Asset) Correlations for CDOs,”
June 27, 2006, p. 4, http://www.fcic.gov/hearings/pdfs/2010-0602-exhibit-finance-default.pdf.
698

For example, Moody’s assumed that borrowers’ with different credit ratings would not default at the same time.
The agency split the securities into three subcategories based on the average FICO score of the underlying
mortgages: prime (FICO greater than 700), midprime (FICO between 625 and 700), and subprime (FICO under
625). Creating three FICO-based subcategories rather than the traditional two (prime and subprime) resulted in
lower correlation assumptions, because mortgage-backed securities in different subcategories were assumed to be
less correlated. “Moody’s Revisits its Assumptions Regarding Structured Finance Default (and Asset) Correlations
for CDOs,” June 27, 2006, p. 15, http://www.fcic.gov/hearings/pdfs/2010-0602-exhibit-finance-default.pdf.

699

FCIC interview of Gary Witt, May 6, 2010, p. 2 [ID# 4824-8104-0390].

700

“U.S. Subprime RMBS in CDOs,” Hedi Katz, Fitch special report, April 15, 2005, p. 3, [ID# 4848-4562-3048];
“CDO Evaluator Applies Correlation and Monte Carlo Simulation to Determine Portfolio Quality,” Sten Bergman,
Standard & Poor’s Global Credit Portal RatingsDirect, November 13, 2001, p. 8 [ID# 4848-2884-5832].
701

“U.S. Fixed Income 2005 Mid-Year Outlook/Review,” Nomura Fixed Income Research, June 30, 2005, p. 107
[ID# 4828-3451-9816].

309

such question is whether tranched instruments might result in unanticipated concentrations of
risk in institutions’ portfolios,”702a report from the Bank for International Settlements, an
international financial organization sponsored by the world’s regulators and central banks,
warned in June 2005.
The ratings were an important marketing tool for CDO managers and underwriters. For each
new CDO, they created a “pitch book,” which investors used to make their decisions. Each book
detailed the types of assets that would make up the portfolio.703 Without exception, every pitch
book the FCIC staff examined cited an analysis from either Moody’s or S&P that contrasted the
historical ratings “stability” of these new products (87-98% had not suffered downgrades) with
the stability of corporate bonds (77% had not suffered downgrades) between 1983 and 2004.
The pitch books said that CDO collateral had tended to have higher recovery rates relative to
corporate bonds. Indeed, underwriters continued to sell CDOs using these statistics in their pitch
books during 2006 and 2007, after mortgage defaults had started to rise but before the rating
agencies had downgraded large number of mortgage-backed securities. Of course, each pitch
book did include the disclaimer that “past performance is not a guarantee of future performance”
and encouraged investors to perform their own due diligence.
As Kyle Bass of Hayman Capital Advisors told the FCIC, CDOs that purchased lower-rated
tranches of mortgage-backed securities “are arcane structured finance products that were
designed specifically to make dangerous, lowly rated tranches of subprime debt deceptively
attractive to investors. This was achieved through some alchemy and some negligence in
adapting unrealistic correlation assumptions on behalf of the ratings agencies. They convinced
702

Fender, I. and J. Mitchell, Structured Finance: Complexity, Risk and the Use of Ratings, BIS Quarterly Review
at 67, 74-77 (June 2005) (http://www.bis.org/publ/qtrpdf/r_qt0506.pdf).
703
Based on an FCIC survey of [XXX] CDO managers and 11 underwriters about the process of creating and
marketing CDOs.

310

investors that 80% of a collection of toxic subprime tranches were the ratings equivalent of U.S.
Government bonds.”704
When housing prices started to fall nationwide and defaults increased, it turned out that the
mortgage-backed securities were in fact much more correlated than the rating agencies had
estimated—that is, they lost value at the same time. This led to massive downgrades in the
ratings of the CDOs. In 2007, 20% of U.S. CDO securities would be downgraded.705 In 2008,
91% would.706 In late 2008, Moody’s would throw out its key CDO assumptions and replace
them with an asset correlation assumption two to three times higher than used before the crisis.707
In retrospect, it is clear that the agencies’ CDO models made two key mistakes. First, they
assumed that securitizers could create safer financial products by diversifying among many
mortgage-backed securities, while in fact these securities weren’t that different to begin with.
“There were lots of things [the credit rating agencies] did wrong,” Federal Reserve Chairman
Ben Bernanke told the FCIC. “Did they use the right models? Clearly they did not. They did
not take into account the appropriate correlation between [and] across the categories of
mortgages.” 708
Second, the agencies based their CDO ratings on their own ratings of underlying collateral – in
popular parlance, they “ate their own cooking.” “The danger with CDOs is when they are based
704

FCIC interview with Kyle Bass, April 26, 2010 [ID# 4829-0222-0038]. This is a paraphrase from an MFR. Quote
needs to be checked.
705

Structured Finance Rating Transitions: 1983-2007,” Moody’s Credit Policy Special Comment, February 2008, p.
2 [ID# 4814-6082-3304].
706
[2] “Structured Finance Rating Transitions: 1983-2008,” Moody’s Credit Policy Special Comment, March 2009,
p. 2 [ID# 4815-7826-3816].
707
“Announcement: Moody’s Updates Its Key Assumptions for Rating Structured Finance CDOs,” Moody’s
Investors Service, December 11, 2008.
708

FCIC interview with Ben Bernanke, November 17, 2009.

311

on structured finance ratings,” Ann Rutledge, a structured finance expert, told the FCIC.709
“Ratings are not predictive of future defaults; they only describe a ratings management process.”
Of course, rating CDOs was a profitable business for the rating agencies. Including all types of
CDOs – not just mortgage-related – Moody’s rated more than 200 deals in 2004, 363 in 2005,
749 in 2006, and 717 in 2007; the value of those deals rose from $90 billion in 2004 to $162
billion in 2005, $337 billion in 2006, and $326 billion in 2007.710 Moody’s Investors Services
reported revenues from structured products – which included mortgage-backed securities and
CDOs – grew from $199 million in 2000, or 33% of Moody’s Corporation’s overall revenues, to
$887 million in 2006 and $886 million in 2007 – 44% and 39%, respectively, of overall
corporation revenue.711 The rating of asset-backed CDOs alone contributed more than 10 percent
of the revenue from structured finance.712 The boom years of structured finance coincided with a
company-wide surge in revenue and profits. From 2000 to 2006, Moody’s Corporation’s

709

Ann Rutledge is a principal in R&R Consulting, co-author of Oxford University Press’ Elements of Structured
Finance (2010) and a former employee of Moody’s Investor Service. She and co-principal Sylvain Raines first
spoke to the FCIC on April 12, 2010.
710

“2004 U.S. CDO Review / 2005 Preview: Record Activity Levels Driven by Resecuritization CDOs and CLOs,”
February 1, 2005, p. 1 [ID# 4817-4839-1176]; “2005 U.S. CDO Review; Looking Ahead to 2006: Record Year
Follows Record Year,” February 6, 2006, p. 1 [ID# 4817-6516-8392]; . “2008 U.S. CDO Outlook and 2007 Review:
Issuance Down in 2007 Triggered by Subprime Mortgages Meltdown; Lower Overall Issuance Expected in 2008,”
March 3, 2008 [ID# 4835-7121-5112]
711

Moody’s Corporation 2000 10-K, p. 29, 48 [ID# 4832-7715-6614]; Moody’s Corporation 2006 10-K, p. 39, 66
[ID# 4834-9526-0422]; Moody’s Corporation 2007 10-K, p. 18, 30 [ID# 4835-1203-7638]; for calculations, see
Excel spreadsheet [ID# 4823-3933-3128].
712
Moody’s annual gross revenues for ABS CDO ratings were $11,730,234 in 2003, $22,210,695 in 2004,
$40,332,909 in 2005, $91,285,905 in 2006, and $94,666,014 in 2007 (Moody's May 3, 2010 response to FCIC
interrogatory #9 [Net Docs ID# 4818-4748-6982]). See also Moody’s Corporation 2006 10-K, p. 66 [ID# 48349526-0422]; Moody’s Corporation 2007 10-K [ID# 4835-1203-7638]; for calculations, see Excel spreadsheet [ID#
4823-3933-3128].

312

revenues grew from $602 million to $2 billion and its profit margin climbed from 26% to
37%.713
Yet, the increase in the CDO group’s workload and revenue was not accompanied by a parallel
staffing increase. “[W]e were under-resourced, you know, we were always playing catch-up,”
Witt said.714 Moody’s “penny-pinching” and “stingy” management was reluctant to pay up for
experienced employees.715 “The problem of recruiting and retaining good staff was insoluble.
Investment banks often hired away our best people. As far as I can remember, we were never
allocated funds to make counter offers,” Witt said. “We had almost no ability to do meaningful
research.”716 Eric Kolchinsky, a former team managing director at Moody’s, told the FCIC that
from 2004 to 2006, the increase in the number of deals rated was “huge… but our personnel did
not go up accordingly.”717 By 2006, Kolchinsky recalled, “My role as a team leader was crisis
management. Each deal was a crisis.”718 When they worked to create a new methodology, Witt
said, “We had to kind of do it in our spare time.”719

713

Moody’s Corporation 2000 10-K, p. 29 [ID# 4832-7715-6614] and 2006 10-K, p. 17 [ID# 4834-9526-0422]; for
calculations, see FCIC staff report, “Moody’s Financial Summary,” p. 5 [ID# 4830-0644-2758].
714

Gary Witt, written testimony to the FCIC, June 2, 2010, p. 11, http://www.fcic.gov/hearings/pdfs/2010-0602Witt.pdf; Gary Witt, interview with the FCIC, April 21, 2010, p. 63 (ID# 4818-7724-2630).
716

Gary Witt, written testimony to the FCIC, June 2, 2010, p. 11, http://www.fcic.gov/hearings/pdfs/2010-0602Witt.pdf
717

Eric Kolchinsky, interview with the FCIC, April 27, 2010, p. 64 [ID# 4828-9967-1046].

718

Eric Kolchinsky, interview with the FCIC, April 27, 2010, p. 64 [ID# 4828-9967-1046].

719

Gary Witt, interview with the FCIC, April 21, 2010, p. 19 (ID# 4818-7724-2630).

313

The agencies worked closely with CDO underwriters and managers as they designed each new
CDO. And the rating agencies now relied for a substantial amount of their revenues on a small
number of players. Citigroup and Merrill alone accounted for $140 billion of CDO deals
between 2005 and 2007.720 Goldman over $40 billion.721 The ratings agencies’ correlation
assumptions had a direct and critical impact on how CDOs were structured, with lower
assumptions allowing for larger easy-to-sell AAA tranches and smaller harder-to-sell BBB
tranches. Thus, as is discussed below, underwriters pressured the agencies for more favorable
ratings, for example, by increasing the size of the senior tranches. Because issuers could choose
which rating agencies to do business with, and because the agencies depended on the issuers for
their revenues, rating agencies felt pressured to remain competitive with favorable ratings.
The pressure on raters was also intense as a result of the high turnover – a revolving door that
often left raters dealing with their old colleagues, this time as clients. In her interview with FCIC
staff, Yuri Yoshizawa, a Moody’s team managing director for U.S. derivatives in 2005, was
presented with an organization chart from July 2005.722 She identified 13 out of 51 analysts—
approximately 25% of the staff—who had left Moody’s to work for investment or commercial
banks.723
Brian Clarkson, who oversaw the structured finance group before becoming the president of
Moody’s Investors Service, explained to FCIC investigators that retaining employees was always

720

Staff calculations (see Sean Flynn).

721

Staff calculations (see Sean Flynn).

722

Yuri Yoshizawa, interview with the FCIC, May 17, 2010, pp. 224-228 [ID# 4828-5164-2118]. The July 2005 org
chart is MOODYS-FCIC-0005198 Organization chart for Derivatives (America), Moody’s Investor Service, p. 2.
723

Yuri Yoshizawa, interview with the FCIC, May 17, 2010, pp. 224-228 [ID# 4828-5164-2118].

314

a challenge, for the simple reason that the banks paid more.724 As a precaution, Moody’s
employees were prohibited from rating deals by a bank or issuer while they were interviewing
for a job with that particular institution, but the responsibility for notifying management of the
interview rested on the employee.725 After leaving Moody’s, former employees were prohibited
from interacting with Moody’s on the same series of deals they had rated while employed by
Moody’s, but there were no prohibitions against working on other deals.726
[also ck Stein transcript excerpt in credit hearing record – Phil entered – must be interesting]

SEC: “Voluntary supervision”
The five major U.S. investment banks expanded their involvement in the mortgage and mortgage
securities industries in the early 2000s with little formal regulation beyond their broker-dealer
subsidiaries. In 2002, the European Union told U.S. financial firms they would need a
“consolidated” supervisor by 2004 to continue to do business in Europe, that is, one regulator
that had responsibility for the holding company. The U.S. commercial banks already had their
consolidated supervisor – the Federal Reserve – so they were okay, and the OTS supervision of
AIG would later also meet the Europeans’ standards. The SEC was supervising the securities
arms of the investment banks, but no one supervisor kept track of these companies on a
consolidated basis. All five of the investment banks faced an important decision: Whom would
they prefer as their regulator?
By 2004, the combined assets at the five firms totaled $2.5 trillion, more than half of the $4.7
trillion of assets held by the five largest bank holding companies. In the next three years that
724
725
726

Transcript of FCIC interview with Brian Clarkson, May 20, 2010, pp. 49-50 [ID# 4828-6796-4934].
Transcript of FCIC interview with Brian Clarkson , May 20, 2010, pp. 54-55 [ID# 4828-6796-4934].
Transcript of FCIC interview with Brian Clarkson , May 20, 2010, pp. 51-52 [ID# 4828-6796-4934].

315

figure would grow to $4.2 trillion. Morgan Stanley was the largest, followed by Merrill and
Goldman, then Lehman and Bear. These large, diverse international firms had transformed their
business models over the years. They relied more and more for their revenues on trading,
investments, securitization and similar activities, on top of their traditional investment banking
functions. Recall that at Bear Stearns, trading and investments accounted for more than 100% of
pretax earnings in some years after 2002.727
The investment banks also owned depository institutions that allowed them to provide FDICinsured accounts to their brokerage customers; the deposits provided cheap but limited funding.
These depositories took the form of a thrift (supervised by the OTS) or an industrial loan
company (supervised by the FDIC and a state supervisor).728 Merrill Lynch had the largest of
both types among the five large investment banks: at their peak at the end of 2007, Merrill’s
thrift had $38 billion in assets and its industrial loan company had $78 billion. Prior to the crisis,
Morgan Stanley’s industrial loan company was as big as $39 billion and Lehman’s thrift was as
big as $24 billion. Merrill and Lehman used these subsidiaries to finance their mortgage
origination activities.

727

Proxies

728

The OTS supervises thrifts and their holding companies on a consolidated basis. Major financial institutions that
owned subsidiaries with thrift charters prior to the crisis included AIG, GE Capital, Merrill Lynch, Lehman
Brothers, and Morgan Stanley. The main purpose of thrifts, formerly known as savings and loans, was originally to
extend residential mortgages. Several states also allow depository institutions to organize as “industrial loan
companies” or ILCs. While ILCs are supervised by their state bank regulator and by the FDIC, ILCs can be owned
by financial or nonfinancial firms that are not supervised or regulated on a consolidated basis by the Federal
Reserve. Prior to the crisis, large institutions with ILCs included financial firms such as Merrill Lynch, Morgan
Stanley, Goldman Sachs, and Discover Financial Services, and nonfinancial firms such as General Motors and
Target. These companies used their ILCs for access to the payments system or to provide insured deposit services to
their customers. Since the financial crisis, most of the largest ILCs have converted to regular bank charters
(including those owned by Morgan Stanley, Discover, GMAC, American Express, and Goldman Sachs) and are now
being supervised by the Federal Reserve on a consolidated basis.

316

Because of those depository subsidiaries, the investment banks had two obvious choices when
they were faced with the need for a consolidated supervisor. If they chartered their depository as
a commercial bank, the Fed would be their holding company supervisor; if they chartered it as a
thrift, the OTS would do the job. But the investment banks came up with a third option. They
lobbied the SEC for a system of regulation that would satisfy the terms of the European directive
and not subject them to consolidated European oversight729 – and the SEC was willing to step in,
although it did not have a history as a safety-and-soundness supervisor. Its focus instead was on
investor protection.
In November 2003, almost a year after the announcement from the Europeans, the SEC proposed
the creation of the Consolidated Supervised Entity (CSE) program to oversee the holding
companies of investment banks and all their subsidiaries.

The CSE program was only open to

investment banks that had large US broker-dealer subsidiaries already subject to SEC
regulation.730 However, this was the SEC’s first foray into supervising firms for safety and
soundness, beyond protection of customer funds. The SEC did not have express legislative
authority to require the investment banks to submit to consolidated regulation, 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 investment banks.731 The proposed program would
apply to broker-dealers that volunteered to be subject to consolidated supervision under the CSE
program, or those that already were subject to supervision by the Fed at the holding company

729

FCIC Interview with Harvey Goldschmid; FCIC Interview with Annette Nazareth.

730

CSE firms had to have a principal US broker dealer with over $5 billion in tentative net capital (regulatory net
capital, less deductions of illiquid assets).
731

Following the repeal of the Glass-Steagall Act in 1999, the SEC unsuccessfully asked Congress to empower it to
monitor investment bank holding companies.

317

level, such as JP Morgan and Citigroup. 732 The CSE program would introduce a limited form of
supervision by SEC examiners. CSE firms were allowed to use a new methodology to calculate
the regulatory capital they were holding against their securities portfolios—a methodology,
based on the volatility of market prices. This methodology, referred to as the “alternative net
capital rule,” would be similar to the standards that large commercial banks and bank holding
companies used for their securities portfolios based on the 1996 Market Risk Amendment to the
Basel rules.733
The traditional net capital rule that had governed broker-dealers since 1975 had required
straightforward calculations based on asset classes and credit ratings, a bright-line approach that
gave firms little discretion in calculating their capital. The new rules would allow the investment
banks to create their own proprietary value-at-risk (VaR) models to calculate their regulatory
capital, that is, the capital they would have to hold to protect their customers’ assets in the event
the firm experienced losses on its securities and derivatives.734,735 All in all, the SEC estimated
that the proposed new reliance on proprietary value-at-risk models would allow broker-dealers to

732

CSE firms had to have a principal US broker-dealer with over $5 billion in tentative net capital (regulatory net
capital, less deductions of illiquid assets).
733

Alternative Net Capital Requirements for Broker-Dealers, 68 Fed. Reg. 62872 (Nov. 6, 2003). The minimum
regulatory net capital requirement for CSE firms was the higher of: (1) $1 billion in tentative capital; (2) $500
million in net capital; or (3) 2% of its aggregate debit items, which generally are obligations of customers to the
broker-dealer (e.g. margin loans).

734

Id. The Alternative net capital rule adopted by the CSE Rules is consistent with International Basel standards

735

Minimum tentative capital requirements and maximum leverage components were unchanged relative to the
traditional net capital rule. Tentative net capital is net capital minus deductions for illiquid assets. What changed is
how net capital was calculated, i.e., what haircuts were applied to the firms’ assets to compensate for their respective
levels of risk. Under the traditional rule, the haircuts were set forth in the SEC regulations. Under the CSE
program, firms’ were permitted to develop and use their own models to determine the appropriate risk weighting of
their assets.

318

reduce average capital charges by 40%.736 The firms 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 $5
billion at any time.
Meanwhile, the Office of Thrift Supervision already supervised the thrifts owned by several
securities firms and argued that it therefore was the natural supervisor of their holding
companies. The OTS was harshly critical of the SEC proposal,737 which it said had “the
potential to duplicate or conflict with OTS’s supervisory responsibilities” over savings and loan
holding companies that would also be CSE entities.738 The OTS argued that the SEC was
interfering with the intentions of Congress, which, in the Gramm-Leach-Bliley Act, “carefully
kept the responsibility for supervision of the holding company itself with the OTS or the Federal
Reserve Board, depending upon whether the holding company was a [thrift holding company] or
a bank holding company. This was in recognition of the expertise developed over the years by
these regulators in evaluating the risks posed to depository institutions and the federal deposit
insurance funds by depository institution holding companies and their affiliates.” In a letter to
the SEC, the OTS said, “[W]e believe that the SEC’s proposed assertion of authority over
[savings and loan holding companies] is unfounded and could pose significant risks to these
entities, their insured deposit institution subsidiaries and the federal deposit insurance funds.”739

736

Id. The Final Rule release states: “We expect that use of the alternative net capital computation will reduce
deductions for market and credit risk substantially for broker-dealers that use that method.” Id.
737
Letter from the Office of Thrift Supervision to the SEC, (Feb. 11, 2004) (available at
http://www.sec.gov/rules/proposed/s72103/ots021104.htm).
738

Letter from the Office of Thrift Supervision to the SEC, (Feb. 11, 2004) (available at
http://www.sec.gov/rules/proposed/s72103/ots021104.htm).

739

Letter from the Office of Thrift Supervision to the SEC, (Feb. 11, 2004) (available at
http://www.sec.gov/rules/proposed/s72103/ots021104.htm).

319

On the other hand, the response from the financial services industry to the SEC proposal, was
overwhelmingly positive, particularly with regard to the alternative net capital computation,
Lehman Brothers wrote that it “applauds and supports the Commission.”740 JP Morgan was
supportive of the rule’s content as an improvement over 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,” the company wrote.741 Deutsche Bank found it to be “a
great stride towards consistency with modern comprehensive risk management practices.”742 In
FCIC interviews, SEC officials and executives at the investment banks stated that the firms
preferred the SEC because it was more familiar with their core securities related businesses.
In April, 2004, at a meeting, SEC commissioners voted unanimously to adopt the CSE program
and the new net capital calculations that went along with it.743 Over the following year and a
half, the five largest investment banks volunteered for this supervision, although Merrill’s and
Lehman’s thrifts continued to be supervised by the OTS. Several firms delayed entry to the
program in order to develop systems that could measure their exposures to market price
movements.
Former SEC Commissioner Harvey Goldschmid told FCIC staff that, prior to the creation of the
CSE program, SEC staff were concerned about how little authority they had over the Wall Street

740

Letter from Lehman Brothers, Inc. to the SEC, (Mar. 8, 2004) (available at
http://www.sec.gov/rules/proposed/s72103/lehmanbrothers03082004.htm).
741

J.P. Morgan Chase, supra note 12.

742

Letter from Deutsche Bank A.G. and Deutsche Bank Secs. to the SEC, (Feb. 18, 2004) (available at
http://www.sec.gov/rules/proposed/s72103/deutsche021804.htm).
743

SEC Press Release, SEC Proposes Thrift Exception from Advisors Act, Comprehensive Disclosure Requirements
for Asset Backed Securities; Adopts Supervision Programs for Broker-Dealers and Affiliates (April 28, 2004).

320

firms, including their hedge funds and overseas subsidiaries. With the CSE program, the SEC
“had the authority to look at everything.”744 SEC Commissioners discussed at the time the risks
they were taking by allowing firms to reduce their capital. “If anything goes wrong it’s going to
be an awfully big mess,” Goldschmid said at a 2004 Commissioners meeting. “Do we feel
secure if these drops in capital and other things [occur] we really will have investor
protection?”745 In response, Annette Nazareth, the SEC official who would be in charge of the
program, assured the Commission that her division was up for the challenge.
The new program was primarily housed in the SEC’s Office of Prudential Supervision and Risk
Analysis, an office with a staff of 12 within the Division of Market Regulation.746 In the
beginning, it was supported by the SEC’s much larger examination staff; by 2008 the staff
dedicated to the CSE program had grown to 24.747 Still, only 10 “monitors” were responsible for
the five investment banks, with a total of $4.2 trillion in assets. The monitors doubled up, with
three assigned to each firm.748
The CSE program was based on the bank supervision model,749 but the SEC did not try to do
exactly what bank examiners did.750 For one thing, unlike supervisors of large banks, the SEC

744
745

FCIC Interview of Harvey Goldschmid.744 Id.
Closed meeting of the Securities and Exchange Commission, April 28, 2004.

746

In 2005, the Division of Market Regulation became the Division of Trading and Markets. To avoid confusion, it
is referred to as the Division of Market Regulation throughout this report.

747

FCIC Interview with Annette Nazareth. Although there are more than 1,000 SEC examiners, collectively they
regulate more than 5,000 broker-dealers, with more than 750,000 registered representatives, as well as other market
participants.
748

Id.

749

FCIC Interview Annette Nazareth; FCIC Interview Erik Sirri.

321

never assigned on-site examiners under the CSE program; for comparison, the OCC alone
assigned more than 60 examiners full time at Citibank. According to Erik Sirri, former director
of trading and markets, the CSE program was intended to focus primarily on liquidity because,
unlike a commercial bank, a securities firm traditionally had no access to a lender of last
resort.751 (Of course, this would change during the crisis.) The investment banks were subject to
an annual examinations, during which staff reviewed the firms’ systems and records and verified
that the firms had control processes.752
The CSE program was troubled from the start. The SEC conducted an exam for each investment
bank when it entered the program. The result of Bear Stearns’s entrance exam, in 2005, showed
several deficiencies. These included a lack of firm-wide value-at-risk limits and a concern that
contingency funding plans relied on overly optimistic stress scenarios. In addition, the SEC was
aware of the firm’s concentration of mortgage securities and its high leverage. Nonetheless, the
SEC did not ask Bear to change its asset balance, decrease its leverage, or increase its cash
liquidity pool, all well within its prerogative, according to SEC officials. Then, because of a
staff reorganization at the CSE program, Bear did not have its next annual exam, where the SEC
was supposed to be on-site. The SEC did meet monthly with all CSE firms, including Bear,753
and it did conduct occasional targeted examinations across firms. In 2006, the SEC suggested
that Bear was too reliant on unsecured commercial paper funding. In response, Bear reduced its
750

The monitors met with senior business and risk managers at each CSE firm every month about general concerns
and risks the firms were seeing. Written reports of these meetings were given to the Director of Market Regulation
every month. In addition, the CSE monitors met quarterly with the treasury and financial control functions of each
CSE firm to discuss liquidity and funding issues.
751

FCIC Written testimony of Erik Sirri, dated May 10, 2010.

752

FCIC interview with SEC Associate Director Michael Macchiaroli.

753

FCIC interview with Michael Macchiaroli, April 13, 2010.

322

exposure to unsecured commercial paper and increased its reliance on secured repo lending.
Unfortunately, tens of billions of that repo lending was overnight funding that could disappear
with little warning. Ironically, the second week of March 2008, when the firm went into its fourday death spiral, the SEC was on site conducting its first CSE exam since Bear’s entrance exam
more than two years earlier.
Leverage at the investment banks increased from 2004 to 2007, which some critics have blamed
on the SEC’s change in the net capital rules.754 Former SEC Commissioner Goldschmid told the
FCIC that the increase owed to “a wild capital time and the firms being irresponsible.”755 In fact,
leverage had been higher at the five investment banks in the late 1990s. It had then dropped
before increasing over the life of the CSE program. The high level of leverage before the
introduction of the CSE program suggests that the program was not solely responsible for the
changes.756 The SEC also noted that under the CSE program the investment banks’ net capital
levels, as measured by [XXX], “remained relatively stable and, in some cases, increased
significantly” over the program.757 Still, Goldschmid, who left the SEC in 2005, argued that the
SEC had the power to do more to rein in the investment banks, saying “There was much more
than enough moral suasion and kind of practical power that was involved…The SEC has the
practical ability to do a lot if it uses its power.”

754

Lee Pickard, former Director of the SEC’s Division of Market Regulation when the 1975 net capital rule was
promulgated said: “The SEC modification in 2004 is the primary reason for all of the losses that have occurred.”
Julie Satow, Ex-SEC Official Blames Agency for Blow-Up of Broker-Dealers, NY Sun, (September 18, 2008).
755
FCIC Interview with Harvey Goldschmid. Transcript dated April 8, 2010.
756

GAO-09-739, Financial Markets Regulation: Financial Crisis Highlights Need to Improve Oversight of Leverage
at Financial Institutions, (July 2009).
757

Id.

323

Overall, the CSE program was widely viewed as a failure. From 2004 until the financial crisis,
all five investment banks continued their spectacular growth, relying heavily on short-term
funding. Former SEC Chairman Christopher Cox called the CSE supervisory program
“fundamentally flawed from the beginning.”758 Sitting SEC Chairman Mary Schapiro concluded
that the program “was not successful in providing prudential supervision.”759 And, as we will see
in the chapters ahead, the SEC’s Inspector General would be quite critical, too. In September
2008, in the midst of the financial crisis, the CSE program was discontinued after all five of the
largest 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 with Goldman and Morgan
Stanley. Fed officials had seen their agency’s regulatory purview shrinking over the course of
the 2000s as JP Morgan switched the charter of its banking subsidiary to the OCC760 and as the
OTS and SEC promoted their alternatives for consolidated supervision.761 “The OTS and SEC
were very aggressive in trying to promote themselves as a regulator in that environment and
wanted to be the consolidated supervisor to meet the requirements in Europe for a consolidated
supervisor,” said Mark Olson, a Fed Governor from 2001 to 2006. “There was a lot of
competitiveness among the regulators.” In January 2008, Fed staff had prepared an internal

758

Press Release “Chairman Cox Announces End of Consolidated Supervised Entities Program,” September 26,
2008 available at http://www.sec.gov/news/press/2008/2008-230.htm.

759

First Public Hearing of the Financial Crisis Inquiry Commission (January 14, 2010) (testimony of Chairman
Mary Schapiro) available at http://fcic.gov/hearings/pdfs/2010-0114-Transcript.pdf.

760

The Fed remained the supervisor of JP Morgan at the holding company level.

761

FCIC Interview with Mark Olson, October 4, 2010.

324

study to find out why none of the investment banks had chosen the Fed as its consolidated
supervisor.762 The staff interviewed five firms that already were supervised by the Fed and four
that had chosen the SEC. According to the report, the biggest reason firms opted not to be
supervised by the Fed was the “comprehensiveness” of the Fed’s supervisory approach,
“particularly when compared to alternatives such as Office of Thrift Supervision (OTS) or
Securities & Exchange Commission (SEC) supervision.”763

762

Bank holding companies that meet certain capital, managerial, and other requirements may elect to become
financial holding companies and thereby engage in a wider range of financial activities than they could otherwise,
including full‐scope securities underwriting, merchant banking, and insurance underwriting and sales.
763
Federal Reserve System, Financial Holding Company Project, January 25, 2008.

325

326

CHAPTER CONCLUSIONS HERE

327

Part II, Chapter 4: “The madness”
Table of Contents
Chapter II-4: “The madness” ................................................................................................................... 328
The bubble: “It’s not going to be pretty” ............................................................................................. 330
Monitoring fraud: “” [To Come] ........................................................................................................... 334
Disclosure and Due Diligence: “A quality control issue in the factory”” ............................................ 334
Regulators: “Risk-focused”.................................................................................................................. 346
Leveraged loans and commercial real estate: “You’ve got to get up and dance” ................................ 352
Lehman: From “moving” to “storage” ................................................................................................. 358
GSEs: “Two stark choices” .................................................................................................................. 361

In 2003, Bakersfield, California homebuilder Warren Peterson was paying as little as $35,000
for a 10,000-square-foot lot, about the size of three tennis courts. The next year the tab had more
than tripled to $120,000 as real estate boomed. And nowhere did it boom more than Bakersfield,
a city at the southern end of the state’s agricultural center, the San Joaquin Valley. Over the
previous quarter-century, Peterson had built between three and 10 luxury homes a year. For a
while, he was building as many as 30.764 And then came the crash.
“I have built exactly one new home since late 2005,” he told the FCIC five years later.765
In 2003, the average [new] house in Bakersfield cost $155,000. That would jump by a third in
2004 and by another third in 2005, peaking in June, 2006 at almost $300,000. 766“By 2004,
764

Lloyd E Plank, broker, written testimony Bakersfield Field Hearing 7 Sept 2010.

765

Warren Peterson testimony Bakersfield Field Hearing 7 Sept 2010.

766

Crabtree written testimony p 1-2.

328

money seemed to be coming in very fast and from everywhere,” said a Bakersfield real estate
broker. Investors looking to make quick profits inundated the nation’s 58th-largest city. “They
would purchase a house in Bakersfield, keep it for a short period and resell it. Sometimes they
would flip the house while it was still in escrow, and would still make 20% to 30%.”
Nationally, housing prices jumped 152% between 1997 and the peak in 2006; that’s more than
they had in any previous decade going back to at least 1920.767 It would all be catastrophically
downhill from there – yet the mortgage machine kept churning out product well into 2007,
apparently indifferent to the increasingly obvious fact that housing prices were now starting to
fall and lending standards had deteriorated, that ubiquitous newspaper stories highlighted the
weakness in the housing market – even the possibility that this was a bubble that could burst at
any moment.
There were checks in the system, but they were failing. Lending standards collapsed – both for
the roughly three-quarters of mortgages that were bound for the securitization pipeline and for
the one-quarter bound for banks’ balance sheets. Mortgage originators overruled or ignored their
own fraud departments in the name of maintaining volume. Loan purchasers and securitizers
ignored their own due diligence about the quality of what they were buying. The Fed and the
other regulators increasingly recognized the impending troubles in housing but thought the
impacts would be contained. At the same time, the combination of increased securitization,
lower underwriting standards, and easier access to credit – all in the face of other rising asset

767

Recent data are based on the CoreLogic Single Family Combined (SFC) Home Price Index, available at
http://www.corelogic.com/Products/CoreLogic-HPI.aspx#container-ProductDetails, Data accessed August 2010.
FCIC calculation of change from January 1997 to April 2006, peak. Earlier data are based on the Case-Shiller
Home Price Index, which goes back to 1920. As a percentage jump, the increase in home prices at the end of World
War II was about as great as the increase that peaked in 2006.

329

prices – was now common in markets removed from home mortgages. Credit was flowing in
commercial real estate markets and in the market for other forms of corporate loans. Companies
now had decisions to make. How to react to what appeared more and more to be a broad credit
bubble? Many companies, such as Lehman, Fannie Mae, and others, chose to push deeper.
All along the assembly line, from the origination of the mortgages to the creation and marketing
of the mortgage-backed securities and CDOs, many players understood and the regulators at least
suspected that every cog of the machine was reliant on the mortgages themselves, which would
prove not be trusted to perform as advertised.
Lewis Ranieri called the willing suspension of disbelief “the madness.” He told the FCIC, “You
had the breakdown of the standards, which first come in the [nonprime mortgage-backed
securities], then they spread to the prime and the agencies, because you break down the checks
and balances that normally would have stopped them. One of [those breakdowns] is the CDO,
which takes away the last of the defenses on who’s protecting the bondholder.” Madness in the
CDO market is the subject of our next chapter, but Ranieri’s point was clear: as the securitization
market grew riskier, people were in danger of losing their homes. The fates of Wall Street and
Main Street had become entwined.768

The bubble: “It’s not going to be pretty”
In September 2005 – seven months before the housing market would hit its official peak –
thousands of originators, securitizers, and investors met at the ABS East 2005 conference in
Boca Raton, Florida, to play golf, do deals, and talk about the market. Business was still good,
but even the most committed optimists could read the signs. Panelists expressed three top
768

FCIC interview with Lewis Ranieri, July 30, 2010.

330

concerns: Were housing prices overheated or just driven by “fundamentals” such as mortgage
market improvements and increased demand from home buyers? Would rising interest rates halt
the market? And was the CDO, because of its ratings-driven investors, distorting the mortgage
market?769
Without a doubt, the numbers were stark. Nation-wide, house prices had never risen so far, so
fast. And prices rose much more dramatically in some markets than others; the national indexes
mask this important variation. House prices in the four sand states, and especially California, had
dramatically larger spikes – and subsequent declines – than did the nation as a whole.
The variety of price appreciation among the states was also mirrored internationally. Countries
such as the UK and Ireland, in particular, experienced dramatic increases in home prices from
1997 to 2007, followed by large declines. Some other countries, however, did not experience a
bubble. Canada, for example, experienced steady but moderate increases over the period with
housing prices flattening and then only slightly declining in 2009. Researchers at the Cleveland
Fed found that Canada’s experience owed to tighter lending standards than in the U.S.770
Economists and policy makers everywhere struggled to explain the price increases. The good
news was that the economy was growing with low unemployment. A Federal Reserve study in
May 2005 presented evidence that it had become much more expensive to own than to rent
relative to the historical relationship: home prices had risen from 20 times the annual cost of
renting to 25 times.771 The change was particularly dramatic in some cities. From 1997 to 2006,
769

Nomura Securities, Notes from Boca Raton, ABS East, September 30, 2005.

770

MacGee, James, “Why Didn’t Canada’s Housing Market Go Bust.” 12/2/2009

771

Morris A. Davis, Andreas Lehnert, and Robert F. Martin, The Rent-Price Ratio for the Aggregate Stock of
Owner-Occupied Housing, Federal Reserve Board, May, 2005.

331

the ratio of house prices to rents rose in Los Angeles, New York, and Miami by 150%, 125%,
and 80%, respectively. In 2006, the National Association of Realtors’ affordability index –
which measures whether a typical family could qualify for a traditional mortgage with a 20%
down-payment on a typical home – had reached a record low.772But that affordability measure
was based on the cost of a traditional mortgage with an obsolete 20% down payment. Perhaps
such measures were no longer relevant when Americans could borrow with one of the now
more-popular alternative mortgages, such as pay-option ARMs and interest-only mortgages, that
had reduced initial mortgage payments. Or perhaps buying a home continued to make financial
sense given homeowners’ expectations of further price gains.
And if there was a bubble, perhaps, as Fed Chairman Alan Greenspan said, it was isolated to
certain regions. He told a Congressional committee in June 2005 that growth in non-prime
mortgages was helping to push home prices in some markets to unsustainable levels, “although a
‘bubble’ in home prices for the nation as a whole does not appear likely.”773 While optimistic
forecasts held by market participants in 2005 turned out to be inaccurate, for many these
forecasts were well considered at the time.774 As one recent study argues, many economists,
“agnostics” on housing, were unwilling to risk their reputations or spook markets by alleging a
bubble without finding support in economic theory. Fed Vice Chairman Donald Kohn was one
such agnostic. “Identification [of a bubble] is a tricky proposition because not all the
772

National Association of Realtors Home Affordability Index, accessed from Bloomberg as composite Index
(AFFDAMOM); US Census Bureau, Household Income, Table H-8 Median Household Income by State: 1984 to
2009, available at http://www.census.gov/hhes/www/income/data/historical/household/index.html, FCIC
Calculations.
773

Greenspan before Joint Economic Committee of Congress 5 June 2005, reported in Washington Post 6 June 2005

774

Gerardi, Kristopher S. Christopher L. Foote, and Paul S. Willen, “Reasonable People Did Disagree: Optimism
and Pessimism about the U.S. Housing Market Before the Crash” Federal Reserve Bank of Boston, Public Policy
Discussion Paper No 10-5, August 12, 2010

332

fundamental factors driving asset prices are directly observable,” Kohn said in a 2006 speech.
“For this reason, any judgment by a central bank that stocks or homes are overpriced is
inherently highly uncertain.”775
But not all economists were hesitant to sound a louder alarm. “[T]he situation is beginning to
look like a credit-induced boom in housing that could very well result in a systemic bust if credit
conditions or economic conditions should deteriorate,”776 FDIC Chief Economist Richard Brown
told colleagues in a March 2005 report. “During the past five years, the average U.S. home has
risen in value by 50 percent, while homes in the fastest-growing markets have approximately
doubled in value.” While this increase might have been explained by strong market
fundamentals, “the dramatic broadening of the housing boom in 2004 strongly suggests the
influence of systemic factors, including the low cost and wide availability of mortgage credit.”
A couple of months later, Fed economists in an internal memo acknowledged the possibility that
housing prices were over-valued but downplayed the potential impacts of a downturn. Even in
the face of a large price decline, many borrowers would not default, given the large equity many
still had in their homes. Structural changes in the mortgage market made a crisis less likely, and
the financial system seemed well capitalized. “Even historically large declines in house prices
would be small relative to the recent decline in household wealth owing to the stock market,” the

775

Donald L. Kohn, Monetary policy and asset prices, March 16, 2006.

776

Richard A. Brown, “Rising Risks in Housing Markets,” memorandum to the National Risk Committee, March
21, 2005, emphasis omitted. Document produced to the FCIC September 22, 2010.

333

economists concluded. “From a wealth-effects perspective, this seems unlikely to create
substantial macroeconomic problems.”777
[add new Fed information re 2005 discussions on housing market]
The Economist in its June 18 to 24, 2005 cover noted that consumer spending and employment
would both be hurt by a collapse in house prices, the lead article warned, “[T]he day of
reckoning is closer at hand. It is not going to be pretty. How the current housing boom ends
could decide the course of the entire world economy over the next few years.”778

Monitoring fraud: “” [To Come]

Disclosure and Due Diligence: “A quality control issue in the factory””
In addition to the incidence of fraud and egregious lending practices, there was an overall
deterioration of lending standards in the final years of the bubble. Subprime loans grew
[XXX%] in 2006. Alt-A loans grew [XXX%] – in particular, option ARMs grew [XXX%] and
no-doc or low-doc loans grew [XXX%]. Overall, by 2006 no-doc or low-doc loans comprised
xx% of all mortgages originated. Many of these products would only perform if prices continued
to rise and the borrower could refinance at a low rate.779
In theory, every participant along the pipeline should have had an interest in the quality of every
underlying mortgage. In practice, their interests were often not aligned. Two New York Fed
777

Board of Governors, memorandum from Josh Gallin and Andreas Lehnert to Vice Chairman Ferguson, “Talking
Points on House Prices,” May 5, 2005. Document produced to the FCIC, September 24, 2010.

778

Economist, June 28-24, 2005.

779

Gary Gorton, The Panic of 2007, August, 2008.

334

economists have pointed out the “seven deadly frictions” in mortgage securitization – places
along the pipeline where one party knew more than the other, creating opportunities to take
advantage.780 For example, the lender who originated the mortgage for sale, earning a
commission, knew a great deal about the loan and the borrower but had no long-term stake in
whether the mortgage paid, beyond the lender’s own business reputation. The securitizer who
packaged mortgages into mortgage-backed securities, similarly, was less likely over the years to
retain a stake in those securities.
The rating agencies were the most important watchdogs over the securitization process. They
described their role as “an umpire in the market.”781 But, they did not review the quality of
individual mortgages in a mortgage-backed security, nor did they check to see that the mortgages
were what the securitizers said they were.
So the integrity of the market depended upon two critical checks. First, firms purchasing and
securitizing the mortgages would conduct due diligence reviews of the quality of mortgage
pools, either using third-party firms or doing the review in-house. Second, following SEC rules,
various parties in the securitization process were expected to disclose what they were selling to
investors. As we will see, both of these checks did not perform as they should have.
Due diligence firms: “Waived-in”
780

The seven are: (1) many mortgage products were complex and subject to misrepresentation by the lender, i.e.,
predatory lending or fraud; (2) the originator knew more about the pool of mortgages than the securitizer; (3) the
securitizer could securitize bad loans at the expense of its lenders or investors; (4) the borrower had an incentive to
not stay current on the mortgage if prices had fallen; (5) the servicer and investor’s interests were not necessarily
aligned; (6) the CDO manager’s incentives were not necessarily aligned with the CDO investors; and, (7) the credit
rating agencies were paid by the securitizers, not the investors. Adam B. Ashcraft and Til Schuermann,
Understanding the Securitization of Subprime Mortgage Credit, 2008.
781

Raymond McDaniel, quoted in MD Town Hall Meeting Survey Results and Transcript, September 11, 2007,
MOODY’S-COGR-0052080 – 0052160, p. MOODY’S-COGR-0052085 [ID# 4820-7781-2487]

335

Investors paid due-diligence firms for independent reviews before bidding for mortgages. A
decade later, as subprime mortgage securitization took off, securitizers, similarly, were willing to
pay for an independent analysis of the mortgage pools that originators were selling them.
The originator and the securitizer negotiated the extent of the due-diligence investigation.782
While the percentage of the pool examined could be as high as 30%, it was often much lower;
according to some observers, as the market grew and origination became more concentrated,
mortgage originators had more bargaining power over the mortgage purchasers, and samples
were sometimes just 5%.783 Some securitizers requested that the due diligence firm analyze a
random sample of mortgages from the pool; others requested a sampling of loans that were most
likely to be deficient in some way, in an effort to efficiently detect more of the problem loans.
The most commonly used third-party due diligence firm hired by securitizers was Clayton
Holdings, based in Connecticut. Clayton handled almost half of the third-party due-diligence
market.784 As Vicki Beal, Vice President of Clayton, explained to the FCIC, these firms 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 whether, among other things, the loans met the
originator’s stated underwriting guidelines and, to some measure, to “negotiate better prices on
pools of loans.”

782

Massachusetts Attorney General’s Comment Letter at p. 9; FCIC interview of Frank Fillips.

783

FCIC interview of FINRA Enforcement officers.

784

FCIC interview of Frank Fillips.

336

The actual review fell into three general classifications: credit, compliance, and valuation.785 Did
the loans meet the underwriting guidelines (generally the originator's standards sometimes with
overlays or additional guidelines provided by the financial institutions purchasing the loans), and
were the loan characteristics reported by the originator accurate?786 Were the loans originated in
compliance with federal and state laws, notably laws regarding predatory-lending prohibitions
and truth-in-lending requirements?787 Were the reported property values accurate?788 One last
review: To the degree a loan was deficient, did it have any “compensating factors” that made up
for these deficiencies? For example, if a loan had a higher loan-to-value ratio than guidelines
called for, did another characteristic such as higher borrower’s income serve as a compensating
factor? The due diligence firm would then grade the loan sample and forward the data to its bank
client. Report in hand, the securitizer would negotiate a price for the pool and could “kick-out”
loans that did not meet the stated guidelines.
Because of the volume of loans Clayton examined during the housing boom, the firm had a
unique inside view of the underwriting standards that originators were actually applying—and
those that the securitizers were willing to accept. At Clayton, loans were classified into three
groups: loans that met guidelines (a Grade 1 Event), those that failed to meet guidelines but were
approved due to compensating factors (a Grade 2 Event) and those that failed to meet guidelines
and were not approved (a Grade 3 Event). Overall, for the 18 months ended June 30, 2007,

785

FCIC interview of Vicki Beal; FCIC interview of Kerry O’Neill; FCIC interview of Joe Swartz; see also,
Massachusetts Attorney General’s Comment Letter at p. 6.

786

FCIC interview of Vicki Beal; FCIC interview of Kerry O’Neill; FCIC interview of Keith Johnson; FCIC
interview of Joe Swartz.

787

Id.

788

Beal testimony from hearing p 117

337

Clayton rated 54% of the 911,039 loans it analyzed as Grade 1, and another 18% as Grade 2 –
for a total of 72% that met the guidelines outright or with or compensating factors. The
remaining 28% of the loans were Grade 3. In theory, the banks could have refused to buy a loan
pool, or, indeed, they could have used the due diligence firm’s findings to probe more deeply the
loans’ quality.789 Over the 18-month period, 39% of the loans that Clayton found to be deficient
– Grade 3 – were waived in, meaning they were [accepted into the pool]. As a result, 11% of the
loans Clayton reviewed were included in mortgage pools despite Clayton finding them
unacceptable.
Clayton
Trending
Reports on
Selected
Financial
Institutions
1Q20062Q2007

789

A. Grade 1
Event &
Grade 2
Event/Total
pool of loans

B. Grade 3
Event/Total
pool of loans

C.
Financial
Institution
waives in
Grade 3
Event loans
waived in

D. Final
loans
rejected
(B-C)

Financial
Institution
Waiver
Acceptance
Rate
(BD)/B

Citigroup

58%

42%

13%

29%

31%

Credit Suisse

68%

32%

11%

21%

33%

Deutsche

65%

35%

17%

50%

Goldman

77%

23%

16%

29%

JP Morgan

73%

27%

14%

13%

51%

Lehman

74%

26%

10%

16%

37%

Merrill

77%

23%

16%

32%

UBS

80%

20%

13%

33%

WaMu

73%

27%

19%

29%

Total Bank
Sample

72%

28%

11%

17%

39%

Angelides q and a with Johnson, Beal at pp xx and pp 146

338

Referring to the percentage of loans that met guidelines outright, Keith Johnson, president of
Clayton from May 2006 to May 2009, told the Commission, “That 54% to me says there [was] a
quality control issue in the factory” for mortgage-backed securities.790 Clayton executives
concluded that their clients’ decisions to waive-in loans were often made to preserve the
securitizer’s business relationship with the loan originator.791 A high number of rejections could
lead the originator to sell the loans to a securitization competitor. Simply put, it was a sellers’
market. “Probably the seller had more power than the Wall Street issuer,” Johnson told the
FCIC.
The high rate of rejections and subsequent waivers may not itself be evidence of something
wrong in the process, Beal testified. She said that as originators’ lending “guidelines were
declining” she saw the securitizing firms introduce additional credit overlays. “As -- you know,
there was stated income, they were telling us look for reasonableness of that income, things like
that.” With tighter overlays, one would expect more rejections, and after the securitizer takes a
closer look at the rejected loans, possibly more waivers. As Moody’s explained in a letter to the
FCIC, “[a] high rate of waivers from an institution with extremely tight underwriting standards
could result in a pool that is less risky than a pool with no waivers from an institution with
extremely loose underwriting standards.”792 Nonetheless, as we discuss below, many

790

P 137 Johnson testimony at line 13-16

791

Id. See also, Massachusetts Attorney General’s Comment Letter, at p. 7, (“At times, however, a sponsor’s
[securitization firm’s] decision to overrule the vendor may be made based on other factors such as the ongoing
business relationship between the investment bank [securitization firm] and the originator. In this relationship, a key
factor is the so-called “pull-through rate”, if the pull-through rate is too low, the originator may decide not to
continue to do business with the investment bank [securitization firm]. In a competitive marketplace, this leads to a
dangerous temptation to purchase flawed loans, particularly flaws that are not identifiable on the typical reports
provided to investors.”
792

Letter to FCIC from Moody’s dated Sept 30, 2010.

339

prospectuses indicated that the loans in the pools either met guidelines outright or had
compensating factors. This, despite the fact that Clayton records show that only a portion of the
loans were sampled, and of those that were sampled, a substantial percentage of Grade 3 Event
loans were waived in.
Johnson said he approached the rating agencies in 2006 and 2007 to gauge their interest in the
exception tracking product that Clayton was developing. Clayton executives said that in 2007
they shared some of the company’s results with the agencies, attempting to convince them that
the data would benefit the ratings process.793 “We told them that we found ‘exceptions’ and we
said, ‘Wouldn’t you like to know this before you rate the loans?’” Beal said. The agencies
thought the due diligence firms’ data was “great” but they didn’t want it, Beal said, because the
data would presumably produce lower ratings for the proposed securitizations, and such lower
ratings would cost the agency business, even in 2007, as the private securitization market was
winding down.794 795
When securitizers did kick loans out of the pools, some originators simply put them into new
pools presumably in hopes that the loans would not be captured in the next pool’s 5% sampling.
The examiner’s report for New Century Financial’s bankruptcy describes such a practice.796 As
another example, the former Regulatory Compliance & Risk Manager at Fremont, Roger Ehrman,
told the FCIC that Fremont had a policy of putting loans into subsequent pools until they were

44
45

796

Report of Michael J. Missal, New Century Bankruptcy Court Examiner, dated February 28, 2007, p.67
340

kicked out three times.797 As Johnson described the practice to the FCIC, is was the “three
strikes, you’re out rule.”798
Some mortgage securitizers did their own due diligence, but seemed to devote only limited
resources to the task. At Morgan Stanley, the head of due diligence was not based in New York
but rather in Boca Raton, Florida. He had, at any one time, two to five direct reports who were
actually employees of a personnel consultant, Equinox, seconded to Morgan Stanley. Deutsche
Bank and JP Morgan also had only small due-diligence teams.799
Banks did not necessarily have better processes for monitoring mortgages that they purchased.
At its hearing on the mortgage business, the FCIC took the testimony of Richard Bowen III, a
whistleblower who had been a senior vice president at [CitiMortgage] in charge of a staff of 200plus professional underwriters. Bowen’s team conducted quality assurance checks on the loans
Citigroup bought from a network of lenders, including both subprime mortgages that Citigroup
intended to hold and prime mortgages that Citigroup intended to sell to the GSEs.
For subprime purchases, Bowen’s team would thoroughly review the physical credit file of the
loans they were purchasing. “During 2006 and 2007, I witnessed many changes to the way the
credit risk was being evaluated for these pools during the purchase processes,” Bowen said. For

797

Staff interview of Roger Ehrman, September 2, 2010. Mr. Ehrman is now an FDIC Examiner in the
greater Los Angeles area.

798

FCIC hearing

799

See also interview of Joseph Scwartz, Deutsche Bank person in charge of mortgage acquisition due diligence,
and interview of William Collins Buell, VI, JP Morgan, head of mortgage acquisition. Third party vendors took
similar steps to cut costs. A large majority of its loan underwriters were independent contractors that only worked
when the vendor had jobs for them to do.

341

example, he said, a chief risk officer in Citigroup’s Consumer Lending business reversed large
numbers of underwriting decisions from “turn down” to “approved.”800
Part of Bowen’s charge was also to supervise the purchase of roughly $50 billion annually in
prime loans pools, a high percentage of which were sold to Fannie Mae and Freddie Mac for
securitization. Bowen’s staff worked with a quality-control sampling that was supposed to
include at least 5% of the total loan pool for a given securitization, but “this corporate mandate
was usually ignored.” Samples of 2% of total loan pools were more likely. Among these, the
loan samples Bowen’s group did examine showed extremely high non-compliance rates. “At the
time that I became involved, which was early to mid-2006, we identified that 40 to 60 percent of
the files either had a ‘disagree’ decision, or they were missing critical documents.”
Bowen repeatedly expressed concerns to his direct supervisor and others regarding the quality
and underwriting of mortgages that CitiMortgage purchased and then sold to the GSEs.73 As we
will see, the GSEs would later put back [billions] of dollars of loans to Citigroup, finding that the
loans Citigroup had sold them did not conform with GSE standards.
SEC: “The elephant in the room is that we didn’t review the prospectus supplements”
By the time the financial crisis hit, investors held more than $2 trillion of non-GSE mortgagebacked securities and close to $700 billion [ck] of mortgage-related CDOs. These securities
were issued with practically no SEC oversight. And only a minority was subject to the SEC’s
ongoing public reporting requirements. The SEC’s mandate is to protect investors – generally
not by reviewing the quality of securities, but simply by mandating adequate disclosures so that
800

Bowen was Senior Vice President and Chief Underwriter for Correspondent and Acquisitions for Citifinancial
Mortgage at Citigroup from 2002 through 2005 and Business Chief Underwriter for Correspondent Lending in the
Consumer Lending Group from 2006 until 2007.

342

investors can make up their own minds. In the case of initial public offerings of a company's
shares, the SEC’s work has historically involved a lengthy review of the issuer’s prospectus and
other “offering materials” prior to sale.
However, with the advent of a new process to register securities on an ongoing basis, called a
shelf registration, the registration process became much quicker for mortgage-backed securities
rated in the highest grades by the rating agencies. The new process allowed issuers to file a base
prospectus with the SEC, giving investors notice that the issuer intended to offer securities in the
future. The issuer then filed a “supplemental prospectus” describing each offering’s terms.
. “The elephant in the room is that we didn’t review the prospectus supplements,” the SEC’s
Deputy Director for Disclosure in Corporation Finance, [name] told the FCIC.801 [Check]
To improve disclosures around mortgage-backed securities, the SEC issued Regulation AB in
late 2004. The regulation required that every prospectus include “a description of the
solicitation, credit-granting or underwriting criteria used to originate or purchase the pool assets,
including, to the extent known, any changes in such criteria and the extent to which such policies
and criteria are or could be overridden.”802
With essentially no review or oversight, how good were disclosures for mortgage-backed
securities? Protected only by the promise of accurate information, how much did investors know
about any breakdowns in due diligence? Prospectuses usually included disclaimers to the effect
that not all mortgages would comply with the lending policies of the originator: “On a case-bycase basis the originator may determine that, based on compensating factors, a prospective

801

FCIC interview of Corporation Finance staff at the SEC.

802

17 CFR PARTS 210, 228, 229, 230, 232, 239, 240, 242, 245 and 249

343

mortgage not strictly qualifying under the underwriting guidelines warrants an underwriting
exception.”803 The disclosure then typically has a sentence that “some,” “a substantial number”
or perhaps “a significant number… of the mortgage loans included in the loan pool will represent
such exceptions.”804 This wasn’t enough, argued Citigroup’s Bowen. “There was no disclosure
made to the investors with regard to the poor underwriting quality of the files they were
purchasing,” he told the FCIC.
Such disclosures would leave investors without sufficient information to know what criteria the
mortgages they were buying did meet. As discussed earlier, only a small portion – as little as 5%
-- of the loans in any deal were sampled for due diligence purposes. Among those, evidence from
Clayton shows that a significant portion of the sampled loans were included in mortgage
securities despite not meeting stated guidelines. For the as-much-as 95% of the mortgage pool
that was not sampled, Clayton and the securitizers had no information about these loans, but
statistically one could expect them to have many of the same deficiencies as the sampled loans.
Prospectuses for investors did not contain this information, or information on how few loans
were reviewed, raising the question of whether the disclosures had a “material omission”
implying a violation of the securities laws.
CDOs were issued under a different regulatory framework from the one that applied to many
mortgage-backed securities, and were not subject even to the minimal shelf registration
803

See Part V of complaint filed by Cambridge Place Investment Management Inc., dated July 9,2010, in Suffolk
County (Massachusetts) Superior Court (hereafter “Cambridge Complaint”) and Part V of complaint filed by
Federal Home Loan Bank of Chicago, dated October 15, 2010, in Circuit Court of Cook County, Illinois (Chancery
Division)(hereafter “FHLBC Complaint”)

804

344

rules. Underwriters typically issued CDOs under the SEC’s Rule 144A, which allows the
unregistered resale of certain securities to so-called qualified institutional buyers, which included
investors as diverse as insurance companies like MetLife, pension funds like the California State
Teachers’ Retirement System, and investment banking firms like Goldman Sachs.805 Publically
traded securities typically have to be registered with the SEC, a time consuming and expensive
process, before they can be sold.
The SEC created Rule 144A in 1990 in order to make U.S. securities markets more attractive to
borrowers and U.S. investment banks more competitive with their foreign counterparts; at the
time, market participants viewed U.S. disclosure requirements as more onerous than those in
other countries. The new rule significantly expanded the market for and liquidity of these
securities by declaring that distributions which complied with the Rule would no longer be
considered “public offerings” and therefore would no longer be subject to the SEC’s registration
requirements under the Securities Act of 1933. In 1996, Congress reinforced the exemption for
private placements with the National Securities Markets Improvements Act, a title Denise Voigt
Crawford, Commissioner on the Texas Securities Board, characterized to the FCIC staff as “a
misnomer if there ever was one.”806 Under this legislation, state securities regulators were
preempted from overseeing private placements such as CDOs.

805

A QIB was defined under Rule 144A to include any “entities, acting for its own account or the accounts of other
qualified institutional buyers, that in the aggregate owns and invests on a discretionary basis at least $100 million in
securities of issuers that are not affiliated with the entity.”
806

Testimony of Denise Voigt Crawford, Commissioner—Texas Securities Board and President of the North
American Securities Administrators Association, Inc.

345

With no registration requirements, a new debt market in the U.S. developed quickly under Rule
144A.807 This market was liquid, as qualified investors could freely trade Rule 144A debt
securities. But the debt securities available when Rule 144A was enacted were not very complex
– they were mostly corporate bonds, very different from the CDOs that came to dominate the
private placement market in the 2000s.
As we will see, after the crisis unfolded, investors would argue that disclosure hadn’t been
adequate and filed numerous lawsuits seeking compensation under federal and state securities
laws. They would allege that sellers of both mortgage-backed securities and CDOs had not
adequately disclosed the nature of these securities, and in some cases these suits have already
resulted in substantial settlements.

Regulators: “Risk-focused”
Where were the regulators? Declining underwriting standards and new mortgage products had
been on regulators’ radar screens for several years before the crisis, but action was delayed
because of regulators’ traditional preference for a “lighter hand” and because of disagreements
among the agencies. 808
Supervisors had, since the 1990s, followed a “risk‐focused” approach that relied extensively on
banks’ internal risk‐management systems.809 “As internal systems improve, the basic thrust of
the examination process should shift from largely duplicating many activities already conducted
within the bank to providing constructive feedback that the bank can use to enhance further the
807

Rule 144A contained provisions which ensured it did not expand to the equity markets where retail investors did
participate.

808

FCIC Interview of Eugene Ludwig, 2010-09-02, transcript, p. 6.
Federal Reserve Board, SR 9724: Risk-Focused Framework for Supervision of Large Complex Institutions,
October 27, 1997.
809

346

quality of its risk‐management systems,” Chairman Greenspan had said in 1999. Across
agencies, there was a “historic vision, historic approach, that a lighter hand at regulation was the
appropriate way to regulate,” former Comptroller of the Currency Eugene Ludwig told the FCIC,
referring to the passage of Gramm-Leach-Bliley.810 The New York Fed, in a “lessons-learned”
analysis after the crisis, pointed to the mistaken belief that “Markets will always self-correct”811
“A deference to the self-correcting property of markets inhibited supervisors from imposing
prescriptive views on banks,” the report said.812
The reliance on banks’ own risk management would extend to capital standards. Banks had
complained for years that the original 1988 Basel standards did not allow banks sufficient
latitude to set capital based on the riskiness of particular assets, and supervisors had noted the
opportunities those standards had created for capital arbitrage. After years of negotiations,
international regulators, with strong Fed support, introduced the Basel II capital regime in June
2004, which would allow banks to lower their capital charges if they could illustrate that they
had sophisticated internal models for estimating the riskiness of their assets. While [never
formally] implemented in the U.S., Basel II reflected and reinforced the supervisors’ riskfocused approach during the 2000s. Rich Spillenkothen, head of bank supervision and regulation
at the Fed from 1991 to 2006, said that one of the supervisors’ biggest mistakes was their
“acceptance of Basel II premises,” which he described as “an excessive faith in internal bank risk
models, an infatuation with the specious accuracy of complex quantitative risk measurement

810

FCIC Interview of Eugene Ludwig, 2010-09-02, transcript, p. 6.
"Federal Reserve Bank of New York: Report on Systemic Risk and Supervision," Draft of August 5, 2009, p. 2.
FRBNY-FCIC-General0079954-0079978, at FRBNY-FCIC-General0079955.
811

812

Federal Reserve Bank of New York: Report on Systemic Risk and Supervision," Draft of August 5, 2009, p. 2.
FRBNY-FCIC-General0079954-0079978, at FRBNY-FCIC-General0079955.

347

techniques, and a willingness (at least in the early days of Basel II) to tolerate a reduction in
regulatory capital in return for the prospect of better risk management and greater risksensitivity.”813
As for the mortgage market, The issue had been on regulators’ radar screens for several years
before the crisis. As early as 2004, they recognized that the nature of mortgage products and
borrowers had changed during and following the refinancing boom of the previous year, and they
began work on providing guidance to banks and thrifts. But too little was done, and too late,
because of interagency discord, industry pushback, and a widely held view that market
participants had the situation well in hand.
“Within the Board, people understood that many of these loan types had gotten to an extreme,”
Susan Bies, then a Fed Governor and chair of the Federal Reserve Board’s subcommittees on
both safety and soundness supervision and consumer protection supervision, told the FCIC. “So
the main debate within the Board was how highly [should we] rein in the abuses that we were
seeing. So it was more of ‘to a degree.’ ”814
John Snow, then Treasury Secretary, told the FCIC that he called a meeting in early 2005 to urge
regulators to address the proliferation of poor lending practices. He said he was struck that
regulators tended not to see a problem at their own institutions. “Nobody had a full 360 degree
view. The basic reaction was, ‘Well, there may be a problem. But it’s not in my field of view,’ ”
Snow told the FCIC. “Our default rate is very low. Our institutions are very well capitalized.

813

Rich Spillenkothen, Notes on the performance of prudential supervision in the years preceding the financial
crisis by a former director of banking supervision and regulation at the Federal Reserve Board (1991 to 2006), May
31, 2010.
814

FCIC interview with Susan Bies, October 11, 2010.

348

Our institutions [have] very low delinquencies. So we don’t see any real big problem.” During
the year, he said, the subject came up at meetings of the President’s Working Group on Financial
Markets on several occasions and participants followed the progress on instituting new
guidance..
In May 2005, the banking agencies did issue guidance on the risks of home equity lines of credit
and home equity loans. The guidance cautioned financial institutions about credit risk
management practices in their home equity lending, particularly interest-only features, limited or
no documentation loans, high loan-to-value and debt-to-income ratios, lower credit risk scores,
greater use of automated valuation models, and increased transactions generated through a loan
broker or other third party.815 While this guidance identified many of the problematic lending
practices engaged in by bank lenders, it was limited in scope to home equity loans and lines. It
did not apply to first mortgages, which make up xx% of mortgage lending to households.
In 2005, examiners from the Fed and other agencies conducted a confidential “peer group” study
of mortgage practices at six companies that had originated a total of $1.3 trillion in mortgages in
2005, almost half of the national total. The group included five banks whose holding companies
were under the Fed’s supervisory purview – Bank of America, Citigroup, Countrywide, National
City, and Wells Fargo – as well as the largest thrift, Washington Mutual. The study “showed a
very rapid increase in the volume of these irresponsible loans, so very risky loans,” Sabeth
Siddique, then head of credit risk at the Federal Reserve Board’s Division of Banking
Supervision and Regulation, told the FCIC.816 In addition to turning over a large percentage of

815

Credit Risk Management Guidance for Home Equity Lending, OCC, FRB, FDIC, OTS, and NCUA (May 16,
2005).
816

FCIC interview with Sabeth Siddique. [Date?]

349

their origination to subprime and Alt-A mortgages, lenders loan underwriting standards for these
products had deteriorated.
Once the Fed and other supervisors had identified the mortgage problems, they agreed to express
those concerns to the industry in the form of nonbinding guidance. “There was among the Board
of Governors folks, you know, some who felt that if we just put out the guidance, the banks
would get the message,” Bies said.”817 [additional Fed info]
The federal agencies issued draft guidance on nontraditional mortgages such option ARMs for
public comment in late 2005.818 The guidance directed lenders to consider a borrower’s ability to
pay based on the rate that they would have to pay when rates adjusted, rather than based on the
(typically low) starting rate. It required lenders to consider a borrower’s ability to make the full
mortgage payment rather than just the minimum payments.819 It warned lenders that reduceddocumentation loans should be “used with caution.”820
The industry was up in arms. In public comments, the American Bankers Association said the
guidance “overstate[d] the risk of non-traditional mortgages;”821 mortgage companies said the
guidance required them to plan for “a worst case scenario,” that is, the scenario in which
borrowers would have to make the full payment when rates adjusted.822 They disputed the
817

FCIC interview with Susan Bies.

818

Interagency Guidance on Nontraditional Mortgage Products, 70 Fed. Reg. 77,249 (Dec. 29, 2005).

819

Interagency Guidance on Nontraditional Mortgage Products, 70 Fed. Reg. at 72,252–53.

820

Interagency Guidance on Nontraditional Mortgage Products, 71 Fed. Reg. at 58,614.

821

Letter from the Am. Bankers Ass’n to Office of Thrift Supervision (Mar. 29, 2006) (available at
http://www.ots.treas.gov/_files/comments/105c90df-b275-4d66-b066-862ad4b72d04.pdf).
822

Letter from Am. Fin. Servs. Ass’n to Office of Thrift Supervision (Mar. 28, 2006) (available at
http://www.ots.treas.gov/_files/comments/d1e85ce1-07ab-4acf-8db5-8d1747afba0a.pdf).

350

warning on reduced-documentation loans, maintaining that “almost any form of documentation
can be appropriate.”823 They disputed the need for better disclosures to protect borrowers from
the risks of nontraditional mortgages,824 arguing that they were “not aware of any empirical
evidence that supports the need for further consumer protection standards.”825 Other comments
highlighted the competitive inequity of cracking down on banks and thrifts while leaving alone
the unregulated mortgage brokers who provided much of the fodder for the mortgage-backed
security and CDO machine.
The need for guidance was controversial within the agencies as well. “We got tremendous
pushback from the industry as well as Congress as well as, you know, internally,” the Fed’s
Siddique told the FCIC. “Because it was stifling innovation, potentially, and it was denying the
American dream to many people.”826
Pressures to weaken and delay the guidance were manifold. Fed Director of Banking Supervision
and Regulation Roger Cole told the FCIC that the OTS delayed the mortgage guidance for
almost a year.827 Susan Bies said, “There was some real concern that if the Fed tightened down
on [banks it regulated] it would create an unlevel playing field [for] stand-alone mortgage

823

Letter from Indymac Bank to Office of Thrift Supervision (Mar. 29, 2006) (available at
http://www.ots.treas.gov/_files/comments/20478116-56b7-4810-938b-60b7688f9652.pdf).

824

The agencies issued model language for these disclosures as a proposed guidance so that financial institutions
need not go through the expense of developing their own disclosures.
825

Letter from the Hous. Policy Council of the Fin. Servs. Roundtable to Office of Thrift Supervision (Mar. 29,
2006) (available at http://www.ots.treas.gov/_files/comments/49524fb0-e29b-423c-9fba-8f2f903082a6.pdf).
826

Id., p. 13

827

Appelbaum & Nakashima (2008); MFR, Interview of Roger Cole, Director of Bank Supervision at the Fed
during 2006-2009 (Aug. 2, 2010), at 91-92.

351

lenders whom the [Fed and other federal bank and thrift regulators] did not regulate.”828 She
added that Congress pushed back on stricter regulation, explaining that the earlier rule on home
equity loans, to which the agencies had agreed, “had members of Congress saying that we were
going to deny the dream of home ownership to Americans if we put this new stronger standard in
place.”829
When guidance was put in place in 2006, Governor Bies explained to the FCIC, regulators
policed their guidance effectively, through bank examinations and informal measures such as
“voluntary agreements” with supervised institutions.830

Leveraged loans and commercial real estate: “You’ve got to get up and dance”
The credit bubble was not confined to the residential mortgage market. The markets for
commercial real estate and leveraged loans (typically loans to below-investment grade
companies to aid their business or to finance buyouts) also experienced similar bubble and burst
dynamics, although the effects were larger and more damaging in residential real estate. From
2000 to 2007, these two markets experienced tremendous growth, spurred by structured finance
products – respectively, commercial mortgage-backed securities and collateralized loan
obligations (CLOs) – with similar characteristics to mortgage-backed securities and CDOs.
Similar to the residential mortgage market, underwriting standards loosened, even as the cost of

828

Bies interview 41 34 onward

829

Bies at 46 32

830

Bies interview at 1 05 06 approx

352

borrowing decreased,831 and trading in these securities was bolstered by the development of new
credit derivative products.
Historically, commercial banks made these loans until a market developed for institutional
investors in the mid to late 1990s. Usually, an “agent” bank would originate a package of loans
to just one company and then sell or syndicate the loans in the package to other banks and large
non-bank investors.832 The package usually included loans with different maturities. Some were
short-term lines of credit, which would be syndicated to banks; the rest were longer-term loans
syndicated to non-bank, institutional investors. Leveraged loan issuance more than doubled from
2000 to 2007, but it was the longer-term loans rather than the short-term lending that grew
rapidly. By 2007, leveraged loans rose to $387 billion, up from was $46 billion in 2000. As the
market grew, securities firms began competing with banks in originating and syndicating these
loans.
Starting in 1998, leveraged loans were packaged in CLOs and the rating agencies used similar
methodologies to rate them as CDOs. Originate-to-distribute was growing–just as it was in the
mortgage market. Like CDOs, CLOs had tranches, underwriters, and collateral managers. The
market was less than $5 billion from 1998 to 2003 but then it started growing dramatically.
Annual issuance exceeded [$40] billion in 2005 and peaked at over [$80] billion in 2007. From
2000 through the third quarter of 2007, over 60% of leveraged loans were packaged into CLOs.

831

The cost of borrowing is reflected by credit spreads, the portion of interest rates that compensate investors for
credit risk. Credit spreads are the interest rates that investors require above the so-called “risk-free” interest rate,
usually measured in terms of Treasuries or interest rate swaps with similar characteristics. [Note to editors: duration
is more precise term than maturity; expected average life is another term that would work but “duration” is a specific
term in finance that applies here.]
832

By the end of the 1990s, leveraged (non-investment grade) loans accounted for a third of all syndicated lending,
compared with only 7% of such lending in 1993.

353

As the market for leveraged loans grew, credit not only became looser, but leverage increased as
well.833 The deals got larger, and interest rates declined. Loans that had paid interest of 4
percentage points over a benchmark rate for prime lending in 2003 were refinanced into loans
paying just 2 percentage points over that same rate in early 2007. During the peak of the
leveraged-buyout boom, leveraged loans were frequently issued with interest-only, “payment-inkind” and “covenant-lite” terms. Payment-in-kind loans allowed borrowers to defer paying
interest by issuing new debt to cover accrued interest. Covenant-lite loans exempted borrowers
from standard loan covenants that usually require corporate firms to limit their other debts and to
maintain minimum levels of cash. Private equity firms, those that specialized in investing
directly in companies, found it easier and cheaper to finance its leveraged buyouts. Just as home
prices rose, so too did the prices for the target companies.
One of the largest leveraged-loan deals ever was announced on April 2, 2007, by KKR, a
private-equity firm. KKR said it intended to purchase First Data Corporation, a huge processor
of electronic data including credit and debit card payments, for about $29 billion. KKR would
issue $8 billion in junk bonds and borrow another $15 billion in leveraged loans from a
consortium of banks including Citigroup, Deutsche Bank, Goldman Sachs, HSBC Securities,
Lehman Brothers, Merrill Lynch and others.
As late as July 2007, Citigroup and others were still increasing their leveraged-loan business.
“When the music stops, in terms of liquidity, things will be complicated. But as long as the
music is playing, you’ve got to get up and dance. We’re still dancing,” Citigroup CEO Charles

833

Leverage as measured by large LBO debt/EBITDA was at 4x in 2002 but increased steadily to over 6x by 2007,
according to S&P/LCD.

354

Prince said in reference to Citi’s leveraged loan business.834 Prince explained that “…at that
point in time, because interest rates had been so low for so long, the private equity firms were
driving very hard bargains with the banks. And at that 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 from this leveraged lending business. It was in that context that I
suggested that all of us, we were all regulated entities, that the regulators had an interest in
tightening up lending standards in the leveraged lending area.”835
The CLO market would seize up in summer of 2007 during the financial crisis just as the muchlarger mortgage-related CDO market seized. The largest originators, such as Citigroup, JP
Morgan, Credit Suisse, and Bank of America and others, would have $[XXX] in outstanding
commitments for new loans that would be made and then, as demand in the secondary market
had dried up, necessarily put on balance sheet.836
Commercial Real Estate: “Risk Management is at the very core of Lehman's business
model”
On October 5, 2007, Lehman Brothers, for which commercial real estate already made up 6.3%
of assets acquired a major stake in Archstone Smith, a publicly traded Real Estate Investment
834

Citigroup chief stays bullish on buyouts” Financial Times, July 9, 2007 http://www.ft.com/cms/s/0/80e2987a2e50-11dc-821c-0000779fd2ac.html
835

FCIC hearing

836

Bank and securities firm underwriters were left holding nearly $400 billion of commitments to provide bridge
financing for LBOs. Underwriters reduced their LBO commitments to $200 billion in early 2008, but they were still
forced to record more than $110 billion of losses related to LBOs by the fall of 2008. [ footnote from Art W: Perre
Paulden & Cecile Gutscher, “Pandit’s ‘Closer to End’ Means No Escaping LBO Loans (Update 3),”
Bloomberg.com, April 29, 2008; Pierre Paulden, “Lenders Squeeze Companies Amid $112 Billion of Losses
(Update 1),” Bloomberg.com, Oct. 7, 2008; Henny Sender, “Debt on Sale: Banks Grease the Leveraged-Loan
Machine,” Wall Street Journal, Oct. 10, 2007.]

355

Trust, for $5.4 billion. Archstone owned over 88,000 apartments, including units still under
construction, in over 340 communities in the United States. It was the bank’s largest commercial
real estate investment.837
Lehman initially projected that Archstone would generate over $1.3 billion in profits over 10
years – optimistic projections based on optimistic assumptions, given the state of the market at
that point. Both Lehman and Archstone were highly leveraged: Archstone had little cushion in
case its rent receipts went down, and Lehman had little cushion if investments such as Archstone
lost value. While Lehman had proclaimed that “Risk Management is at the very core of
Lehman’s business model,” the Executive Committee simply left its risk officer, Madelyn
Antoncic, out of the loop when it made the investment.838 When Lehman would file for
bankruptcy in September 2008, its remaining investment in Archstone was still the largest single
asset on the company’s books [verify].
Commercial real estate – multifamily apartment buildings, office buildings, hotels, retail
establishments, and industrial properties – went through the same kind of bubble as did the
housing market. Investment banks created commercial mortgage-backed securities and even
CDOs out of commercial real estate loans, just as they did with residential mortgages. And, just
as houses appreciated over the 2000s, so too did commercial real estate values. In nominal terms,
office prices rose by nearly 60 percent between 2003 and 2008 on average in the central business

837

Id., at page 356.

838

Madelyn Antoncic, "Lehman Brothers Risk Management," August 7, 2007, LBEX-DOCID 342851, p. 5; and
MFR, FCIC interview with Madelyn Antoncic, July 14, 2010, p. 17.

356

districts of the 32 markets for which data are available.839 The increase was 193% in Phoenix,
153% in Tampa, 147% in Manhattan, and 146% in Los Angeles.840
Issuance of commercial mortgage-backed securities rose from $47 billion in 2000 to $169 billion
in 2005 and peaked at $230 billion in 2007. When securitization markets contracted, issuance
fell to $122 billion in 2008 and $3 billion in 2009. This seems small relative to the [$1.2 trillion]
of residential mortgages that were securitized in private markets in 2007, but these loans were
also moving from being bank financed to the broader capital markets. At the peak in 2007, after
growing for years, about one-fourth of commercial real estate mortgages were securitized.841
That year, securitizers issued $41 billion of commercial mortgage CDOs, a number which again
dropped precipitously in 2008.842
Leveraged loans and the commercial real estate sector came together July 3, 2007. Blackstone
Group announced its plan to buy Hilton – a hotel chain with 2,900 properties – for $26 billion, a
40% premium to where the shares were trading. Writing about the deal, one author described it
as the “apogee of the early-millennial megabuyout frenzy, where cheap and readily available
credit, coupled with a relentless one-upmanship, spurred private equity firms to buy out
companies at often absurd overvaluations, saddle them with massive debt, and then pay
themselves hefty fees for the trouble.” The $20 billion in financing came from the top five
investment banks and large commercial banks such as Bank of America and Deutsche Bank.

839

Gyourko, p. 23.

840

Gyourko, p. 38.

841

CRE Financial Council, Compendium of Statistics, November 5, 2010, Exhibits

842

CRE Financial Council, Compendium of Statistics, November 5, 2010, Exhibit 2.

357

Bear Stearns led the deal, a big coup. While Bear topped the 2006 market in residential
securitizations, it ranked in the bottom half of the commercial space. But Bear was racing to
catch up843 and in a 2007 presentation proclaimed, "In 2006, we firmly established Bear Stearns
as a global presence in commercial real estate finance."844 The firm's commercial real estate
mortgage originations more than doubled between 2004 and 2006.
And then the market crashed to a halt. While, the commercial real estate market was much
smaller than the residential real estate market—in 2008, commercial real estate was less than $4
trillion compared to $12 trillion for residential mortgages845-- the declines were even
steeper. From the peak, commercial real estate declined roughly 45% in value and prices have
remained closer to their lows. Losses on commercial real estate would be an issue across Wall
Street and in particular for Lehman and Bear. And, potentially for the taxpayer. When the
Federal Reserve would assume $30 billion of Bear's illiquid assets in 2008, they would also get
roughly $4 billion in loans from the unsold portion of the Hilton financing package. And, the
commercial real estate market would continue to [decline] long after the housing market had
stabilized.

Lehman: From “moving” to “storage”
Even as the market was close to peaking, Lehman took on more risk. Since the late 1990s it had
built a large mortgage origination arm, with Aurora making Alt-A mortgages and BNC making
subprime loans, a formidable issuance business, and a powerful underwriting division as well.

843

MFR of interview with Tom Marano, p. 11.

844

Jeff Mayer and Tom Marano, "Fixed Income Overview," Bear Stearns, March 29, 2007, p. 18.

845

Joseph Gyourko, "Understanding Commercial Real Estate: Just how Different from Housing is it?" NBER
Working Paper 14708, National Bureau of Economic Research, February 2009, p. 1.

358

Then, in its March 2006 “Global Strategy Offsite,” CEO Richard “Dick” Fuld and other
executives explained to their colleagues a shift toward an aggressive growth strategy, including
greater risk and more leverage.846 They described the shift from a “moving” or securitization
business to a “storage” business in which Lehman made and held longer-term investments.847
By summer 2006, the housing market faced ballooning inventories, sharply reduced sales
volumes, and wavering prices. Lehman saw an opportunity. Lehman’s senior management
regularly disregarded the firm’s risk policies and limits – and warnings from risk managers –
when pursuing its “countercyclical growth strategy.”848 This strategy had worked well during
prior market dislocations. This time, Lehman’s management assumed that the subprime crisis
would not spread to other markets and the economy in general.849 Lehman’s BNC continued to
originate subprime mortgages and its Aurora continued to originate Alt-A loans after the housing
market had begun to show signs of weakening.850 Lehman also continued to securitize mortgage
assets for sale but was now holding more of them as investments. Across both the commercial
and residential real estate sectors, the mortgage-related assets on Lehman’s books increased from

846

Valukas Report at 4; Antoncic MFR at 7; Gelband MFR at ___.

847

Valukas Report at 43.

848

Valukas Report at 46-52. Valukas found that management’s conduct of placing a higher priority on increasing
profits and ignoring risk limits and warnings from risk managers was questionable and raised questions about the
role of risk management at Lehman but concluded the conduct fell within the business judgment rule and did not
give rise to colorable claims for breach of fiduciary duty.
849

Valukas Report at 44-45; 79-80.

850

“Lehman entered subprime lending in 1999, buying a stake in Finance America and made an investment in BNC
Mortgage the next year, before taking full control of those lenders and merging them by 2005, under the BNC
name.” Jody Shenn, “Lehman Said to Return to Mortgage Market Through Aurora Unit,” Bloomberg.com, Oct. 21,
2009.

359

$62 billion in 2005 to $67 billion in 2006 and $111 billion in 2007.851 This strategic decision
would be part of Lehman’s undoing that would come to pass in fall of 2008.
Lehman’s supervisors did not check its rapid growth. The SEC, Lehman’s supervisor, knew of
Lehman’s disregard of risk management. “We found that the SEC was aware of these excesses
and acquiesced,” said the Lehman examiner, hired by the company’s receiver in bankruptcy.
The SEC knew that Lehman continued to increase its holding of mortgage securities, and that it
had increased and exceeded risk limits – facts noted almost monthly in official reports obtained
by the FCIC.852 Nonetheless, Eric Sirri, who led the SEC’s supervision program, told the FCIC
that even if the agency had fully recognized the risks associated with commercial real estate, it
would not have been able to make much difference on Lehman’s strategy at this point. To avoid
serious losses, Sirri maintained Lehman would have had to start selling real estate assets in 2006.
Instead, it kept buying, well into the first quarter of 2008.
The Office of Thrift Supervision also regulated Lehman through its jurisdiction over Lehman’s
thrift subsidiary, Aurora. Although “the SEC was regarded as the primary regulator,” the OTS
examiner told the FCIC, “[w]e in no way just assumed that [the SEC] would do the right thing,
so we regulated and supervised the holding company.” Still, it would only be in July 2008—just
a few months before Lehman failed – that the OTS would issue a report warning that Lehman
had made an “outsized bet” on commercial real estate – larger than its peer firms, despite
Lehman’s smaller size,853 that Lehman was “materially overexposed” to the commercial real
851

2006 Form 10-K at 90 (Note 2) and 2007 Form 10-K at 103 (Note 3).

852

Footnote all of the monthly reports obtained by FCIC.

853

See Ronald S. Marcus, OTS, Report of Examination Lehman Brothers Holdings Inc. (July 7, 2008), at pp. 1‐2

[LBEX‐OTS 000392].

360

estate sector, and that Lehman had “major failings in its risk management process.” [insert OTS
rating]

GSEs: “Two stark choices”
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 in the market they had created. One sign of the times: Fannie’s
biggest source of mortgages, Countrywide, expanded –meaning loosened--its underwriting
criteria, and Fannie wouldn’t buy the new mortgages, Countrywide president and CEO David
Sambol told the FCIC.854 Typical of the market as a whole, Countrywide sold 72% of its loans
to Fannie in 2003 but only 45% in 2004 and 32% in 2005.855
“The risk in the environment has accelerated dramatically,” Thomas Lund, Fannie’s head of
single-family lending, told fellow senior officers at a strategic planning meeting on June 27,
2005.856 The market was seeing the “proliferation of higher risk alternative mortgage products,
growing concern about housing bubbles, growing concerns about borrowers taking on increased
risks and higher debt, [and] aggressive risk layering.”
“We face two stark choices: stay the course [or] meet the market where the market is,” Lund
said.857 If Fannie Mae stayed the course, it would, according to the presentation, maintain its
854

Transcript of David Sambol Interview at 28. https://vault.netvoyage.com/neWeb2/goId.aspx?id=4821-42242567&open=Y
855

FCIC Preliminary Investigative Report on Countrywide.

856

“Single Family Guarantee Business: Facing Strategic Crossroads.” June 27, 2005, available at the FCIC website,
http://www.fcic.gov/hearings/pdfs/2010-0409-doc-strategic-crossroads.pdf, accessed July 15, 2010. Punctuation has
been changed from the original.
857

Id. at FM-COGR00088745.

361

credit discipline, protect the quality of its book, preserve capital, and intensify the company’s
public concerns.858 However, it would also face lower volumes and revenues, continued market
share declines, lower earnings, and a weakening of key customer relationships.859 It was simply
a matter of relevancy, former CEO Dan Mudd told the FCIC: “If you’re not relevant, you’re
unprofitable, and you’re not serving the mission. And there was danger to profitability. I’m
speaking more long-term than in any given quarter or any given year. So this was a real strategic
rethinking.”
Lund saw significant obstacles to meeting the market. He noted Fannie’s lack of capability and
infrastructure to structure the types of riskier mortgage-backed securities Wall Street offered, its
unfamiliarity with the new credit risks, concerns that the price of the mortgages wouldn’t be
worth the risk, and regulatory concerns surrounding certain products.860 At this and other
meetings, Lund recommended studying whether the current market changes were cyclical or
more permanent, but he also recommended that Fannie “dedicate significant resources to develop
capabilities to compete in any mortgage environment.” Citibank executives also made a
presentation to Fannie’s board in July, 2005, warning that Fannie was increasingly at risk of
being marginalized, and that the “stay the course” option was actually not an option. Citibank
proposed that Fannie expand its guarantee business to cover non-traditional products such as AltA and subprime mortgages.861 Of course, as the second largest seller of mortgages to Fannie,

858

Id. at FM-COGR00088746.

859

Id. at FM-COGR00088748.

860

Id. at FM-COGR00088749.

861

FM-COGR00143219-238 at 222-223.

362

Citibank would benefit from such a move.862 Over the next two years, it would turn out that
Citibank would increase its sales to Fannie by almost a third, to $56 billion [over that period] ,
while nearly tripling its sales of interest-only mortgages.863
In 2006, Lund told the FCIC that the Board would adopt his recommendation: for now, they
would “stay the course,” while developing capabilities to compete with Wall Street in non-prime
mortgages later on.864 In fact, however, Fannie internal reports show that by September 2005,
the company had already begun to increase its acquisitions of riskier loans with the goal to
increase market share. By the end of 2005, its Alt-A loans were $181 billion, up from $147
billion in 2004 and $138 billion in 2003; its loans without full documentation were $278 billion,
up from $200 billion in 2003; and its interest-only mortgage were $75 billion in 2005, up from
$12 billion in 2003. (Note that these categories can overlap. For example, Alt-A loans may also
not have full documentation.) To cover potential losses from all of its business activities,, Fannie
had a total of $40 billion in capital at the end of 2005. “[P]lans to meet market share targets
resulted in strategies to increase purchases of higher risk products, creating a conflict between
prudent credit risk management and corporate business objectives,” FHFA, OFHEO’s successor
would write in September, 2008 on the eve of the government takeover of Fannie Mae. “Since
2005, Fannie Mae has grown its Alt-A portfolio and other higher risk products rapidly without

862

FM-FCIC-00030208

863

FM-FCIC-00030218, FM-FCIC-00030867, FM-FCIC-00030221

864

Interview with Lund.

363

adequate controls in place.”865 In addition, as noted, by 2005, Fannie had purchased $45 billion
in non-GSE mortgage-backed securities backed by subprime and Alt-A mortgages.866
[insert information on how these statistics were reported contemporaneously]
Similarly, Freddie had grown its portfolios quickly with limited capital.867 In 2005, CEO
Richard Syron fired David Andrukonis, Freddie’s longtime Chief Risk Officer, after he voiced
concerns about Freddie’s increasing purchases of Alt-A and other non-traditional mortgages.
Syron told the FCIC that “I had a legitimate difference of opinion on how dangerous it was.
Now, as it turns out… he was able to foresee the market better than a lot of the rest of us
could.”868 The new risk officer, Anurag Saksena, told FCIC staff that he repeatedly argued for
increasing capital to compensate for the increasing risk,869 although Donald Bisenius, Freddie’s
Executive Vice President for Single Family Housing, told FCIC staff that he did not recall
that.870 Syron never made Saksena part of the senior management team.

865

9/6/08 memo at 14.

866

FM-FCIC-N_00003-4 (produced by Fannie Mae 3/24/2010, on NetDocuments
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4832-2397-6711&open=Y).
867

OFHEO reported that Freddie’s purchases began in the fourth quarter of 2003. By 2005, with capital of only
[$XXX billion], Freddie held $173 billion in loans with FICO scores below 660, almost five times its capital; $80
billion in high loan-to-value loans; and $93 billion in loans for investment and for vacation homes. OFHEO reported
a “dramatic increase in hybrid option ARMs and affordability products with no historical performance data.”
Source: 2005 Exam report at 8-9. And Freddie purchased even more non-GSE mortgage backed securities than
Fannie – by 2005, a total of $232 billion. Source: 2006 Freddie Mac Form 10-K at Page 116.

868

Syron Interview, August 31, 2010 (transcript) at 130. Doc. ID - 4851-6887-5783, v. 1

869

Saaksena interview, MFR June 22, 2010

870

Interview with Donald Bisenius, Freddie Mac, [recording at 55 minutes]; see also Syron interview (transcript)

364

OFHEO, the companies’ regulator, noted the GSEs’ increasing purchases of riskier loans and
securities in every examination report. But OFHEO never told the GSEs to stop. Rather, year
after year, the regulator said that both companies had adequate capital, strong asset quality,
prudent credit risk management, and qualified and active officers and directors.
In May 2006, at the same time as it paid the $400 million penalty related to deficiencies in its
accounting practices, Fannie agreed to limit its on-balance-sheet mortgage portfolio to $728
billion, the level on December 31, 2005. Two months later, Freddie agreed to limit the growth of
its portfolio to 2% per year. In May, 2006 special examination reports to both companies,
OFHEO noted the growth in purchases of risky loans and non-GSE securities but said that the
two companies were managing their risks well.
OFHEO pinned many of the GSEs’ problems on their corporate cultures. Its May, 2006
examination report on Fannie Mae detailed the “arrogant and unethical corporate culture where
Fannie Mae employees had manipulated accounting and earnings to trigger bonuses for senior
executives from 1998 to 2004.”871 OFHEO Director James Lockhart (who had assumed that
position the month the report was issued) recalled discovering an email during the special
examination from Mudd, then Fannie’s chief operating officer, to CEO Franklin Raines. Mudd
wrote, “The old political reality [at Fannie] was that we always won, we took no prisoners…we
used to…be able to write, or have written rules that worked for us.”872
Soon after his arrival, Lockhart began advocating for reform. “The need for legislation was
obvious. OFHEO was regulating two of the largest and most systematically important US

871

5/23/06 press release at http://www.fhfa.gov/webfiles/2095/52306fnmserelease.pdf.

872

Lockhart written testimony at 2.

365

financial institutions,” he told the FCIC. But no reform legislation would be passed until July
30, 2008, and by then it would be too late.
2006: “Increasing penetration into subprime”
After several years of purchasing riskier loans and securities, Fannie Mae Chief Financial Officer
Robert Levin reported a strategic initiative to “increase penetration into subprime” at Fannie’s
January 2006 board meeting. The next month the board gave its approval. Fannie would
become more and more aggressive in its purchases. During a summer retreat for Fannie’s senior
officers, Stephen Ashley, the Chairman of the Board, introduced Fannie's new chief risk officer,
Enrico Dallavecchia, saying that the new CRO would not stand in the way of risk-taking:
“We have to think differently and creatively about risk, about compliance,
and about controls. Historically these have not been strong suits of Fannie
Mae...Today’s thinking requires that these areas become active partners
with the business units and be viewed as tools that enable us to develop
product and address market needs. Enrico Dallavecchia was not brought
on-board to be a business dampener.”873
In 2006, Fannie acquired $516 billion of loans; of those, including some overlap, $65 billion, or
22%, had combined loan-to-value ratios above 95%, 15% were interest-only, and 28% did not
have full documentation. Fannie also purchased $36 billion of subprime and $12 billion of Alt-A
non-GSE mortgage-backed securities. The total amount of riskier loans represented larger
multiples of capital than before.

873

Remarks Prepared for Delivery by Stephen B. Ashley, Chairman Fannie Mae, Senior Management Meeting,
Cambridge, Maryland, June 27, 2006,” FM-COGR_00051495-00051501.

366

At least initially, with house prices still increasing, the strategic plan to increase risk and market
share appeared to be successful. Fannie reported net income of $6 billion in 2005 and then $4
billion in 2006.874 In those two years, CEO Mudd’s compensation totaled $24.4 million and
CFO Levin received $15.5 million.
In 2006, Freddie Mac also continued to increase risk, “expand[ing] the purchase and guarantee of
higher-risk mortgages … to increase market share, meet mission goals, stay competitive, and be
responsive to sellers’ needs.”875 It lowered its underwriting standards, increasing the use of
credit policy waivers and exceptions. Newer, alternative products offered to a broader range of
customers than ever before, accounted for approximately 24% of purchases. Freddie Mac’s plan
also seemed to be successful. The company increased risk and market share and reported net
income of $2 billion in 2005 and $2 billion in 2006. CEO Richard Syron’s compensation totaled
$23.2 million for 2005. Freddie Chief Operating Officer Eugene McQuade received $13.4
million.876
Again, OFHEO was aware. In March 2007, the regulator found “significant control
deficiencies” in its annual examination of Fannie. OFHEO noted that Fannie’s new initiative to
purchase higher risk products included a plan to capture 20% of the subprime market by 2011.
And, OFHEO reported that weaknesses in several areas of credit risk management and that credit
risk increased “slightly” from growth in subprime and other non-traditional products. But
overall asset quality was “strong,” and the Board members were “qualified and active.” And, of
course, Fannie was “adequately capitalized.”
874

8/16/07 press release at http://www.fanniemae.com/media/pdf/newsreleases/form10k_newsrelease_081607.pdf.

875

2006 Exam report at 8.

876

2006 Proxy, pg 52, 2005 Proxy, pg. 37.

367

Similarly, OFHEO told Freddie in [month], 2007, that it had risk-management weaknesses that
raised some possibility of failure, but that overall, Freddie’s strength and financial capacity made
failure unlikely.877 Freddie did remain a “significant supervisory concern,”878 and OFHEO noted
the significant shift toward higher risk mortgages.879 But again, as in previous years, the
regulator concluded that Freddie was “adequately capitalized,” and its asset quality and credit
risk management were “strong.”880
OFHEO was silent about Fannie’s practice of undercharging for fees to guarantee securities,
relative to the fees their models indicated given the riskiness of the underlying mortgages and
effectively overpaying for mortgages they held in portfolio. Recall that the GSEs charged a fee
for guaranteeing payments on GSE mortgage-backed securities. Mark Winer, head of Fannie’s
Business, Analysis and Development Group since May 2006, who was responsible for
calculating the fees, raised concerns that Fannie Mae was not appropriately pricing the risk.
Winer recalled Levin disregarded this input, “Can you show me why you think you’re right and
everyone else is wrong...” Levin said, according to Winer.881 Undercharging for the guarantee
fees was intended to increase market share, according to Todd Hempstead, the manager of
Fannie’s western region. Mudd attributed the difference between the model fee and the fee
actually charged to the fact that many of the mortgages Fannie guaranteed had little historical
data. That lack of historical data contributed to the model fee being too high.

877

2006 Exam report at 2.

878

2006 Exam report at 2.

879

2006 Exam report at 7-8.

880

2006 Exam report at 3, 7-8.

881

Memorandum for the Record, Interview with Mark Winer, March 23, 2010.

368

In the September 6, 2008 memo that would recommend that Fannie be placed into
conservatorship, OFHEO would expressly cite this practice as unsafe and unsound: “During
2006 and 2007, modeled loan fees were higher than actual fees charged, due to an emphasis on
growing market share and competing with Wall Street and the other GSE.”882
2007: “Moving deeper into the credit pool”
Home prices peaked in the [second quarter] of 2006. By then, delinquencies had started to rise.
In fact, during the April, 2007, board meeting, Lund said that dislocation in the housing market
was an opportunity for Fannie to reclaim market share. At the same time, Fannie would help
support the housing market by increasing liquidity. The next month, Lund reported that Fannie’s
market share could increase to 60% from approximately 37% as of 2006. Indeed, in 2007, Fannie
Mae forged ahead, purchasing more high-risk loans. Fannie also purchased $16 billion of
subprime non-GSE securities, and $5 billion of Alt-A.
In June, Fannie prepared its 2007 five-year strategic plan, entitled “Deepen-Segments – Develop
Breadth.” The plan mentioned Fannie’s “tough new challenges - a weakening housing market”
and “slower-growing mortgage debt market.”883 The plan included taking and managing “more
mortgage credit risk, moving deeper into the credit pool to serve a large and growing part of the
mortgage market.”884 Overall, revenues and earnings were projected to increase each of the
following five years.885

882

2006 Exam report at 3, 7-8.

883

Fannie Mae Strategic Plan, FMSE 720693-787, at 697.

884

Fannie Mae Strategic Plan, FMSE 720693-787, at 699.

885

Fannie Mae Strategic Plan, FMSE 720693-787, at 701.

369

Management told the Board that Fannie’s risk management function “had all the necessary
means and budget to act on the plan.” Chief Risk Officer Dallavecchia, did not agree, especially
in light of a planned 16% cut in his budget risk management. In a July 16, 2007 email to CEO
Mudd, Dallavecchia wrote that he was very upset that he had to hear at the Board meeting that
Fannie had the “will and the money to change our culture and support taking more credit risk”
given the proposed budget cut for his department in 2008 after a 25% reduction in headcount in
2007.886 In this same email, Dallavecchia wrote that Fannie had “one of the weakest control
processes” that he “ever witnessed in [his] career, … was not even close to having proper control
processes for credit, market and operational risk” and was “already back to the old days of
scraping on controls … to reduce expenses.” That indicated that “people don’t care about the
[risk] function or they don’t get it.”
Mudd responded, “My experience is that email is not a very good venue for conversation,
venting or negotiating.” If Dallavecchia felt that he had been dealt with in bad faith, he should
“address it man to man” unless he wanted Mudd “to be the one to carry messages for you to your
peers.” Mudd concluded, “Please come and see me today face to face.” Dallavecchia told the
FCIC that when he wrote this email—a key piece of evidence in several lawsuits—he was tired
and upset, and that the email was more extreme than his views at the time. Fannie, after
continuing to purchase and guarantee higher risk mortgages in 2007, would report a $2.1 billion
net loss for the year caused by credit losses.
In 2007, Freddie Mac also continued to increase purchases of riskier loans. A strategic plan from
March highlighted “pressure on the franchise” and the “risk of falling below our return

886

7/16-17/07 email thread. FM-COGR_00156147.

370

aspirations.”887 The company would try to improve earnings by expanding into adjacent markets:
“Freddie Mac has competitive advantages over non-GSE participants in nonprime,” the strategy
document explained, “We have an opportunity to expand into markets we have missed –
Subprime and Alt-A.”888 It did. As OFHEO would note in its 2007 examination report, Freddie
purchased and guaranteed loans originated in 2006 and 2007 with higher-risk characteristics,
including interest-only loans, loans with FICO scores less than 660, higher loan-to-value loans,
loans with high debt-to-income ratios, loans without full documentation and loans with
secondary financing.889 Financial results in 2007 were poor: a $3.1 billion net loss driven by
credit losses.890 The value of the $152 billion subprime and Alt-A PLS book suffered a $13
billion market value decline.891892
Goals: “GSEs cried bloody murder forever”
As discussed in an earlier chapter, beginning in 1992, HUD periodically set goals for the GSEs
related to increasing homeownership among low- and moderate-income borrowers and
borrowers in underserved areas. Until 2005, these goals were computed based on the GSEs’
actually lending over the [prior year], as well as the fraction of the total mortgage market made
up of low and moderate-income families. The goals were only intended to be a modest reach
relative to the mortgage the GSEs would purchase in their normal course of business.
887

Freddie Mac, “Freddie Mac’s Business Strategy, Board of Directors Meeting,” March 2-3, 2007, pp. 3-4,
FMAC0000448-FMAC0000526..
888

Ibid., p. 70

889

2007 OFHEO Report of Examination at 8. (no Bates number, available on Epiq, docID FHF_00000058)

890

2007 OFHEO Report of Examination at 9. (no Bates number, available on Epiq, docID FHF_00000058)

891

2007 OFHEO Report of Examination at 10. (no Bates number, available on Epiq, docID FHF_00000058)

892

2007 OFHEO Report of Examination at 10. (no Bates number, available on Epiq, docID FHF_00000058)

371

Using this backed looking approach, under the Clinton administration, HUD steadily increased
the percentage of total GSE mortgage purchases that were required to satisfy the affordable
housing goals. For example, from 1997 to 2000, 42% of GSE purchases were required to meet
goals for low and moderate income borrowers. In 2001, the goal was raised to 50%. Mudd said
that loans made in the normal course of business satisfied the goals as long as they remained
below half of their lending: “[W]hat comes in the door through the natural course of business
will tend to match the market, and therefore will tend to meet the goals.” Levin told the FCIC
that “there was a great deal of business that came through normal channels that met goals” and
that most of the loans that satisfied the goals “would have been made anyway.”893
In 2004, under President George W. Bush, HUD made the goals more aggressive. The agency
announced that starting in 2005, 52% of the GSEs’ purchases would need to satisfy the low and
moderate income goals. The targets would reach 55% in 2007 and 56% in 2008. With the
dramatic growth in the number of riskier loans originated in the market, the new goals were
closer to where the market really was. But, as Mudd noted, “When 50% became 57[%]
ultimately, then you have to work harder, pay more attention, and create a preference for those
loans.”894 Targeted goals loans – loans that were made specifically to meet the targets – while
always a small share of the GSEs purchases, rose in importance.
Mudd testified that by 2008, with the housing market in turmoil, Fannie Mae could no longer
balance its obligations to shareholders with its affordable housing goals and other missionrelated demands: “There may have been no way to satisfy 100% of the myriad demands for
Fannie Mae to support all manner of projects [or] housing goals which were set above the
893

Levin MFR at __; 4/9/10 Hearing Transcript at 60-61.

894

Mudd MFR at __; 4/9/10 Hearing Transcript at 60-61.

372

origination levels in the marketplace...” As the combined size of the GSEs rose steadily from
$3.6 trillion in 2003 to $4.9 trillion in 2007, the number of mortgage borrowers the GSEs needed
to serve in order to fulfill the affordable housing goals rose. By 2005, Fannie and Freddie
stretched to meet the higher goals, according to a number of GSE executives, OFHEO officials,
and market observers.
But, all but two of the dozens of current and former Fannie Mae employees and regulators
interviewed on the subject of reaching the goals told the FCIC that reaching the goals was not a
primary driver of the GSEs’ purchases riskier mortgages and of subprime and Alt-A non-GSE
mortgage-backed securities. Executives from Fannie, including Mudd, pointed to a “mix” of
reasons for the purchases including reversing the market share declines, responding to
originators’ demands, and responding to shareholder demands to increase market share and
profits, in addition to fulfilling the mission of meeting affordable housing goals and providing
liquidity to the market.
As an example, Levin told the FCIC that while Fannie did purchase some subprime mortgages
and mortgage-backed securities it would not have otherwise purchased in order to meet housing
goals, Fannie was driven to “meet the market” and to reverse declining market share. On the
other hand, Levin said that Alt-A loans were high-income oriented and would have been
negative for goal purposes, so those were purchased solely to increase profits.895 Similarly, Lund
told the FCIC that market share objectives were the primary driver behind Fannie’s strategy in
2005. Housing goals had been a factor, but not the primary factor. Similarly, Dallavecchia told

895

Levin MFR at __; 4/9/10 Hearing Transcript at 68-72 (During the hearing Levin testified that some Alt-A loans
contributed to the housing goals).

373

the FCIC that Fannie increased its purchases of Alt-A loans to regain relevance in the market and
meet customer needs.
Todd Hempstead, a senior vice president and Fannie’s primary contact with Countrywide, told
the FCIC that while housing goals were one reason for Fannie’s strategy, the main reason Fannie
entered the riskier mortgage market was because those were the types of loans being originated
in the primary market. If Fannie wanted to continue purchasing large quantities of loans, the
company would need to buy riskier loans. Kenneth Bacon, Fannie’s executive vice president of
multifamily lending, said much the same thing, and added that shareholders also wanted to see
market share and returns rise.896 Former Fannie Chairman Ashley told the FCIC that change in
strategy in 2005 and 2006 owed to a “mix of reasons” including regaining market share,
responding to pressures from originators and pressures from real estate industry advocates to be
more engaged in the marketplace.897
To ensure a supply of mortgages that would fulfill the goals in case the goals were not met in the
normal course of business, Fannie and Freddie instituted outreach programs in underserved
geographic areas and conducted educational programs for originators and brokers.898 In addition,
as explained by Mike Quinn, the Fannie executive responsible for the goals, Fannie set lower
fees on loans that met the goals, although it would not purchase mortgages outside of
predetermined risk targets.899 Ashley also told the FCIC that Fannie did not shift eligibility or
underwriting standards to meet goals but instead deployed resources to marketing and
896

Bacon MFR at __.

897

Ashley MFR at __.

898

Levin MFR at __.

899

Quinn MFR at __.

374

promotional efforts, housing fairs and outreach programs through the company’s partnership
offices. “The effort was really in the outreach as opposed to reduced or diminished or loosened
standards,” Ashley told the FCIC.900
Regulator Falcon testified that the GSEs invested in subprime and Alt-A mortgages in order to
increase profits and regain market share and that any impact on meeting affordable housing goals
was a byproduct of the activity.901 Lockhart, who took over OFHEO from Falcon, said the GSEs’
change in strategy came from their drive for profit and market share, as well as meeting housing
goals. Noting that the affordable housing goals increased markedly in 2005,902 he said the “goals
were just one reason, certainly not the exclusive reason” for the change.903 These views were
corroborated by numerous other officials from the GSEs’ regulator.904
Former HUD official Mike Price told the FCIC that while the “GSEs cried bloody murder
forever” when it came to the goals, they touted their contribution to increasing homeownership
just as they touted their profitability. In addition, Price and other HUD officials told the FCIC
that the GSEs never claimed that the meeting the goals would leave them in an unsafe or
unsound condition.
Indeed, the law allowed both Fannie Mae and Freddie Mac to fall short of meeting housing goals
that were “infeasible” or that would affect the companies’ safety and soundness. And, while the
GSEs often exceeded the goals, in some cases they were adjusted downward by HUD or simply
900

Ashley MFR at __.

901

4/9/10 Hearing Transcript at 155-56; 192-193; Falcon written testimony at __.

902

Lockhart written testimony at 6; 4/9/10 Hearing Transcript at 159-161

903

Lockhart MFR at __.

904

DeMarco MFR at __. Pollard, Dickerson, Fernandez, Spohn and Newell

375

missed by the GSEs.905 As an example, on December 12, 2007, Mudd wrote to HUD stating,
“Fannie Mae believes that achieving the low- and moderate-income and special affordable
housing subgoals are infeasible for 2007.”906 Fannie Mae’s 2007 strategic plan had already
anticipated this need, stating, “In the event we reach a viewpoint that achieving the goals this
year is ‘infeasible,’ we will determine how best to address the matter with HUD and will keep
the board apprised accordingly.”907 In fact, both Fannie and Freddie appealed to HUD to lower
two components of the overall affordable housing goals. HUD complied and allowed the GSEs
to fall short without any consequences.908
Assessing the impact of the goals
At least until HUD set new affordable housing goals for 2005, GSEs only supplemented their
routine purchases with a small volume of loans and non-GSE mortgage-backed securities needed
to meet the affordable housing goals. The GSEs knew they might not earn as much on these
targeted goal loans as they would earn on both goal-qualifying and non-goal-qualifying
purchased in the usual course of business; they might even lose money on some of the targeted
goal loans. And, the organizations spent money on administrative costs and other efforts related
to the housing goals.
In June 2009 Freddie Mac staff made a presentation to the Business and Risk Committee of the
Board of Directors on the costs of meeting the goals. From 2000 to 2003, the cost of the targeted
905

11/1/04, HUD

906

FM-FCIC_00171915 to 171921.

907

Fannie Mae Strategic Plan, FMSE 720693-787, at 707

908

Letters from HUD to Fannie and Freddie: HMG_MAC_-_2007_Feasibility_-_April_2008, HMG_MAE__2007_Feasibility_-_April_2008

376

goal loans was effectively zero as the company met the goals through “profitable expansion” of
its multi-family business. During the refinance boom, meeting the goals became harder and cost
Freddie money in the multi-family business; only after 2004 did the multi-family and single
family goals cost the GSE money. Still, only about 4% of all loans Freddie purchased between
2005 and 2008 were bought “specifically because they contribute to the goals” – loans they label
as “targeted affordable.” These loans did have higher expected default rates, although Freddie
also charged a higher fee to guarantee them. From 2003 through [2008], the cost – defined as the
expected losses on the narrow set of loans specifically purchased to achieve the goals, as
opposed to goals-qualifying loans purchased in the normal course of business, averaged $200
million annually. This expected loss figure reflected projected defaults on these loans, projected
revenue, as well as the difference between the expected return on these loans versus a benchmark
return. [ck] By comparison, net earnings averaged just over $3 billion per year from xx to xx.
Fannie used a slightly different strategy to achieve its targets, but its experience was roughly the
same as Freddie's. In 2004, Fannie Mae retained McKinsey and Citigroup to determine whether
it would be worthwhile to give up the company's charter as a GSE, which—while according the
company enormous benefits—imposed regulations, put constraints on business practices, and
including mission goals for the GSE. The final report to Fannie Mae's top management, called
the Phineas Project, found that the explicit cost of compliance with the goals from 2000 to 2003
was close to zero: “it is hard to discern a fundamental marginal cost to meeting the housing goals
on the single family business side.” The report found this even though meeting the goals had
become somewhat harder for Fannie Mae in the 2003 refinancing boom: with so many
homeowners refinancing, in particular middle and upper income homeowners, the percentage of
the pool that would qualify for the goals was necessarily smaller.
377

Fannie Mae calculated a so-called "opportunity cost" for goals-qualifying loans, which reflected
the difference between pricing on goals-qualifying loans and computations from Fannie Mae's
pricing models. Across Fannie’s portfolio, Fannie charged lower fees than its models computed
for targeted goals loans as well as even non-goal qualifying loans. As a result, this measure of
opportunity cost is not limited to targeted goals loans. In fact, the discount that Fannie charged
from the fee determined by its pricing models was actually smaller for many goals-qualifying
loans than for the others from 2000 to 2004. With this caveat, by one measure Fannie estimated
the opportunity cost of the targeted goals loans in 2006 at $474 million.909 As the markets
tightened, in the middle of 2007 the opportunity cost for that year was forecasted to be roughly
$1 billion.
Facing more aggressive goals in 2006 and 2007, Fannie Mae instituted initiatives to purchase
loans that specifically met the goals. These included mortgages acquired under the My
Community Mortgage program, mortgages underwritten with looser standards, manufactured
housing loans and others. For targeted goals loans purchased in 2006, Fannie Mae estimated the
so-called ‘cash flow cost’, or the expected losses less the expected revenue from the loans, to be
$140 million, compared to total returns that year to Fannie of $4.1 billion—which includes
returns on the goals-qualify loans made during the normal course of business. The targeted goals
loans amounted to $18 billion, or 3.4% of Fannie Mae’s $524 billion of single-family mortgage
purchases in 2006.
Looking back at the performance of the targeted-affordable portfolio relative to overall losses,
the 2009 presentation at Freddie Mac took the analysis of goals costs one step further. While the

909

Cite. Other estimates from Fannie Mae are lower.

378

outstanding $60 billion of these targeted affordable loans was only 4% of the total portfolio,
these were relatively high risk loans and were expected when they were made to account for 19%
of total projected losses. In fact, as of late 2008, they had only accounted for 8% of losses –
meaning they had performed better than expected relative to the whole portfolio. Major losses
for the company came from goal-qualifying loans acquired in the normal course of business.
The presentation notes that many of these defaulted loans were Alt-A.

379

CHAPTER CONCLUSIONS HERE

380

Part II, Chapter 5. CDOs: The real money leaves the table
Table of Contents
Chapter II 5. CDOs: The real money leaves the table............................................................................. 381
CDO managers: “We are not a rent-a-manager”.................................................................................. 383
Credit default swaps: “Dumb question”............................................................................................... 385
Citigroup: “Eager to make up for lost time” ........................................................................................ 397
AIG: “I’m not getting paid enough to stand on these tracks” .............................................................. 406
Merrill: “Aggressive build-out CDO business strategy” ..................................................................... 410
Regulators: “Are undue concentrations of risk developing?” .............................................................. 416
Moody’s: “It was all about revenue” ................................................................................................... 419

The CDO machine could have reached a natural end by the spring of 2006. Housing prices
peaked, and AIG – the golden goose of the CDO market – decided it was going to begin winding
down its business of insuring subprime CDOs through derivatives. But it turned out that Wall
Street didn’t need its golden goose any more. Securities firms were starting to take a
disproportionate share of the risks from their own deals, replacing AIG as the ultimate bearer of
the risk of losses on super-senior CDO tranches. The machine kept humming throughout 2006
and into 2007. “That just seemed kind of odd, given everything we had seen and what we had
concluded,” Gary Gorton, a Yale finance professor who designed AIG’s model for analyzing its
CDO positions, told the FCIC.910
The explanation was simple. Senior executives – particularly at three of the leading promoters of
CDOs, Citigroup, Merrill Lynch, and UBS – just did not believe or perhaps even understand the
risks inherent in the products they were pushing. They were enchanted by the alchemy of

381

structured finance, accepted the rating agencies’ AAA stamp of approval, and were perhaps
making too much money to quit.
The CDO machine was running on its own fuel. More and more, the senior tranches were
retained by the arranging securities firms, the mezzanine tranches were bought by other CDOs,
and the equity tranches were bought by hedge funds that were hedging their positions with a
trading strategy known as correlation trading: they made money when the CDOs performed, but
they would make more should the market finally crash. That machine helped keep the mortgage
market going long after house prices had begun to fall and created massive exposures on the
books of many large financial institutions that would ultimately bring many of them to the brink
of failure.
The insatiable demand fueled a boom in synthetic CDOs. Synthetic CDOs provided easier
opportunities for bearish investors to bet against the housing boom and the securities that
depended on it. They also made it easier for investment banks and CDO managers to create
CDOs more quickly. But synthetic CDO managers had two sets of investors with two very
different interests. And managers often had help from investors in selecting the collateral – even
from investors who were betting against the collateral, as a high-profile SEC case against
Goldman Sachs would eventually illustrate.
Regulators reacted weakly. As early as 2005, supervisors recognized that CDOs and credit
default swaps could actually concentrate rather than diversify risk but concluded that Wall Street
knew what it was doing. Supervisors issued guidance in late 2006 warning banks of the risks of
complex structured finance transactions – but excluded mortgage-backed securities and CDOs,
because they saw the risks of those products as relatively straightforward and well understood.

382

Yet the end game was fast approaching.

CDO managers: “We are not a rent-a-manager”
During the “madness,” with everyone wanting a piece of the action, CDO managers faced
growing competitive pressures. Managers’ compensation even declined, as demand for
mortgage-backed securities drove up prices, squeezing the profit they made on CDOs. And, new
CDO managers came in to compete. Wing Chau, a CDO manager who frequently worked with
Merrill Lynch, said the fees were cut in half for mezzanine CDOs issued in 2006. For a $500
million deal, they fell from as much as $2 million per year to $1 million, and sometimes as little
as $500,000. A big decline, but still a decent payday. And, overall compensation could be
maintained by creating more new product.
More than they had been three or four years earlier, when they picked the collateral, the
managers were influenced by the underwriters – the securities firms who created and marketed
the deals. An FCIC survey of 40 CDO managers confirmed this point. In some cases, managers
were given a portfolio constructed by the securities firm; the managers would then choose the
mortgage assets from this portfolio. The equity investors – who often initiated the deal in the
first place – also influenced the selection of assets in many cases. Still, some managers said that
they acted independently. “We are not a rent-a-manager, we actually select our collateral,” said
Lloyd Fass, general counsel at Vertical Capital.911 As we will see, securities firms often had
CDO managers with whom they preferred to work. Merrill, the market leader, had a
constellation of managers; CDOs underwritten by Merrill frequently bought tranches issued by
other CDOs underwritten by Merrill.

Vertical Capital email response to FCIC survey, October 29, 2010.

383

According to market participants, CDOs stimulated greater demand for mortgage-backed
securities, particularly those with high yields, which in turn affected origination standards.912 As
those standards fell, at least one firm opted out: PIMCO, one of the largest investment funds in
the country, whose CDO management unit was one of the nation’s largest in 2004. Early in
2005, it announced that it would not manage any new deals in part because of the deterioration in
the credit quality of mortgage-backed securities. “There is an awful lot of moral hazard in the
sector,” Scott Simon, a managing director at PIMCO, said at an industry conference in 2005.
“You either take the high road or you don’t – we’re not going to hurt accounts or damage our
reputation for fees.”913 Simon said rating agency methodologies were not sufficiently stringent,
particularly because they rated new types of subprime and Alt-A loans with little or no historical
performance data. Not everyone agreed with this viewpoint, which seems obvious in retrospect.
“Managers who are sticking in this business are doing it right,” Armand Pastine, chief operating
officer at Maxim Group, said in response, at that same conference. “To suggest that CDO
managers would pull out of an economically viable deal for moral reasons – that’s a cop-out.”914
Typical of the industry, during the crisis, two of Maxim’s eight mortgage-backed CDOs, Maxim
High Grade CDO I and Maxim High Grade CDO II, would default on interest payments to
investors – including many investors holding tranches that had originally been rated AAA – and

912

As two market observers would later write, “Starting in 2004, CDOs and CDO investors became the dominant
class of agents pricing credit risk on sub-prime mortgage loans….In the absence of restraints, lenders started
originating unreasonably risky loans in late 2005 and continued to do so into 2007.” Mark Adelson and David
Jacob, The Sub-prime Problem: Causes and Lessons, January 8, 2008.
913

Allison Pyburn, CDO investors debate morality of spread environment, Asset Securitization Report, May 9,
2005.
914

Allison Pyburn, CDO investors debate morality of spread environment, Asset Securitization Report, May 9,
2005. According to the FCIC database, PIMCO did manage one more new CDO, Costa Bella CDO, which was
issued in December 2006.

384

the other six would be downgraded to below investment grade, including all of those originally
rated AAA.915
Another development: in 2005 and 2006, CDO managers were less likely to put their own money
into their deals. Early in the decade, investors had expected the managers to invest in the equity
tranche of the CDOs they managed because they believed that if the managers were sharing the
risk of loss, they would have an incentive to pick collateral wisely. But this fail-safe lost force as
the amount of managers’ investment per transaction declined over time, from 25% to 50% of the
equity tranches in the early years to 10% or less by 2006. ACA Management, a unit of ACA
Capital, a financial guarantor, is a good example. ACA held 100% of the equity in the CDOs it
originated in 2002 and 2003, 52% and 61% of two deals it originated in 2004, between 10% and
25% of deals in 2005, and between 0% and 11% of deals in 2006.916
And with synthetic CDOs, as we will see, there was no fail-safe at all regarding the managers’
incentives. By the very nature of the credit default swaps bundled into these synthetics, half of
the investors were betting that the assets failed.

Credit default swaps: “Dumb question”
In June, 2005, derivatives dealers introduced the “pay-as-you-go” credit default swap, a complex
instrument that mimicked the timing of the cash flows of real mortgage-backed securities.917

915

Source on downgrades: Bloomberg. Source on events on default: Moody’s Investors Service, Moody’s
downgrades ratings of Notes issued by Maxim High Grade CDO I, Ltd., April 18, 2008, and Moody’s downgrades
ratings of Notes issued by Maxim High Grade CDO II, Ltd., April 18, 2008.
916

ACA Capital, 2006 10-K.

917

International Swaps and Derivatives Association, ISDA publishes template for credit default swaps on assetbacked securities with pay as you go settlement, June 21, 2005. http://www.isda.org/press/press062105.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 protection seller is required to pay the buyer the amount of the shortfall.

385

This feature made the synthetic CDOs into which these new swaps were bundled much easier to
issue and sell.
The pay-as-you-go swap also enabled a second major development, introduced in January 2006:
the first index based on the prices of credit default swaps on mortgage-backed securities.918
Known as the ABX.HE, it was really a series of indices, meant to act as a sort of Dow Jones
Industrial Average for the non-prime mortgage market, and it became a popular way to bet on
the performance of the market. Every six months, a consortium of securities firms would select
20 credit default swaps on mortgage-backed securities in each of five ratings-based tranches:
AAA, AA, A, BBB, and BBB-. Investors who believed that the bonds in any given category
would fall behind in their payments could buy protection through credit default swaps. As
demand for protection rose, the index would fall. The index was therefore a barometer recording
the confidence of the market.
Synthetic CDOs proliferated, partly because it was much quicker and easier for managers to
assemble a synthetic portfolio out of pay-as-you-go credit default swaps or one of the ABX
indices than to assemble a regular cash CDO out of mortgage-backed securities.919 “The beauty
in a way of the synthetic deals is that you can look at the entire universe, you don’t have to go

For long investors – the protection provider under the swap – the advantage was the leverage embedded in the trade:
they did not have to come up with the cash upfront for the principal amount of the bond; they simply agreed to
receive quarterly swap fees in return for accepting the risk of loss if the securities experienced a shortfall. The short
investors – the purchasers of protection under the swap – also liked the leverage of the trade; they simply agreed to
pay quarterly fees in return for the possibility of getting a payment of up to the full principal amount.
918

Markit, CDS Indexco and Markit Launch Synthetic ABS Index: ABX.HE, an Asset-Backed Credit Derivative
Index, Allows Investors to Go Long or Short U.S. Sub-Prime Residential Mortgages, January 17, 2006.

919

Note that hybrid CDOs absorbed cash securities composed of subprime and Alt-A mortgages; also ABCDS,
which are synthetic positions in such MBS, facilitated the completion of portfolios and thereby the issuance of cash
CDOs. In other words, the synthetic market facilitated the cash market and vice versa.

386

out and buy the cash bonds,” said Laura Schwartz of ACA Capital.920 There were also no
warehousing costs, or the associated risks. And, since these deals were cheaper to put together
than cash deals, they tended to pay higher returns on the equity tranches – one analyst estimated
the equity tranche on a synthetic CDO would typically pay about 21%, rather than 13% for the
equity tranche of a typical cash CDO.921
Synthetic CDOs were an important source of demand for credit default swaps on mortgagebacked securities. There was growing demand for the “short” side of these credit default swaps
from hedge funds and others that wanted to bet against the inflated mortgage market. The “long”
side of the bet was increasingly taken by synthetic CDOs. Greg Lippman, a Deutsche Bank
mortgage trader, told the FCIC that he often brokered these deals, matching the “shorts” with the
“longs” and avoiding taking any risk at all for his own bank. Lippman said that between 2005
and 2007 he brokered deals for at least 50, maybe 100 hedge funds that wanted to short the
mezzanine tranches of mortgage-backed securities. Meanwhile, on the long side, “Most of our
[credit default swap] purchases were from UBS, Merrill and Citibank, because they were the
most aggressive underwriters of [synthetic] CDOs.”922 They were buying those positions from
Lippman to put them into synthetic CDOs; as it would turn out, those banks would retain much
of the risk of those synthetic CDOs by retaining the super-senior and AAA tranches, selling
below-AAA tranches largely to other CDOs and equity tranches to hedge funds.
Issuance of synthetic CDOs jumped from $15 billion in 2005 to $61 billion just one year later.
Even CDOs that were labeled as “cash CDOs” also increasingly held some credit derivatives. A
920

FCIC interview with Laura Schwartz, May 10, 2010.

921

Subprime Mortgage Credit Derivatives, p. 176.

922

FCIC interview with Greg Lippman, [XXX], 2010.

387

total of $225 billion in cash CDOs were issued in 2006; the FCIC estimates that 27% of the
collateral was derivatives, compared with 9% in 2005 and 7% in 2004.
With synthetic CDOs, the incentives of CDO managers and hedge fund investors changed. Once
“short” investors were involved, the manager had two sets of clients with conflicting interests:
those who would benefit if the assets performed, and those who would benefit if some of the
mortgage borrowers stopped making payments and the assets did not perform as advertised.
Even the incentives of long investors became conflicted. What had started a few years back as a
way to spread the risk of the mortgage market had become an arena in which sophisticated
investors could place bets against the housing market or pursue more complex trading strategies.
Often, investors, usually hedge funds, used credit default swaps to take offsetting positions in
different tranches of the same security; that way, they could make some money as long as the
CDOs performed, but they stood to make more money if the market crashed en masse. This was
called the correlation trade.923 An FCIC survey of over 170 hedge funds encompassing over $1.1
trillion in assets as of early 2010 found that this trade was common among medium-sized hedge
funds: of all the mortgage-related CDOs issued in the second half of 2006, more than half of the
equity tranches were purchased by hedge funds engaged in the correlation trade.924 The same

923

In this trade, hedge funds would buy the equity or mezzanine tranche of a mortgage-backed security or CDO, and
then buy protection through credit default swaps on the mezzanine or senior tranches of the same mortgage-backed
security or CDO. The equity tranche would pay a high return in the short run – 15%, 20%, even more – and those
returns would cover the premiums on the credit default swaps. In the long run, the short position in the senior or
mezzanine tranches would pay off if, or when, the mortgage bubble came to an end. In effect, this was a bet against
the rating agencies’ models. When the market discovered that mortgage-backed securities were in fact highly
correlated and subject to severe losses, the correlation trade would pay off.

924

[shorten] From July through December 2006, several hedge funds with an [average] assets under management of
[$1-$4 billion] accumulated positions totaling over $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 Moody’s proprietary
CDO database to estimate the total mortgage-related CDO equity tranche issuance. Please see FCIC website for

388

trade was happening in the mortgage-backed securities market as well. The FCIC’s survey
found that by June 2007, the largest hedge funds held $25 billion in equity and other lower-rated
tranches of mortgage-backed securities. These were offset by short derivative positions in
approximately $45 billion of mezzanine tranches.925 Importantly, to create this large volume of
derivative short positions for their hedge fund clients, dealers – like Lippman at Deutsche Bank –
also had to create long positions that they needed to store somewhere, such as a synthetic CDO.
The correlation trade changed the structured finance market. Investors in the equity and most
junior tranches of CDOs and mortgage-backed securities had traditionally had the greatest
incentive to monitor the credit risk of an underlying portfolio. Once those investors were
predominantly hedged through the correlation trade, it was no longer clear who had that
incentive, if anyone.
One example in which the correlation trade contributed to an apparent conflict of interest is
provided by Merrill Lynch’s $1.5 billion Norma CDO, issued in 2007. The equity investor,
Magnetar Capital, a hedge fund, was correlation trading – it bought the equity tranche while
shorting other tranches in Norma and other CDOs. Magnetar was also involved in the asset
selection for Norma and was paid $4.5 million out of the proceeds from the deal, even though the
selection was officially the job of the CDO manager, NIR Capital Management. NIR was paid a
fee of $75,000 plus additional fees for its management duties. With Merrill’s knowledge, NIR
allowed Magnetar to assume control over the collateral selection process. When one Merrill
employee learned of Magnetar’s role, she questioned the propriety of Magnetar taking over

more information about the hedge fund survey. Note: the FCIC did not survey hedge funds that fully liquidated or
closed. These funds may have purchased substantial “long only” positions in mortgage-related securities.
925

Please see the FCIC website for more details.

389

NIR’s responsibility, emailing colleagues, “Dumb question. Is Magnetar allowed to trade for
NIR?”926,927 Merrill failed to disclose either that very pertinent fact, that Magnetar was paid to
select collateral, and that it also had a short position that would benefit from losses.
Counsel for Merrill’s new owner, Bank of America, told the FCIC in a letter that 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.”928 The letter did not specifically mention
the Norma CDO.
Federal regulators have identified abuses when investors influenced the choice of the instruments
inside synthetic CDOs, such as credit default swaps on mortgage assets. In April, 2010, the SEC
charged Goldman Sachs with fraud in telling investors that an independent CDO manager, ACA
Management, had picked the underlying assets in a CDO while in fact, a short investor, the
Paulson & Co. hedge fund, founded by the investor John Paulson, had played a “significant role”
in the selection.929 The SEC alleged those misrepresentations were in Goldman’s marketing
materials for Abacus 2007-AC1, one of Goldman’s 24 Abacus deals. After ensuring that the
underlying loans were especially shaky, Paulson took a short position and bet against the CDO,
the SEC alleged.930

926

FCIC has requested document ML01396714 referenced by Rabobank’s counsel.

927

BAC-ML-CDO-000079743 Document of Magnetar Investments in Norma; Attachment G-13: BAC-ML-CDO000059221 Document of Fees Received.
928
929

Reg Brown Letter to FCIC re Merrill Lynch, November 2, 2010 at 3. CONFIDENTIAL.
SEC Release No. 21592 (July 15, 2010). FCIC interview with Laura Schwartz, May 10, 2010. Emphasis added.

930

SEC, SEC Charges Goldman Sachs With Fraud in Structuring and Marketing of CDO Tied to Subprime
Mortgages, April 16, 2010.

390

Ira Wagner, the head of Bear Stearns’ CDO Group in 2007, told the FCIC that he rejected the
deal when approached by Paulson representatives because he believed the deal would present a
fundamental conflict of interest. When asked about Goldman’s contention that Paulson picking
the collateral was immaterial because the collateral was disclosed and because Paulson was not a
well-known short at that time, Wagner called the argument “ridiculous.” He said the structure
created motives to pick the worst assets. While acknowledging the point that every synthetic deal
had long and short investors, Wagner saw a serious difference in having the short investors pick
the referenced collateral.
ACA executives told the FCIC they were not initially aware that the collateral had been chosen
by the short investor. CEO Alan Roseman said that he first heard of Paulson’s role when he
reviewed the SEC’s complaint.931 Laura Schwartz, who was responsible for the deal at ACA,
said she believed that Paulson’s firm was the investor taking the equity tranche and would
therefore have an interest in the deal performing well. She said she would not have been
surprised that Paulson would have also had a short position because the correlation trade was
common in the market but, “To be honest, until the SEC testimony I did not even know that
Paulson was solely short.”932 Paulson told the FCIC that any synthetic CDO would have to
invest in “a pool that both a buyer and seller of protection could agree on.” “Every CDO has a
buyer and seller of protection. So for anyone to say that they didn’t want to structure a CDO
because someone was buying protection in that CDO, then you wouldn’t do any CDOs.”933

931

FCIC interview with Alan Roseman, May 17, 2010.

932

FCIC interview with Laura Schwartz, May 10, 2010.

933

FCIC interview with John Paulson, October 28, 2010, 32:50.

391

In July 2010, Goldman Sachs settled the case, paying a record $550 million fine.934 Goldman
“acknowledge[d] that the marketing materials for the ABACUS 2007-AC1 transaction contained
incomplete information. In particular, it was a mistake for the Goldman marketing materials to
state that the reference portfolio was ‘selected by’ ACA Management LLC without disclosing
the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson’s economic
interests were adverse to CDO investors.”
The shorts: “A final judgment on housing”
The new derivatives provided a golden opportunity for bearish investors – generally hedge funds
– to bet against the housing boom. Home prices in the hottest markets in California and Florida
had blasted into the stratosphere; it was hard for skeptics to believe this could continue. And if it
didn’t, the landing would not be a soft one. Some spoke out publicly. A handful bet tens of
millions of dollars on a bursting bubble. They would reap hundreds of millions in return.
Initially, the naysayers tended to work at small, obscure hedge funds and investment firms, run
by people who hadn’t drunk “the Kool-Aid that housing prices would never go down,” as Steven
Eisman told the FCIC.935 The outspoken Eisman was the founder of a fund within FrontPoint
Partners, a collection of hedge funds. In 2005, he began to believe that something was wrong—
and not just with all the companies in the mortgage business, but perhaps with the entire market.
People who had bought homes, thanks only to the now ubiquitous adjustable-rate mortgages,
wouldn’t be able to afford the new payments when the rate ratcheted up; nor would they able to
934

SEC, Goldman Sachs to Pay Record $550 Million to Settle SEC Charges Related to Subprime Mortgage CDO;

Firm Acknowledges CDO Marketing Materials Were Incomplete and Should Have Revealed Paulson’s Role, July
15, 2010.
935

Steve Eisman, interview with FCIC, April 22, 2010

392

refinance their way out of the hole, so a crash was likely—and the crash was also likely to bring
down these elaborate securities that were only a step or two away from disaster.
Betting against CDOs was also, in some cases, a bet against the rating agencies and their models.
Jamie Mai and Ben Hockett, principals at the small investment firm Cornwell Capital, told the
FCIC that they had warned the SEC in 2007 that the agencies were dangerously over-optimistic
in their assessment of mortgage-backed CDOs. Mai and Hockett saw the rating agencies as “the
root of the mess,” because their ratings removed the need for buyers to study prices and perform
due diligence, even as “there was a massive amount of gaming going on.”936
“Shorting ABS CDOs was pretty attractive because we thought that the rating agencies gave too
much credit for diversification,” Sihan Shu of Paulson & Co told the FCIC. “Each MBS tranche
typically would be 30% mortgages in California, 10% in Florida, 10% in New York, and when
you aggregate 100 MBS positions you still have the same geographic diversification. To us, there
was not much diversification in CDOs.” Shu’s research convinced him that should home prices
stop appreciating, BBB and BBB- rated mortgage-backed securities would be at risk for
downgrades. Should prices drop 5%, CDO losses would increase 20-fold.
And if a relatively small number of the underlying loans were to go into foreclosure, the losses
would mean that virtually all of the riskier BBB rated tranches would be worthless. “The whole
system worked fine as long as everyone could refinance,” Eisman told the FCIC. The minute
refinancing stopped, “losses would explode. …By 2006, about half [the mortgages sold] were
no-doc or low-doc. You were at max underwriting weakness at max housing prices. And so the

936

Cornwell Capital, FCIC interview, April 22, 2010

393

system imploded. Everyone was so levered there was no ability to take any pain.”937 James
Grant, in Grant’s Interest Rate Observer newsletter, wrote on October 5, 2006, about the
“mysterious alchemical processes” in which “Wall Street transforms BBB-minus-rated
mortgages into AAA-rated tranches of mortgage securities” by creating CDOs. He estimated
that even the AAA tranches of CDOs would experience some losses in the event that national
home prices were to fall just 4% or less within two years, and if prices were to fall 10%,
investors of tranches rated AA- or below would be completely wiped out.938
In 2005, Eisman and others were already looking for the best way to bet on this disaster by
shorting all these shaky mortgages. Shorting credit default swaps was efficient. Eisman realized
that he could pick what he considered the most toxic tranches of the mortgage-backed bonds and
bet millions of dollars against them, relatively cheaply and with considerable leverage. And
that’s what he did.
By the end of 2007, Eisman had put millions of dollars into short positions on credit-default
swaps.939 It was, he was sure, just a matter of time. “Everyone really did believe that things were
going to be okay,” Eisman said. “[I] thought they were certifiable lunatics.”
Michael Burry, another short who became well-known after the crisis hit, was a doctor-turnedinvestor whose hedge fund, Scion Capital in Northern California’s Silicon Valley, bet big against
mortgage-backed securities—a change of heart, because he had invested in homebuilder stocks
in 2002. But the closer he looked, the more he wondered about the financing that supported this

937

Ibid

938

James Grant, Mister Market Miscalculates.

939

Eisman interview with FCIC, April 22, 2010

394

booming market. Burry decided that some of the new-fangled adjustable-rate mortgages were
“the most toxic mortgages created.” He told the FCIC, “I watched those with interest as they
migrated down the credit spectrum to the subprime market. As [home] prices had increased on
the back of virtually no accompanying rise in wages and incomes, I came to the judgment that in
two years there will be a final judgment on housing when those two-year [adjustable-rate
mortgages] seek refinancing.”940
By the middle of 2005, Burry had bought credit default swaps on billions of dollars of mortgagebacked securities and the bonds of financial companies in the housing market, including Fannie
Mae, Freddie Mac and AIG. Years later, Burry wrote an op-ed for The New York Times
headlined “I Saw the Crisis Coming: Why Didn’t the Fed?”941 “I entered these trades
carefully,” Burry wrote in his New York Times op-ed. “Suspecting that my Wall Street
counterparties might not be able or willing to pay up when the time came, I used six
counterparties to minimize my exposure to any one of them. I also specifically avoided using
Lehman Brothers and Bear Stearns as counterparties, as I viewed both to be mortally exposed to
the crisis I foresaw.”
[insert sentence on the overall extent of shorting in the mortgage market] The concentrated
purchases of credit default swaps to bet on the housing market tanking by Paulson & Co.,
Eisman, Burry and others illustrate the impact of derivatives in introducing new risks and
leverage into the system. Although these investors profited spectacularly from the housing
crisis, they never made a single subprime loan or bought an actual mortgage. In other words,
they were not purchasing insurance against anything they owned. Instead they merely made side
940

Michael J. Burry, interview with FCIC, May 18, 2010

941

The New York Times, April 3, 2010 at http://www.nytimes.com/2010/04/04/opinion/04burry.html

395

bets on the risks undertaken by others. Paulson told the FCIC that he could purchase credit
default swap protection on BBB tranches very cheaply but that his research indicated that if
home prices remained flat losses would wipe out the BBB tranche. Therefore, he set up a
separate credit fund in June 2006 that focused initially exclusively on this particular trade.942 By
the end of 2007, Paulson & Co.’s Credit Opportunities fund, set up less than a year earlier to bet
exclusively against the subprime housing market, without having any direct exposure to it – was
up 590% from [XXX] to [XXX].
Across the market, while the “shorts” were up on their housing bets in 2007, the other side of
that “zero sum game” – often the major U.S. financial institutions that had risked billions of
dollars for credits spreads of less than a quarter of a percent for taking on the risk of super-senior
CDO tranches – would be battered. Burry told the FCIC, “There’s an argument that can be made
that you shouldn’t allow what I did.” But the problem, he said, was not the short positions he
was taking; it was the risks that others were accepting. “When I did the shorts, the whole time I
was putting on the positions, there were people on the other side who were eating them up. I
think it’s a catastrophe that this was preventable.”943
As noted, credit default swaps greased the CDO machine in several ways. First, they allowed
CDO managers to create hybrid CDOs more quickly than they could create cash-only CDOs.
Second, they allowed investors (including the originating banks such as Citigroup and Merrill) to
provide funding for a security while ostensibly transferring the risk to somebody else (such as
AIG and other insurance companies). Third, correlation trading depended on credit default
swaps. As the FCIC survey illustrated, most hedge fund purchases of equity and other junior
942

http://www.pionline.com/article/20070709/FACETOFACE/70705017

943

Burry, FCIC interview, May 18, 2010

396

tranches of mortgage-backed securities and CDOs were done as part of correlation trades. As a
result, credit default swaps were critical to creating demand among hedge funds for the equity or
other junior tranches of mortgage-backed securities and CDOs.
On the other hand, there are arguments that credit default swaps helped end the housing and
mortgage-backed securities bubble. Because CDO arrangers could more easily buy mortgage
exposure for their CDOs through credit default swaps than through actual bonds, demand for
credit default swaps may have actually reduced the need to originate high-yield mortgages. In
addition, some market participants have argued that the ability to short the housing market via
credit default swaps also helped pop the bubble. As we will see, the declines in the ABX index in
late 2006 would be one of the first harbingers of market turmoil. “Once [pessimists] can, in
effect, sell short via the CDS, prices must reflect their views and 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 both invested in and managed CDOs, told the FCIC.

Citigroup: “Eager to make up for lost time”
While the hedge funds were betting against the housing market in 2005 and 2006, Citigroup’s
CDO desk was pushing more money to the center of the table.
But the bank’s treasury department had put a stop to the liquidity puts. To keep doing deals, the
CDO desk had to find a market for the super-senior tranches of the CDOs it was writing – or it
had to find another way to get the company to support the CDO production line. It did. Starting
in early 2006, the CDO desk accumulated another $18 billion in super-senior exposures by

397

August 2007—securities it would only be able to sell into the market for a loss.944 It was also
increasingly financing securities that it was holding in its CDO warehouse – that is, securities
that were waiting to be put into new CDOs.
Historically, building huge balance sheet positions was not what securities firms did. The adage
“we are in the moving business, not the storage business” suggests that they should be in the
business of structuring and supporting financial transactions between sellers and buyers, as
opposed to becoming the buyers themselves. As underwriters, these firms had historically
limited their exposure to securities that they created and sold into the market.
However, as the biggest commercial banks and investment banks competed in the securities
business in the late 1990s and early 2000s, they often touted the “balance sheet” they could make
available to support the sale of new deals. In this regard, Citigroup broke new ground. The
Citigroup conglomerate retained significant exposure to losses on its CDO business, particularly
within Citibank, the $1 trillion commercial bank at the heart of the empire. It did this in four
ways. While its competitors did the same, few did so with such abandon, nor ultimately with
such losses.
In 2006, Citigroup retained the super-senior and AAA tranches of most of the CDOs it created.
In many cases Citigroup would hedge the associated credit risk from these tranches by obtaining
credit protection from a monoline insurance company such as Ambac. With these hedges in
place, Citigroup presumed that the risk associated with these retained tranches had been
neutralized.

944

OCC, Subprime CDO Valuation and Oversight Review – Conclusion Memorandum, Memorandum from Michael
Sullivan, RAD and Ron Frake, NBE, to John Lyons, Examiner-in-Charge, Citibank, NA, January 17, 2008, page 6.

398

Citigroup held these tranches on its balance sheet valued at the price at which it had failed to
obtain in the open market – even though many would say that, by definition, that meant they
were overvalued. “As everybody in any business knows, if inventory is growing, that means
you’re not pricing it correctly,” Richard Bookstaber, who had been head of risk management at
Citigroup in the early 2000s, told the FCIC. But, keeping the tranches on the books at these
prices improved the finances of creating the deal. “It was a hidden subsidy of the CDO business
by mispricing,” Bookstaber said.945 The company would not begin writing the securities down
toward the market’s real valuations until the fall of 2007.
Part of the reason for retaining exposures to super-senior positions in CDOs was the favorable
capital treatment, regardless of where the bank held them. As we have seen, under the 2001
Recourse Rule, one of the salient qualities of AAA-rated securities was that they required banks
to hold relatively less capital against them than lower-rated securities. And if the bank held
those assets in their trading account (as opposed to holding it as a long term investment), it could
get even better capital treatment under the 1996 Market Risk Amendment. That rule allowed
banks to use their own models to determine the amount of capital to hold, based on how much
market prices moved. Citigroup judged that the capital requirement for the super-senior tranches
of synthetic CDOs it held for trading purposes was effectively zero, because the prices didn’t

945

FCIC interview with Richard Bookstaber, [XXX], 2010.

399

move much.946 As a result, Citigroup did not have to hold much regulatory capital against the
super-senior tranches.947
Citibank, Citigroup’s largest commercial bank subsidiary, also held “unfunded” positions in
super-senior AAA tranches of some CDOs; that is, they sold protection to the short investors by
writing credit default swaps. If the value of the referenced mortgage collateral deteriorated, the
CDO investors who were short would begin to get paid. Money to pay them would first come
from wiping out long investors who were below-AAA tranches. Then, if the short investors
were still owed money, Citibank would have to pay. In aggregate, Citi had amassed [$XXX
billion] in such liabilities between 2004 and 2007. For taking on this risk, Citi typically received
about [0.20]% to [0.40]% in annual fees on the credit default swap protection; on a billion dollar
transaction they would earn an annual fee of $2 million to $4 million.
Citigroup also had exposure to the mortgage-backed and other securities that went into CDOs for
the six- to nine-month ramp-up period, during which Citigroup accumulated all this collateral
prior to packaging and selling the CDO. Typically, this involved Citigroup’s securities unit
setting up a warehouse funding line for the CDO manager. During the ramp-up period, the
collateral securities would pay interest; depending on the terms of the agreement, that interest

946

Citigroup did not disclose to regulators//FED??// until 200x that it failed to set aside xx in 0.8% capital charges
for the commercial paper linked to its other CDO tranches. The omission is noteworthy when considering to what
extent capital requirements entered into Citigroup’s calculations for the different CDO structures it employed.
947

The 1996 Market Risk Amendment to the Basel Capital Accord required banks to consider the volatility of a
security when determining their capital requirements. Federal Reserve Board of Governors, Application of the
Market Risk Capital Requirements to Credit Derivatives, June 13, 1997. By the early 2000s, Fed officials had noted
that the Market Risk Amendment had the potential to allow insufficient capital charges for CDOs and credit default
swaps. “More products related to credit risk, such as credit default swaps and tranches of collateralized debt
obligations, are now included in the trading book,” Fed Governor Susan Bies said in a May 2006 speech. “These
products can give rise to default risks that are not captured well in models” based on market prices. Susan Bies,
Supervisory Perspective on Current Bank Capital, Market Risk, and Loan Product Issues, Speech at the Bank
Administration Institute Treasury Management Conference, Orlando, Florida, May 4, 2006.

400

would either go exclusively to Citigroup or be split with the manager. For the CDO desk, this
often represented a substantial income stream. The securities sitting in the warehouse facility
had relatively attractive yields – often 1% to 2.5% more than the typical bank borrowing rate –
and it was not uncommon for the CDO desk to earn $10 to $15 million on a single transaction.
The desk would get credit for those revenues at bonus time. Of course, these revenues came
with risks. Citigroup would ultimately be on the hook for any losses incurred on assets stuck in
the warehouse. When the financial crisis deepened, many CDO transactions could not be
completed; Citigroup and other investment banks were forced to mark down the value, or sell at
a loss, securities held in their warehouses. This would result in substantial losses across Wall
Street. In many cases, underwriters placed collateral from CDO warehouses into other CDOs to
offload assets.
Citigroup did not hedge these exposures within units or across the company. Making firm-wide
hedging complicated, different units of Citigroup could have various and offsetting exposures to
the same CDO. It was possible, even likely, that the CDO desk would structure a given CDO, a
different division would buy protection from it, and yet another division would sell protection on
the super-senior tranches. If the collateral in this CDO ran into trouble, the CDO immediately
would have to pay the division that bought credit protection; if the CDO ran out of money to pay,
it would have to draw on the division that sold the protection. In November 2007, after
Citigroup had reported substantial losses on its CDO portfolio, supervisors would note that the
company did not have a good understanding of its firm-wide CDO exposures. “The nature,
origin, and size of CDO exposure were surprising to many in senior management and the board.

401

The liquidity put exposure was not well known. In particular, management did not consider or
effectively manage the credit risk inherent in CDO positions.”948
Citigroup’s willingness to use its balance sheet to support the CDO business had the desired
effect. Its CDO desk created $11 billion in mortgage-related CDOs in 2005 and $22 billion in
2006. Among CDO underwriters, including all types of CDOs, Citigroup rose from 13th place in
2003 to second place in 2007. The ranking was a point of pride, because CDOs were lucrative.
Citigroup’s investment bank would typically earn an underwriting fee of 1% or more, that is, $10
million or more for a $1 billion CDO. In addition, it would earn interest on assets sitting in the
warehouse line during the CDO ramp-up period.
What was good for Citigroup’s investment bank was also lucrative for its investment bankers.
Thomas Maheras, the co-CEO of the investment bank who said he spent less than 1% of his time
thinking about CDOs, was Citigroup’s single highest paid executive and earned more than $34
million in salary and bonus compensation [in 2006 ck].949 Co-Heads of Global Fixed Income
Randolph Barker and Geoffrey Coley each made approximately $21 million [in that same
year].950 By contrast, Citigroup’s chief risk officer made $7.4 million.951
Others were also well compensated. The co-heads of the global CDO business, Nestor
Dominguez and Janice Warne, each made approximately $6 million in total compensation in

948

Senior Supervisors Group, Notes on senior supervisors’ meetings with firms, November 19, 2007, page 3.

949

Letter from Brad Karp of Paul, Weiss, on behalf of Citigroup to the FCIC, regarding the FCIC’s second
supplemental request, March 1, 2010, “Response to Interrogatory No. 7.”
950

Letter from Brad Karp (Paul, Weiss) on behalf of Citigroup to Bradley J. Bondi in re the FCIC’s second
supplemental request, March 1, 2010, “Response to Interrogatory No. 7.”
951
Letter from Brad Karp of Paul, Weiss, on behalf of Citigroup to the FCIC, regarding the FCIC’s second
supplemental request, March 1, 2010, “Response to Interrogatory No. 7.”

402

2006. Directors on the CDO desk, who were responsible for overseeing the structuring of one to
three deals at a time, generally made from $1 to $2.5 million a year.952 [check.]
Citi did have “clawback” provisions: under narrow circumstances, compensation would have to
be returned to the firm. But, despite Citigroup’s eventual large losses, no compensation was ever
clawed back under this policy. The Corporate Library, which rates firms’ corporate governance,
gave Citigroup a “C.” In early 2007, the Corporate Library would downgrade Citigroup to a
“D,” “reflecting a high degree of governance risk.” Among issues cited: executive compensation
practices that were poorly aligned with shareholder interests.
“Substantial progress”
Where were Citigroup’s regulators while the company piled up tens of billions of dollars of risk
in the CDO business? Citigroup had a complex corporate structure and, as a result, faced a
complex field of supervisors. The Federal Reserve supervised the holding company but, as per
the Gramm-Leach-Bliley legislation, relied on others to supervise the most important
subsidiaries: the Office of the Comptroller of the Currency (OCC) supervised the largest bank
subsidiary, Citibank and the SEC supervised Citigroup Global Markets, the securities firm.
Moreover, Citigroup did not really organize its various business in accordance with the legal
entities. An individual working on the CDO desk on a complex transaction could touch various
legal entities in complicated ways.
The SEC examined the securities arm on a three-year examination cycle, although it would also
sometimes conduct target examinations on specific concerns. Unlike the Fed and OCC, the SEC

952

FCIC staff telephone interview with John Ruddy, former Citigroup Global Structured Credit Products Director,
March 18, 2010. [XXX]% in Citigroup compensation was in the form of shares.

403

had no risk-management or safety and soundness rules for securities firms, but rather looked for
general risk management weaknesses during these exams. Unlike safety and soundness
supervisors, the SEC’s focus was always on protecting investors rather than preventing firms
from failing. When the crisis came, the SEC had most recently performed exam work at
Citigroup’s securities arm in 2005, completing the exam report in June 2006. In that exam, they
told the FCIC, they saw nothing “earth shattering,” but they did note key weaknesses in risk
management practices that would prove relevant – weaknesses in internal pricing and valuation
controls, for example, and a willingness to allow traders to exceed their risk limits. [ck cite and
FN]
Unlike the SEC, the Fed and OCC did maintain a continuous onsite presence. From [20xx] to
[20xx], the OCC team criticized the company for risk-management weaknesses on a regular
basis, including specific problems in the CDO business. “Earnings and profitability growth have
taken precedence over risk management and internal controls,” the OCC told the company in
January 2005.953 Another document from that time stated, “The findings of this examination are
disappointing, in that the business grew far in excess of management’s underlying infrastructure
and control processes.”954 But despite these concerns, the OCC continued to rate Citibank
management as “satisfactory” from [XXX] to [XXX].
The New York Fed, then headed by now-Treasury Secretary Timothy Geithner, received a
critical review in May 2005 for its oversight of Citigroup from peers at the other Federal Reserve
banks. The review concluded that the Fed’s on-site Citigroup team appeared to have
“insufficient resources to conduct continuous supervisory activities in a consistent manner. At
953

OCC, Citigroup Risk Management, January 13, 2005.

954

OCC, cover letter to credit derivatives examination findings memo, December 22, 2005.

404

Citi, much of the limited team’s energy is absorbed by topical supervisory issues that detract
from the team’s continuous supervision objectives…the level of the staffing within the Citi team
has not kept pace with the magnitude of supervisory issues that the institution has realized.”955
Perhaps illustrative of these problems, in the Fed’s 2005 examination of Citigroup, the regulator
did not raise the concerns expressed by the OCC that same year. [Will add comment on Fed’s
view on liquidity puts.] Four years later, the next peer review would again find substantial
weaknesses in the oversight of Citigroup.
Then, in April 2006, the Fed raised the holding company’s supervisory rating from the previous
year’s “unsatisfactory” to “satisfactory.” It lifted the ban on new mergers imposed the previous
year in reaction to Citigroup’s many regulatory problems. The Fed and OCC examiners
concurred that the company had made “substantial progress” implementing CEO Chuck Prince’s
plan to overhaul risk management. The Fed stated, “The company has . . . completed
improvements necessary to bring the company into substantial compliance with two existing
Federal Reserve enforcement actions related to the execution of highly structured transactions
and controls.”956 The following year, Citigroup’s board would allude to Prince’s successful
resolution of its regulatory compliance problems in justifying a 20% pay and bonus increase.957
The OCC noted in retrospect that the lifting of supervisory constraints in 2006 had been a key
turning point. “Eager to make up for lost time, and to match the financial metrics of its
competitors, Citigroup starting in 2006, and continuing into 2007, aggressively increased its risk
955

2009 New York Operations Review, Internal Scope Memorandm, Nov 16, 2009, p.10.

956

Federal Reserve Board, memo to Governor Susan Bies, February 17, 2006.

957

The Board reversed a 15% reduction that had been implemented when the issues began and then added a 5%
raise. Citigroup 2006 Proxy Statement, p. 37 of Proxy Statement (p. 40 of PDF)
http://www.citigroup.com/citi/fin/data/ar06cp.pdf

405

profile as it reached for additional profits,” the OCC wrote to Vikram Pandit, Prince’s
replacement, in early 2008. “Enterprise risk management granted exceptions to limits, and
increased exposure limits (instead of keeping business units in check as they had told the
regulators).”958 Well after Citigroup sustained large losses on its CDOs, the Fed would criticize
Citigroup for using its commercial bank to support its investment bank. “Senior management
allowed business lines largely unchallenged access to the balance sheet to pursue revenue
growth,” the Fed wrote in a April 2008 letter to Pandit. “Citigroup attained significant market
share across numerous products, including leveraged finance and structured credit trading,
utilizing balance sheet for its ‘originate to distribute’ strategy. Senior management did not
appropriately consider the potential balance sheet implications of this strategy in the case of
market disruptions. Further, they did not adequately access the potential negative impact of
earnings volatility of these businesses on the firm’s capital position.”959

AIG: “I’m not getting paid enough to stand on these tracks”
Unlike their peers at Citigroup, some senior executives at AIG’s Financial Products subsidiary
had figured out that the company was taking too much risk. Nonetheless, they did not do enough
about it. Doubts about all the credit default swaps they were originating emerged in 2005 among
AIG Financial Products executives, including Andrew Forster and Gene Park. Park witnessed
Financial Products CEO Joe Cassano berating a salesman over the large volume of credit default
swaps AIG Financial Products was writing, suggesting there was already some high-level
disagreement about these deals. Told by another executive, Adam Budnick, that the “multisector” ABS CDOs on which AIG was selling credit default swaps primarily invested in
958

OCC, letter to Citigroup CEO Vikram Pandit, February 14, 2008.

959

PIR p 60 [Need reference.]

406

mortgage-backed securities with less than 10% subprime and Alt-A mortgages, Park asked for
verification. Budnick returned and said, according to Park, “‘I can’t believe it. You know it’s like
80 or 90%.’”960
Reviewing the portfolio – and thinking about a friend who had received 100% financing for his
new home after losing his job – Park said, “My God, we should shut this down.”
In July 2005, Park’s colleague Andrew Forster sent an email to Alan Frost, the AIG salesman
primarily responsible for the company’s booming credit default swap business, and Professor
Gary Gorton, the consultant who engineered the formula to determine how much risk AIG was
taking on in each CDS it wrote. Forster wrote, “[W]e are taking on a huge amount of sub-prime
mortgage exposure here …. Everyone we have talked to says they are worried about deals with
huge amounts [of high-risk mortgage] exposure yet I regularly see deals with 80% [high-risk
mortgage] concentrations currently. Are these really the same risks as other deals?”
Park and others studied the issue for weeks, talked to bank analysts and other experts, and
considered whether it made sense for AIG to continue to write protection on the subprime and
Alt-A mortgage markets. The general view was that some of the underlying mortgages “were
structured to fail, [but] that all the borrowers would basically be bailed out as long as real estate
prices went up.”[cite] In other words, as long as prices rose and borrowers could make money by
selling their houses, they would be able to repay their mortgages.
AIG executives said one bullish Bear Stearns analyst they met was “out of his mind” and “must
be on drugs or something.”961 Another analyst, from Goldman Sachs, took Park aside after AIG
960

Gene Park Transcript at --.

961

Gary Gorton Interview Transcript at __

407

had indicated the firm was considering no longer writing credit default swaps on subprimebacked CDOs and said he agreed with Park’s pessimism. Park and some of his colleagues had
come to the conclusion, as Park related to the FCIC, “We weren’t getting paid enough money to
take that risk…I’m not going to opine on whether there’s a train on its way. I just know that I’m
not getting paid enough to stand on these tracks.”962
By February 2006, Park and others persuaded Cassano and Frost to stop writing CDS protection
on subprime mortgage-backed securities. In an email to Cassano, Park wrote on February 28:
Joe,
Below summarizes the message we plan on delivering to dealers later this week with regard to
our approach to the CDO of ABS super senior business going forward. We feel that the CDO of
ABS market has increasingly become less diverse over the last year or so and is currently at 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 such concentrated exposure to certain parts of the non prime mortgage securitizations.
On the deals that we participate on we would like to see significant change in the composition of
these deals going forward – i.e. more diversification into the non-correlated asset classes.
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 asset class… We realize that this is likely to take us
out of the CDO of ABS market for the time being given the arbitrage in subprime collateral.
However, we remain committed to working with underwriters and managers in developing the
962

Park interview p. 96

408

CDO of ABS market to hopefully become more diversified from a collateral perspective. With
that in mind, we will be open to including new asset classes to these structures or increasing
allocations to others such as [collateralized loan obligations] and [emerging market] CDOs.963
AIG’s counterparties responded with indifference. “The day that you drop out, we’re going to
have 10 other people who are going to replace you,” Park says he was told.964 In any event,
counterparties had some time to find new takers, because AIG Financial Products continued to
write the credit default swaps. While the bearish executives were researching the issue from the
summer of 2005 onward, the team continued to complete the deals in the pipeline, even after
February 2006. Overall, they did 24 deals between September 2005 and July 2006 – one of them
on a CDO backed by 93% subprime assets.965
By June of 2007, AIG had written swaps on approximately $80 billion in CDOs, five times the
$16 billion held at the end of 2005.966 Park asserted that neither he nor most others at AIG knew
at the time that the swaps demanded collateral calls on AIG if the market value of the referenced
securities declined. Park said their concern was simply that AIG would be on the hook if
subprime and Alt-A borrowers defaulted in large numbers. Cassano, however, told the FCIC he
did know about the possible calls, but only the risk of collateral calls if AIG was downgraded is
noted in AIG’s SEC filings to investors for 2005.967

963

Gene Park email to Joseph Cassano dated February 28, 2006, AIG-FCIC00109490.

964

Park p.97.

965

PIR p.36.

966

AIG, Residential Mortgage Presentation, p.28

967

PIR p.

409

Still, AIG never hedged more than $150 million of its total subprime exposure.968 Some of
AIG’s counterparties not only used AIG’s swaps to hedge other positions, but they also hedged
AIG’s ability to make good on its contracts. As we will see later, Goldman Sachs hedged
aggressively by buying CDS protection on AIG and by shorting other securities and indexes to
counterbalance the risk that AIG would fail to pay up on its swaps, or that the subprime market
would pull down mortgage-backed securities.

Merrill: “Aggressive build-out CDO business strategy”
When Dow Kim became head of Merrill Lynch’s Fixed Income, Currencies, and Commodities
group in July 2003, he had been instructed to boost revenue, especially in businesses where
Merrill lagged competitors.969 Kim focused on the CDO business; clients saw CDOs as an
integral part of their trading strategy, he told the FCIC.970 He hired Chris Ricciardi from Credit
Suisse, where Ricciardi’s group had sold more CDOs than anyone in 2001 and 2002.971
Ricciardi came through, lifting Merrill’s CDO business from fifteenth place in 2002 to second
place behind only Citigroup in 2004 and Goldman in 2005. Then, in February 2006, he left the
bank to become CEO of Cohen & Company, an asset management business; at Cohen he would
manage several CDOs, often deals underwritten by Merrill.
After Ricciardi left, Kim instructed the rest of the team to do “whatever it takes” not just to
maintain market share, but also to take over the number one ranking, former employees said in a

968

Park interview p 134-135.

969

Kim MFR at 4.

970

O’Neal MFR at 9-10.

971

Kim MFR at 4.

410

complaint filed against Merrill Lynch.972 Kim told FCIC staff that he couldn’t recall specific
conversations but that after Ricciardi left, Merrill was still trying to expand the CDO business on
a global basis and that he, Kim, wanted people to know that Merrill was committed in terms of
people, resources and balance sheet.973
It was indeed committed. Despite the loss of its rainmaker, Merrill swamped the competition,
originating a total $55.3 billion in CDOs [ck whether just mortgage CDOs] in 2006 while the
number two ranked firm did only $22 billion, plus another first place ranking in 2007, on the
strength of the CDO machine Ricciardi had built—a machine that brought in more than $1
billion in fees between 2003 and 2006.974,975
Manufacturing demand
With all the investment banks churning out CDOs, the market was starting to top out—definitely
a problem, but not something Merrill considered insurmountable. Merrill pursued three strategies
in response, all of which involved repackaging riskier mortgages more attractively or buying its
own toxic 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;
it increasingly repackaged the hard-to-sell, BBB and other low-rated tranches of its CDOs into
its other CDOs; and it used the cash sitting in its synthetic CDOs to purchase other CDO
tranches.
972

“Subprime Suspect,” The New Yorker (3/31/08) at 85; Complaint at Paragraph 147.

973

Kim MFR at 8.

974

Merrill document, BAC-ML-CDO-000077073

975

10/21/07 Presentation to the ML Board of Directors – Leveraged Finance and Mortgage/CDO Review; BACML-CDO-000077035-073 at 073.

411

It had been standard practice for CDO underwriters to sell some mezzanine tranches to other
CDO managers. Even in the early days of asset-backed CDOs, these assets often contained a
nominal percentage of mezzanine tranches of other CDOs; the rating agencies signed off on this
practice when rating each deal. But the practice became more common as the demand waned
from traditional investors, as it had for the riskier mortgage-backed securities tranches. The
market came to call traditional investors the “real money” to distinguish them from CDO
managers who were buying tranches just to put them into their CDOs. Between 2005 and 2007,
the typical amount a CDO could buy of the tranches of other CDOs and still maintain its ratings
grew from 5% to 30%, according to CDO manager Wing Chau.976 According to data compiled
by the FCIC, tranches from CDOs rose from an average of 7% of the collateral in mortgagebacked CDOs in 2003 to 14% by 2007.977 CDO-squared deals – those engineered primarily from
the tranches of other CDOs – grew from 36 market-wide in 2005, to 48 in 2006 and 41 in 2007.
Merrill created and sold 11.
Still, there are clear signs that few “real money” investors remained in the CDO market by late
2006. Consider Merrill: for the 44 ABS CDOs that Merrill created and sold from the fourth
quarter of 2006 through August 2007, [XXX%] of the mezzanine tranches were purchased by
CDO managers.978 Same for Chau: An FCIC analysis found [XXX%] of the mezzanine tranches
sold by the [XXX] CDOs Chau managed were sold for inclusion into other CDOs. For example,
an estimated 10 different CDO managers purchased tranches in Merrill’s Norma CDO. In the

976

FCIC interview with Wing Chau.

977

Data based on FCIC staff analysis of Moody’s Enhanced CDO Monitoring Database.

978

BAC-ML-CDO-000079709-710; BAC-ML-CDO-000079726-752. Relevant information not yet provided for
Robeco High Grade CDO I. BAC-ML-CDO-000079745-46.

412

most extreme case the FCIC found, CDO managers were the only purchasers of Merrill’s Neo
CDO.979
Market wide, in 2003, CDOs bought approximately 13% of the A tranches, 23% of the Aa (the
Moody’s version of xxx) tranches, and 43% of the Baa tranches issued by other CDOs (Baa is
the Moody’s version of BBB). In 2007, those numbers were approximately 87%, 81%, and 89%,
respectively.980 It came down to this: Merrill and other investment banks simply created demand
for CDOs by manufacturing new ones to buy the harder-to-sell portions of the old ones.
As SEC attorneys told the FCIC that heading into 2007 there was a street-wide club: you buy my
BBB tranche and I’ll buy yours.981
Merrill and its CDO managers were the biggest buyers of their own products. Merrill created
and sold 142 CDOs from 2003 to 2007. All but eight of these – 134 CDOs – sold at least one
tranche into another Merrill CDO, and 86 bought at least one tranche from another Merrill CDO.
In Merrill’s deals, on average, 10% of the collateral packed into the CDOs consisted of tranches
of other CDOs that Merrill itself had created and sold.982 This was a relatively high percentage,

979

BAC-ML-CDO-000079726-752 (listing of CDO tranche purchasers); BAC-ML-CDO-79752 (listing of collateral
managers).
980

Total Baa tranches issued by CDOs in the FCIC data base were $684 million in 2003 and $3.9 billion in 2007.
Aa tranches were $1.4 billion in 2003 and $8.3 billion in 2007. A tranches were $522 million in 2003 and $4.3
billion in 2007. The FCIC selected CDOs with at least 10% of their collateral invested in mortgage-backed
securities or other characteristics that identified them as ABS CDOs.
981

September 1, 2010 Notes of Phone Conversation between SEC and FCIC staff; Netdocs ID: 4821-8692-1735.

982

Data based on FCIC staff analysis of Moody’s Enhanced CDO Monitoring Database.

413

but not the highest: For Citigroup, another big player in this market, it was a somewhat higher
13%. For UBS, it was just 3%.983
And Merrill continued to push its CDO business despite signals that the market was weakening.
It did not even reconsider its strategy in the spring of 2006, when AIG stopped insuring even the
very safest, super-senior CDO tranches for Merrill and others. Without AIG, which had already
insured $8 billion of CDO bonds for Merrill – Merrill was AIG’s third largest counterparty, after
Goldman and SocGen – Merrill switched to the monoline insurance companies for protection. In
the summer of 2006, Merrill management noticed that Citigroup, its biggest competitor in ABS
CDO underwriting, was taking more super-senior tranches of CDOs onto its own balance sheet
at razor-thin margins, effectively subsidizing returns for investors in the BBB 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 AIG or the monolines.984
Why didn’t anyone in the banks question the fact that, to keep the machine humming, the banks
had to swallow more and more of their own product because nobody else would buy? In fact,
managers defended the practice. Chau, who managed [XXX] CDOs created and sold by Merrill
at Maxim Advisory and later Harding Advisory and had worked with Ricciardi at Prudential
Securities in the early days of multi-sector CDOs, told the FCIC that plain mortgage-backed
securities had become expensive relative to their returns, even as the real estate market sagged.

983

Data based on FCIC staff analysis of Moody’s Enhanced CDO Monitoring Database.

984

10/21/07 Presentation to the ML Board of Directors – Leveraged Finance and Mortgage/CDO Review; BACML-CDO-000077035-073 at 061.

414

Because CDOs paid better returns than similarly rated mortgage-backed securities, they were in
demand, and that is why CDO managers packed their securities with other CDOs.985
This would not be the end of Merrill’s all-in wager on the mortgage and CDO businesses. Even
though it did grab the first-place trophy in the CDO business in 2006, it had come late to the
“vertical integration” mortgage model that Lehman Brothers and Bear Stearns had pioneered,
with a stake in every step of the mortgage business--originating mortgages, bundling these loans
into securities, bundling these securities into other securities, selling all of them on Wall Street.
In September 2006, months after the housing bubble had started to deflate and delinquencies
began to rise, Merrill announced it would acquire a subprime lender, First Franklin Financial
Corp., from National City Corp. for $1.3 billion. This move “puzzled analysts because the
market for subprime loans was souring in a hurry….”986 And, Merrill already had a $100 million
ownership position in Ownit Mortgage Solutions Inc., for which it also provided a warehouse
line of credit, and it provided another line of credit to Mortgage Lenders Network. Both of these
companies would cease operations soon after the First Franklin purchase, requiring Merrill to
seize $2.7 billion of subprime mortgage product that was collateral for these lines of credit.987
Nor did Merrill cut back in September 2006, when one of its own analysts, Kenneth Bruce,
issued a report warning that this subprime exposure could suddenly cut earnings, because
demand for these mortgages assets could dry up quickly.988 That assessment was not in line with

985

FCIC interview with Wing Chau, November 11, 2010.

986

“Merrill’s Own Subprime Warnings Unheeded,” Reuters (10/30/07).

987

1/4/07 SEC OPSRA Memo, SEC_TM_FCIC_002442-2446; 2/2/07 SEC OPSRA Memo,
SEC_TM_FCIC_002447-51
988

“Merrill’s Own Subprime Warnings Unheeded,” Reuters (10/30/07).

415

the corporate strategy, and Merrill did nothing. Finally, at the end of 2006, Kim finally
instructed his people to reduce credit risk across the board. 989 As it would turn out, this was too
late. The pipeline was too large.

Regulators: “Are undue concentrations of risk developing?”
As in the case of nontraditional mortgage guidance, the regulators failed to act on a timely basis
to the rapidly changing structured finance market. They had an opportunity. On January 2,
2003, one year after the collapse of Enron, the U.S. Senate Permanent Subcommittee on
Investigations called upon the Fed, OCC, and SEC “to immediately initiate a one-time, joint
review of banks and securities firms participating in complex structured finance products with
U.S. public companies to identify those structured finance products, transactions, or practices
which facilitate a U.S. company’s use of deceptive accounting in its financial statements or
reports.”990 Congress [be specific] gave the agencies a June 2003 deadline to issue joint guidance
[ck nature of request or requirement].991 Four years later, the banking agencies and the SEC
issued their “Interagency Statement on Sound Practices Concerning Elevated Risk Complex
Structured Finance Activities,”992 a document that was all of nine pages long.
In the intervening years, 2003 to 2007, the banking agencies and SEC issued two draft
statements for public comment. The 2004 draft, issued the year after the OCC, Fed, and SEC

989

Kim MFR at 9.

990

U.S. Senate Permanent Subcommittee on Investigations, “Fishtail, Bacchus, Sundance, and Slapshot: Four
Enron Transactions Funded and Facilitated by U.S. Financial Institutions” (January 2, 2003), pg. 36, available at:
www.gpo.gov/fdsys/pkg/CPRT.../pdf/CPRT-107SPRT83559.pdf
991

Fishtail Report at pg. 37.

992

Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities
issued by OCC, OTS, FRB, FDIC, and SEC (January 5, 2007).

416

brought enforcement actions against Citigroup and JP Morgan for helping Enron manipulate its
financial statements, focused upon the policies and procedures that financial institutions should
have for managing the structured finance business.993 The focus was to avoid another Enron –
and for that reason, it encouraged financial institutions to look out for customers that, like Enron,
were trying to use structured transactions to circumvent regulatory or financial reporting
requirements, evade tax liabilities, or engage in other illegal or improper behavior.
Meanwhile, industry groups criticized the draft guidance as too broad, prescriptive, and
burdensome. Several said it would encompass many structured finance products that did not
pose significant legal or reputational risks. Another said that it “would disrupt the market for
legitimate structured finance products and place U.S. financial institutions at a competitive
disadvantage in the market for [complex structured finance transactions] in the United States and
abroad.”994
Two years later, in May 2006, the agencies issued an abbreviated draft based on a more
“principles-based” approach, and again requested comments. Most of the requirements were very
similar to those that the OCC and Fed had imposed on Citigroup and JP Morgan in the 2003
enforcement actions.995

993

Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities issued by OCC,
OTS, FRB, FDIC, and SEC (Notice of Interagency statement with request for public comments) (May 13, 2004).
994

Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities
issued by OCC, OTS, FRB, FDIC, and SEC (Notice of Interagency statement with request for public comments)
(May 9, 2006), at pp 7-8.
995

Statement of John C. Dugan, Comptroller of the Currency, before the FCIC (April 8, 2010), Appendix E: OCC
Supervision of Citibank, N.A., pg. 10. [Document available on FCIC website.]

417

When the regulators issued the final guidance in January 2007, the industry was more supportive.
One reason: it specifically excluded mortgage-backed securities and CDOs. “Most structured
finance transactions, such as standard public mortgage-backed securities and hedging-type
transactions involving ‘plain vanilla’ derivatives or collateralized debt obligations, are familiar to
participants in the financial markets, have well-established track records, and typically would not
be considered [complex structured finance transactions] for purposes of the Final Statement.”996
Those exclusions had been added after the regulators received comments on the 2004 draft.
Supervisors did take note of the potential risks of CDOs and credit default swaps. In 2005, the
Basel Committee on Banking Supervision’s Joint Forum, which includes banking, securities, and
insurance regulators across the world, issued a comprehensive report on these products. The
report focused on whether banks and other firms involved in the CDO and credit default swap
business understood the credit risk they were taking.997 It advised banks and other firms to make
sure they understood the nature of the rating agencies’ models, especially for CDOs. And it
advised them to make sure that counterparties from whom they bought credit protection –
namely, AIG and the financial guarantors – would be good for that protection if they were
needed.998
The supervisors also said they had researched in some depth the question, “Are undue
concentrations of risk developing?” in the CDO and derivatives market. Their answer: probably
996
997

Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities
issued by OCC, OTS, FRB, FDIC, and SEC, January 5, 2007.
997

Credit Risk Transfer, Joint Forum, Basel Committee on Banking Supervision, Bank for International Settlements
(March 2005).

998

Credit Risk Transfer at pp. 5-10.

418

not. The credit risk was “quite modest,” the supervisors concluded, and the monoline financial
guarantors appeared to know what they were doing. “The [Joint Forum’s Working Group on
Risk Assessment and Capital] has not found evidence of ‘hidden concentrations’ of credit risk.
There are some non-bank firms whose primary business model focuses on taking on credit risk.
Most important among these firms are the monoline financial guarantors. Other market
participants seem to be fully aware of the nature of these firms. In the case of the monolines,
credit risk has always been a primary business activity and they have invested heavily in
obtaining the relevant expertise. While obviously this does not rule out the potential for one of
these firms to experience unanticipated problems or to misjudge the risks, their risks are
primarily at the catastrophic or macroeconomic level. It is also clear that such firms are subjected
to regulatory, rating agency, and market scrutiny.”
The supervisors noted that industry participants appeared to have learned from earlier flare-ups
in the CDO sector. “The Working Group believes that it is important for investors in CDOs to
seek to develop a sound understanding of the credit risks involved 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 probably been salutary in highlighting the potential risks
involved.”999

Moody’s: “It was all about revenue”
Like other market participants, Moody’s Investors Service, one of the three dominant rating
agencies, was swept up in the frenzy of the structured products market. Mortgage-backed
securities and CDOs were standardized according to guidelines set by the agencies; without their

999

Credit Risk Transfer, page 3-4.

419

models and their generous allotment of AAA ratings, there would have been little investor
interest and most deals just wouldn’t have gotten done. Between 2002 and 2006, the volume of
Moody’s business for rating residential mortgage-backed securities more than doubled; the dollar
value of that business increased from $62 million to $169 million;1000 staffing levels for rating
these deals doubled.1001 However, over the same period, volume for rating CDOs increased
seven-fold, but staffing increased only 24%.1002 From 2003 to 2006, annual CDO revenue grew
from $12 million to $91 million.
When Moody’s Corporation went public in 2000, investor Warren Buffett’s Berkshire Hathaway
held 15% of the company through affiliates and as much as 20% by [20xx] .1003 As of 200xx,
Berkshire Hathaway and three other investors owned a combined 50.5% of Moody’s. When
asked whether he was satisfied with the internal controls at Moody’s, Buffett responded to the
FCIC that he knew nothing about the management of Moody’s. “I had no idea. I’d never been at
Moody’s, I don’t know where they are located.” Buffett said he invested in the company
because the rating agency business was “a natural duopoly” which gave it “incredible” pricing
power – “the single-most important decision in evaluating a business is pricing power.”1004
Many employees said the company culture changed after the public listing. They also identified
a new focus on market share during the 2000s under the direction of Brian Clarkson. Clarkson
1000

SEC_OCIE_FCIC_000496 - Examination Report to Moody's Investor Services, Inc, p. 4 (ID# 4835-0383-5144).

1001

SEC_OCIE_FCIC_000496 - Examination Report to Moody's Investor Services, Inc, p. 4 (ID# 4835-0383-5144).

1002

SEC_OCIE_FCIC_000496 - Examination Report to Moody's Investor Services, Inc, p. 4 (ID# 4835-0383-5144).

1003

Buffett and three other institutional investors own a combined 50.5% of Moody’s: Capital Group (18.4%),
Fidelity Investments (10.6%), and Davis Selected Advisers (8.1%). Moody’s 2009 proxy.
1004

Warren Buffett, interview with the FCIC, May 26, 2010, p. 4, 8 [ID# 4823-5102-3622]; Warren Buffett,
testimony to the FCIC, hearing on “Credibility of Credit Ratings, the Investment Decisions Made Based on those
Ratings, and the Financial Crisis,” June 3, 2010, p. 302, ID# 4849-3039-7959.

420

had joined Moody’s in 1991 as a senior analyst in the residential mortgage group, and after
successive promotions became co-chief operating officer of the rating agency in 2004, and then
president in August 2007. 1005Gary Witt, a former team managing director covering U.S.
derivatives, described culture transformation under Clarkson: “[M]y kind of working hypothesis
was that [former Chairman and CEO] John Rutherford was thinking, ‘I want to remake the
culture of this company to increase profitability dramatically [after Moody’s became an
independent corporation],’ and that he made personnel decisions to make that happen, and he
was successful in that regard. And that was why Brian Clarkson’s rise was so meteoric…he was
the enforcer who could change the culture to have more focus on market share.”1006 Former
managing director Jerome Fons, who was responsible for assembling an internal history of
Moody’s, agreed:1007 “[T]he main problem was… that the firm became so focused, particularly
the structured area, on revenues, on market share, and the ambitions of Brian Clarkson, that they
willingly looked the other way, traded the term’s reputation for short-term profits.”1008
Clarkson and Chairman and CEO Raymond McDaniel adamantly disagreed with the perception
that market share concerns trumped rating quality. He cited unforeseen market conditions as the
reason the models did not accurately predict the credit quality.1009 McDaniel testified to the
FCIC, “We believed that our ratings were our best opinion at the time that we assigned them. As

1006

Transcript of FCIC interview with Gary Witt, April 21, 2010. John Rutherford was the president and CEO of
Moody’s Corporation from its spin-off from Dun & Bradstreet in 2000 until he retired from the firm in 2005.

1007

Jerome Fons, interview with the FCIC, April 22, 2010, p. 27-28 (ID# 4842-7212-1862).

1008

Jerome Fons, interview with the FCIC, April 22, 2010, p. 60 (ID# 4842-7212-1862).

1009

[Transcript of FCIC interview with Raymond McDaniel, May 21, 2010] [ck]; transcript of FCIC interview with
Brian Clarkson, May 20, 2010.

421

we obtained new information and were able to update our judgments based on the new
information and the trends we were seeing in the housing market, we made what I think are
appropriate changes to our ratings.”1010
Nonetheless, Moody’s President, Clarkson, did not seem to have the same enthusiasm for
compliance as he did for market share and profit, said those who worked with him. Scott
McCleskey, a former chief compliance officer at Moody’s, recounted a story to the FCIC about
an evening when he and Clarkson were dining with the board of directors after the company
announced strong earnings, particularly in 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.’….[F]or him to say that in front of the board, that’s just so telling of how he felt that he
was bulletproof…. For him, it was all about revenue.”1011
Clarkson’s management style left little room for discussion or dissent. Witt referred to Clarkson
as the “dictator” of Moody’s and said that, if he asked an employee to do something, “either you
comply with his request or you start looking for another job.”1012 “When I joined Moody’s in
late 1997, an analyst’s worst fear was that we would contribute to the assignment of a rating that
was wrong,” Mark Froeba, former senior vice president, testified to the FCIC. “When I left

1010

FCIC hearing

1011

Scott McCleskey, interview with the FCIC, April 16, 2010, p. 39 (ID# 4842-3856-7430).

1012

Gary Witt, interview with the FCIC, April 21, 2010, p. 18, 76 (ID# 4818-7724-2630)

422

Moody’s, an analyst’s worst fear was that he would do something, or she, that would allow him
or her to be singled out for jeopardizing Moody’s market share.”1013
Former team managing director Gary Witt recalled that he received a monthly email from
Clarkson “that outlined basically my market share in the areas that I was in charge of…. I
believe it listed the deals that we did, and then it would list the deals like S&P and/or Fitch did
that we didn’t do that was in my area. And at times, I would have to comment on that verbally
or even write a written report about—you know, look into what was it about that deal, why did
we not rate it. So, you know, it was clear that market share was important to him.”1014 Witt
acknowledged the pressures that he felt as a manager: “When I was an analyst, I just thought
about getting the deals right…. Once I [was promoted to managing director and] had a budget to
meet, I had salaries to pay, I started thinking bigger picture. I started realizing, yes, we do have
shareholders and, yes, they deserved to make some money. We need to get the ratings right first,
that’s the most important thing; but you do have to think about market share.”1015
Even as far back as 2001, a strong emphasis on market share was evident in employee
performance evaluations. In July 2001, Clarkson circulated a spreadsheet to subordinates that
listed 49 analysts and the number and dollar volume of deals each had “rated” or “NOT
rated.”1016 Clarkson’s instructions: “You should be using this in PE’s [performance evaluations]
1013

Mark Froeba, testimony to the FCIC, hearing on “The Credibility of Credit Ratings, the Investment Decisions
Made Based on those Ratings, and the Financial Crisis,” Session 3: The Credit Rating Agency Business Model, June
2, 2010, p. 347 (ID# 4818-8776-0390)

1014

Gary Witt, interview with the FCIC, April 21, 2010, p. 25 (ID# 4818-7724-2630)

1015

Gary Witt, testimony to the FCIC, hearing on “The Credibility of Credit Ratings, the Investment Decisions
Made Based on those Ratings, and the Financial Crisis,” Session 3: The Credit Rating Agency Business Model, June
2, 2010, p. 394 (ID# 4818-8776-0390)

1016

MOODYS-FCIC-0035796, “1st Half 2001 AFG” (emphasis in original document).

423

and to give people a heads up on where they stand relative to their peers.”1017 Team managing
directors, who oversaw the analysts rating the deals, received a base salary, cash bonus and stock
options. Performance goals for team managing directors generally fell into the following
categories: market coverage, revenue, market outreach (such as speeches and publications),
ratings quality, and development of analytical tools. Only one of these categories couldn’t be
measured in real time as compensation was being awarded: ratings quality. It might take years
for the poor quality of rating to become clear as the rated asset failed to perform as expected.
In January 2006, a derivatives manager listed his top achievements in a 2005 performance
evaluation. At the top of the list: “Protected our market share in the CDO corporate cash flow
sector... To my knowledge we missed only one CLO from BofA and that CLO was unratable by
us because of it’s [sic] bizarre structure.”1018
Another example of emphasis on market share was an email circulated in the fall of 2007, in the
midst of significant downgrades in the structured finance market. Group Managing Director of
U.S. Derivatives Yuri Yoshizawa asked her team’s managing directors to explain a market share
decrease from 98% to 94%.1019 Yoshizawa confirmed to FCIC staff that her inquiry was typical
of others she would make concerning market coverage.1020

1017

MOODYS-FCIC-0035795 – MOODYS-FCIC-0035797 email from Brain Clarkson to Ed Bankole, Pramila
Gupta, Michael Kanef, Andrew Kriegler, Sam Pilcer, Andrew Silver, and Linda Stesney re “June YTD AFG by
analyst.xls” (July 5, 2001).

1018

PSI-MOODYS-000072 [Exhibit #16] Email from William May to Gus Harris “RE: BES and PEs” (January 12,
2006). PIR pg 40

1019

PSI-MOODYS-MS-000001 [Exhibit #24a] Email from Yuri Yoshizawa to direct report MDs re “3Q Market
Coverage-CDO,” October 5, 2007. PIR pg 51

1020

Transcript of FCIC interview with Yuri Yoshizawa, May 17, 2010.

424

Witt recalled that the “smoking gun” moment of his employment at Moody’s occurred during a
third quarter 2007 “town hall” meeting with Moody’s management and its managing directors,
after Moody’s had already announced mass downgrades on mortgage-related securities.1021 After
McDaniel made a presentation about Moody’s financial outlook for the year ahead, one
managing director replied: “I was interested, Ray, to hear your belief that the first thing in the
minds of people in this room is the financial outlook for the remainder of the year…. [M]y
thinking is there’s a much greater concern about the franchise,” he explained.1022 “I think that the
greater anxiety being felt by the people in this room and… by the analysts is what’s going on
with the ratings and what the outlook is…specifically the severe ratings transitions we’re dealing
with… and uncertainty about what’s ahead on that, the ratings accuracy.”1023 Witt recalled,
“Moody’s reputation was just being absolutely lacerated; and that these people are standing here,
and they’re not even addressing – they’re acting like it’s not even happening, even now that it’s
already happened…. [T]hat just made it so clear to me… that the balance was far too much on
the side of short term profitability.”1024
In an internal memorandum from October 2007 sent to McDaniel, in a section entitled “Conflict
of Interest: Market Share,” Chief Credit Officer Andrew Kimball explained that “Moody’s has

1021

Gary Witt, testimony to the FCIC, hearing on “The Credibility of Credit Ratings, the Investment Decisions
Made Based on those Ratings, and the Financial Crisis,” Session 3: The Credit Rating Agency Business Model, June
2, 2010, p. 456-457 (ID# 4818-8776-0390)

1022

MD Town Hall Meeting Survey Results and Transcript, September 11, 2007, MOODY’S-COGR-0052080 –
0052160, pp. MOODY’S-COGR-0052122, 0052131 [ID# 4820-7781-2487]

1023

MD Town Hall Meeting Survey Results and Transcript, September 11, 2007, MOODY’S-COGR-0052080 –
0052160, pp. MOODY’S-COGR-0052131 - 0052132 [ID# 4820-7781-2487]

1024

Gary Witt, interview with the FCIC, April 21, 2010, p. 20 (ID# 4818-7724-2630).

425

erected safeguards to keep teams from too easily solving the market share problem by lowering
standards.”1025 However, he observed that these protections were far from failsafe:
(a) Ratings are assigned by committee, not individuals. (However,
entire committees, entire departments, are susceptible to market
share objectives)1026
(b) Methodologies & criteria are published and thus put boundaries on
rating committee discretion. (However, there is usually plenty of
latitude within those boundaries to register market influence.)1027
Moreover, the pressure for market share, combined with complacency, may have served as a
disincentive to create new models or update assumptions. In the October 2007 memorandum,
Kimball acknowledges the disincentives: “Organizations often interpret past successes as
evidencing their competence and the adequacy of their procedures rather than a run of good
luck…. [O]ur 24 years of success rating RMBS may have induced managers to merely fine-tune
the existing system—to make it more efficient, more profitable, cheaper, more versatile. Finetuning rarely raises the probability of success; in fact, it often makes success less certain.”1028

1025

MOODY’S-COGR-0038027 “Credit policy issues at Moody’s suggested by the subprime/liquidity crisis”
(internal October 2007 memorandum by Chief Credit Officer Andrew Kimball).

1026

MOODY’S-COGR-0038027 “Credit policy issues at Moody’s suggested by the subprime/liquidity crisis”
(internal October 2007 memorandum by Chief Credit Officer Andrew Kimball). The susceptibility of a ratings
committee to external pressures was evidenced in the CPDO scandal in Europe. See infra.

1027

MOODY’S-COGR-0038027 “Credit policy issues at Moody’s suggested by the subprime/liquidity crisis”
(internal October 2007 memorandum by Chief Credit Officer Andrew Kimball).

1028

MOODY’S-COGR-0038027 “Credit policy issues at Moody’s suggested by the subprime/liquidity crisis”
(internal October 2007 memorandum by Chief Credit Officer Andrew Kimball.

426

If an issuer didn’t like Moody’s rating on a particular deal, it might get a better rating from
another rating agency. 1029 The agencies were compensated only for rated deals—in effect, only
for the deals for which their ratings were accepted by the issuer. So the pressure came from two
directions: in-house, as well as direct demands from the issuers and investment bankers, who
pushed for better ratings with fewer conditions. 1030
Richard Michalek, a former Moody’s vice president and senior credit officer, testified to the
FCIC, “[T]he threat of losing business to a competitor, even if not realized, absolutely tilted the
balance away from an independent arbiter of risk towards a captive facilitator of risk
transfer.”1031 Witt agreed. Asked if the investment banks frequently threatened to withdraw their
business if they didn’t get their desired rating, Witt replied, “Oh god, are you kidding? All the
time. I mean, that’s routine. I mean, they would threaten you all of the time…It’s like, ‘Well,
next time, we’re just going to go with Fitch and S&P.’”1032
Former managing director Fons suggested that Moody’s was complacent about this pressure.
“[Moody’s] knew that they were being bullied into caving in to bank pressure from the
investment banks and originators of these things…. Moody’s allows itself to be bullied. And,
you know, they willingly played the game …. They could have stood up and said, ‘I’m sorry,
this is not—we’re not going to sign off on this. We’re going to protect investors. We’re going to
1029

David Teicher, interview with the FCIC, May 4, 2010, pp. 59-60, 83-84 [ID# 4842-6086-2726].

1030

David Teicher, interview with the FCIC, May 4, 2010, pp. 59-60, 83-84 [ID# 4842-6086-2726]; “Credit FAQ:
The Basics of Credit Enhancement in Securitizations,” Standard & Poor’s RatingsDirect, June 24, 2008,
http://www2.standardandpoors.com/spf/pdf/media/subprime_credit_enhance_062408.pdf.

1031

Richard Michalek, testimony to the FCIC, hearing on “The Credibility of Credit Ratings, the Investment
Decisions Made Based on those Ratings, and the Financial Crisis,” Session 3: The Credit Rating Agency Business
Model, June 2, 2010, p. 361 (ID# 4818-8776-0390)

1032

Transcript of FCIC interview with Gary Witt April 21, 2010.

427

stop—you know, we’re going to try to protect our reputation. We’re not going to rate these
CDOs, we’re not going to rate these RMBS.’”1033
Kimball elaborated further in his October 2007 memorandum: “Ideally, competition would be
primarily on the basis of ratings quality, with a second component of price and a third
component of service. Unfortunately, of the three competitive factors, rating quality is proving
the least powerful given the long tail in measuring performance…. 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 needed
for the highest rating. Unchecked, competition on this basis can place the entire financial system
at risk. It turns out that ratings quality has surprisingly few friends: issuers want high ratings;
investors don’t want rating downgrades; short-sighted bankers labor short-sightedly to game the
rating agencies for a few extra basis points on execution.”1034 [check italics in original]
Moody’s employees told the FCIC that a tactic the investment bankers used to apply implicit
pressure was submit a deal for a rating under a very tight timeframe. Eric Kolchinsky, a former
team managing director overseeing CDOs, recalled in particular having a short timeframe to rate
a particular CDO. “What the trouble on this deal was, and this is crucial about the market share,
was that the banker gave us hardly any notice and any documents and any time to analyze this
deal…. [B]ecause bankers knew that we could not say no to a deal, could not walk away from

1033

Jerome Fons, interview with the FCIC, April 22, 2010, p. 69 (ID# 4842-7212-1862).

1034

MOODY’S-COGR-0038026 “Credit policy issues at Moody’s suggested by the subprime/liquidity crisis”
(internal October 2007 memorandum by Chief Credit Officer Andrew Kimball, (emphasis added).

428

the deal because of a market share, they took advantage of that.”1035 For this CDO deal, the
bankers gave only three or four days for review and final judgment. Kolchinsky emailed
Yoshizawa that the transactions had “egregiously pushed our time limits (and analysts).”1036
Before the frothy days of the peak of the housing boom, an agency took six weeks, even two
months to rate a CDO.1037 By 2006, Kolchinsky described the environment in the CDO group:
“Bankers were pushing more aggressively, so that it became from a quiet little group to more of
a machine.”1038 In 2006, Moody’s gave triple-A ratings to an average of more than 30 mortgage
securities each and every working day.
Evidence of such pressure can be seen in an April 2006 email from a managing director in
synthetic CDO trading at Credit Suisse to Yoshizawa. The Credit Suisse managing director
explained, “I’m going to have a major political problem if we can’t make this [deal rating] short
and sweet because, even though I always explain to investors that closing is subject to Moody’s
timelines, they often choose not to hear it.”1039
The external pressure was summed up in Kimball’s October 2007 memorandum: “Analysts and
[managing directors] are continually ‘pitched’ by bankers, issuers, investors—all with reasonable
arguments—whose views can color credit judgment, sometimes improving it, other times
1035

Eric Kolchinsky, testimony to the FCIC, hearing on “The Credibility of Credit Ratings, the Investment
Decisions Made Based on those Ratings, and the Financial Crisis,” Session 1: The Ratings Process, June 2, 2010, p.
68-69 (ID# 4818-8776-0390)

1036

E Kolchinsky email to Y Fu, Y Yoshizawa 2006-5-30_1

1037

Eric Kolchinsky, testimony to the FCIC, hearing on “The Credibility of Credit Ratings, the Investment
Decisions Made Based on those Ratings, and the Financial Crisis,” Session 1: The Ratings Process, June 2, 2010, p.
68-69 (ID# 4818-8776-0390)

1038

Transcript of FCIC interview with Eric Kolchinsky, April 14, 2010.

1039

PSI-MOODYS-000090 [Exhibit #19] Email from Riachra O’Driscoll to Yuri Yoshizawa, subject “Magnolia
2006-5 Class Ds,” April 27, 2006.

429

degrading it (we ‘drink the kool-aid’). Coupled with strong internal emphasis on market share &
margin focus, this does constitute a ‘risk’ to ratings quality.”1040
So matters stood in 2007, when the machine that had been humming so smoothly and so
lucratively slipped a gear, and then another, and another—and then seized up entirely. [insert
information on SEC report on Moody’s]

1040

MOODY’S-COGR-0038027 “Credit policy issues at Moody’s suggested by the subprime/liquidity crisis”
(internal October 2007 memorandum by Chief Credit Officer Andrew Kimball.

430

CHAPTER CONCLUSIONS HERE

431

Part, Chapter 6: The bust
Contents
Section II, Chapter 6: The bust ................................................................................................................ 432
Delinquencies: “The turn of the housing market”................................................................................ 434
Downgrades: “Never before” ................................................................................................................ 443
CDOs: “Climbing the wall of subprime worry” ................................................................................... 448
Remedies: “Based on incorrect assumptions”....................................................................................... 450
Losses: “Who owns residential credit risk?” ........................................................................................ 455

What does it look like when a bubble pops? In early 2007, it became obvious that home prices were
falling in regions that had once boomed, that mortgage originators were foundering, and that more and
more families would be unable to make their mortgage payments, especially those with subprime and AltA loans.
What wasn’t immediately clear was how the housing crisis would affect the financial system that had
helped to inflate the bubble. Were all those mortgage-backed securities and CDOs ticking time bombs on
the balance sheets of the world’s largest financial institutions? “[T]he concerns were just that if people …
couldn’t value the assets, then that created …questions about the solvency of the firms,” as William C.
Dudley, now president of the Federal Reserve Bank of New York, told the FCIC.1041
In theory, securitization and the many pathways of the shadow banking system were supposed to
distribute risk among many investors. The theory was about to be tested – and proved wrong. Much of
the risk from mortgage-backed securities had in actuality been taken by a small group of companies with
out-sized holdings of the super-senior and AAA tranches of CDOs. These companies would ultimately
bear great losses, even though those investments were supposed to be super-safe.

1041

Need cite

432

As 2007 went on, rising mortgage delinquencies and defaults compelled the rating agencies to downgrade
first mortgage-backed securities, then CDOs. Alarmed investors would send prices plummeting. Hedge
funds faced with margin calls from their repo lenders would be forced to sell at distressed prices; many
would shut down. Banks would write down the value of their holdings of mortgage-backed securities and
CDOs by billions of dollars.
The summer of 2007 also marked the freezing up in the private mortgage securitization markets, where
non-GSE subprime and Alt-A securitizations were sold. A total of $75 billion in subprime securitizations
were issued in the second quarter of 2007 (already down from the prior quarters). That figure dropped
precipitously to $27 billion in the third quarter and to only $11 billion in the fourth quarter of 2007. Alt-A
issuance topped $100 billion in the second quarter only to fall to $13 billion in the fourth quarter of 2007.
Once booming markets were now gone – less than $4 billion in subprime or Alt-A mortgage-backed
securities were issued in first half of 2008 and none after that.
CDO issuance followed suit. From a high of more than $100 billion in the second quarter of 2007,
issuance worldwide plummeted to $40 billion in the third quarter of 2007 and only $18 billion in the
fourth quarter. And as the mortgage-related CDO market ground to a halt, investors no longer trusted
other structured products. While $80 billion of CLOs, securitized leveraged loans, were issued in 2007,
only $10 billion were issued in 2008. Commercial real estate mortgage-backed securities issuance
plummeted from $230 billion in 2007 to $12 billion in 2008.
Those securitization markets that held up initially during the turmoil in 2007 eventually suffered in 2008
as the crisis deepened. Securitization of auto loans, credit cards, small business loans, and equipment
leases all nearly ceased in the third and fourth quarters of 2008. These markets have somewhat recovered,
unlike the private market for mortgage securitizations.

433

Delinquencies: “The turn of the housing market”
Home prices rose 16% nationally in 2005, their third year of double-digit growth. Then, by the spring of
2006, the number of months it would take to sell off all the homes on the market —given the slowing
sales pace—was at its highest level in 10 years.1042 Nationwide, home prices peaked in April 2006. In
October 2006, with the housing market downturn underway, Moody’s Economy.com, a separate business
unit from Moody’s Investor Services, issued a report authored by Chief Economist Mark Zandi entitled
“Housing at the Tipping Point: The Outlook for the U.S. Residential Real Estate Market.” The report
concluded that:
Nearly 20 of the nation’s metro areas will experience a crash in house prices: a double-digit peakto-trough decline in house prices…These sharp declines in house prices are expected along the
Southwest coast of Florida, in the metro areas of Arizona and Nevada, in a number of California
areas, throughout the broad Washington, D.C. area, and in and around Detroit. Many more metro
areas are expected to experience only house-price corrections in which peak-to-trough price
declines remain in the single digits. …It is important to note that price declines in various markets
are expected to extend into 2008 and even 2009.
With over 100 metro areas representing nearly one-half of the nation’s housing stock
experiencing or about to experience price declines, national house prices are also set to decline.
Indeed, odds are high that national house prices will decline in 2007; the first decline in nominal
national house prices since the Great Depression.1043

1042

NAR

1043

Moody’s 2006

434

For 2007, the National Association of Realtors announced that the number of existing home sales had
declined the most in 25 years. That year, home prices declined 9%. In 2008, prices would drop a
stunning 17%. Overall, by the end of 2009, prices dropped 29% from their peak in 2006. 1044
In some areas, home prices started to fall as early as late 2005. For example, in Ocean City, New Jersey,
where many properties are vacation homes, home prices had risen 144% since 2001; they topped out in
December 2005 and fell 4% in just the first half of 2006. (In mid-2010, they would be 22% below their
peak.) In most places, prices rose for a bit longer. For instance, in Tucson, Arizona, prices kept increasing
for much of 2006, rising 95% from 2001 to their high point in August 2006, and then fell only 3% by the
end of the year.
The first evidence of the housing crash was in early payment defaults– usually defined as borrowers being
between 60 and 90 days delinquent within the first year. Figures released to the FCIC show that by
summer of 2006, 1.5% of loans less than a year old were in default. The figure would peak in late 2007 at
2.5%, well above the 1.0% peak in the 2000 recession.1045 Even more stunning, first payment defaults —
literally, borrowers who took out home loans and never made a single payment — reached above 1.5% of
loans in early 2007.1046 Responding to questions about these data, CoreLogic Chief Economist Mark
Fleming told the FCIC that the early payment default rate “certainly correlates with the increase in the
Alt-A and subprime shares and the turn of the housing market and the sensitivity of those loan
products.”1047

1044

Cite: CoreLogic CSBA Home Price Index, FCIC calculations
Data provide by Mark Fleming, Chief Economist for CoreLogic at the FCIC Sacramento Field Hearing,
9/23/2010, available at http://www.fcic.gov/hearings/pdfs/2010-0923-Fleming.pdf Figure 4

1045

1046

Data provide by Mark Fleming, Chief Economist for CoreLogic at the FCIC Sacramento Field Hearing,
9/23/2010, available at http://www.fcic.gov/hearings/pdfs/2010-0923-Fleming.pdf Figure 5

1047

Transcript of the FCIC Sacramento Field Hearing, available on NetDocs at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4834-0266-0104&open=Y

435

Mortgages in serious delinquency, defined as 90 or more days past due, or in foreclosure, had hovered
around 1% during the early 2000s, jumped in 2006, and kept climbing. By the summer of 2009, 4% of
mortgage loans were 90 days or more delinquent. By comparison, serious delinquencies peaked at 2.4%
right after the recession in 2002. 1048
Serious delinquency was highest in areas of the country that had experienced the biggest housing booms.
In the “sand states” --California, Arizona, Nevada, and Florida—serious delinquency rose to 3% in mid2007 and 15% by September 2009, double the rate in other areas of the country.

Figure 11
20%

Serious
Delinquency
Rates by Region
Sand States
US
Non‐Sand States

15%
10%
5%
0%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Note: Serious delinquency represents mortagages that are 90 days past due or in

Serious delinquencies also varied by type of loan. Subprime ARMs began to show increases in serious
delinquency in early 2006, even as house prices were peaking; the rate rose rapidly to 20% in 2007. By
September 2009, the delinquency rate for subprime ARMs was 40%. Prime ARMs did not weaken until
more than a year later, at about the same time as subprime fixed-rate mortgages. Prime fixed-rate
mortgages, which have been historically the least risky, showed a slow increase in serious delinquency
that coincided with the increasing severity of the recession and unemployment in 2008.

1048

Current figures from Data from the National Delinquency Survey provided to the FCIC by The Mortgage
Bankers Association

436

Figure 12
50%

Serious Delinquency
Rates
by Product
Prime ARM
Subprime FRM
Subprime ARM

Prime FRM

40%
30%
20%
10%
0%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Note: Serious delinquency represents mortagages that are 90 days past due or in
process of foreclosure.

The FCIC examined the relative performance among mortgages purchased or guaranteed by the
GSEs, those securitized in the private market, and securitized FHA- or VA- insured mortgages. The
analysis was conducted using roughly 25 million mortgages that were outstanding at the end of each year
from 2006 through 2009.1049 The data contain mortgages in four groups – loans that were sold into
securitizations labeled subprime by investors (labeled SUB), loans sold into Alt-A securitizations (ALT),
loans either purchased or guaranteed by the GSEs, and loans guaranteed by the federal agencies
(FHA).1050 The GSE group includes any mortgages that the GSEs identified as subprime and Alt-A loans
owing to their characteristics, as described in previous chapters.
Within each group, we created subgroups based on characteristics that affect the performance of
the loan: FICO credit scores, loan-to-value ratios (LTV), and mortgage size. As an example, one
subgroup would be GSE loans with a balance below $417,000 (conforming to GSE loan limits), a FICO
score between 640 and 659 (a borrower with below average credit history), and LTV between 80% and

1049

The underlying data come from Corelogic and Loan Processing Svcs. Tabulations were provided to the FCIC by
staff at the Federal Reserve.

1050

Subprime mortgages were defined as [XXX]. Alt-A mortgages were defined as [XXX]. GSE mortgages
included [XXX]. FHA mortgages included [XXX].

437

100% (having relatively small down payments). Another group would be Alt-A loans with the same
characteristics. In each year, in each group, the loans were broken into 144 [ck] different subgroups.

[Chart will include changes to legend; explanatory text will define the four groups shown. Legend will
not say “next 40%”]
Examining the rates of serious delinquency after the bubble burst shows that the differences
across the four broad groups were significant. Imagine lining up the 144 subgroups within each group
from best performing to worst performing. Then pinpoint the loan 25% of the way up the line; one-quarter
of the loans would then be in subgroups with an equal or lower average rate of serious delinquency than
the subgroup containing that loan. Repeat that exercise at the other end of the line so that exactly onequarter of the loans are in subgroups with an equal or greater average rate of serious delinquency than the
subgroup containing that worse performing, second loan. This leaves exactly one-half of all the loans, the
“middle 50%,” between these two points as shown in Figure X.X. A similar exercise leaving only 5% of
the loans on each end defines the “middle 90%.”.
At the end of 2008, the middle 50% of GSE loans were in subgroups with average delinquency
rates between 0.6% and 2.4%. The middle 90% of GSE loans were in subgroups with average

438

delinquency rates between 0.1 x% and 6%. That means that only 5% of GSE loans were in subgroups
with average delinquency rates above 6%. In sharp contrast, the middle 50% of securitized subprime
loans were in subgroups with average delinquency rates between 24% and 31%., The middle 90% of SUB
loans were in subgroups with average delinquency between 10% and 32%. The GSE and SUB groups just
barely overlap. The worst performing 5% of GSE loans are in subgroups with rates of serious delinquency
that match the rate of serious delinquency of the best performing 5% of SUB loans. 1051
By the end of 2009, the performance within all segments of the market had weakened. The
median delinquency rate -- the rate where one-half the loans are in subgroups with lower rates of serious
delinquency and one-half are in subgroups with higher rates of serious delinquency -- rose from 1% to
2.5% for GSE loans, from 29% to 39% for SUB loans, from 12% to 21% for Alt-A loans, and remained at
roughly 6% for FHA loans.
The data illustrate that GSE loans performed significantly better than privately securitized or nonGSE subprime and Alt-A loans. That holds true even for loans in GSE pools that had many of the same
characteristics as privately securitized mortgages, such as low FICO scores. For example, among
borrowers with FICO scores below 660, a privately securitized mortgage was more than four times as
likely to be seriously delinquent as a GSE mortgage: 28.3% vs. 6.2%.1052
These patterns are most likely driven by differences in underwriting standards as well as some
differences not captured in these data. For instance, in the GSE pool, borrowers tended to make bigger
down payments. The FCIC’s data show that 58% of GSE loans with FICO scores below 660 had an
original loan-to-value ratio (LTV) below 80%, meaning the borrower made a down payment of at least
20% of the sales price. This would help offset the effect of the lower FICO score. In contrast, only 31%

1051

A recent analysis published by the FHFA comes to very similar conclusions. See XXXX.

1052

In the sample data provided by the Federal Reserve, Fannie Mae and Freddie Mac mortgages with a FICO score
below 660 had an average rate of serious delinquency of 6.2% in 2008. In public reports, the GSEs stated that the
average serious delinquency rates for loans with FICO scores less than 660 in their guarantee books was 6.3%.

439

of loans with FICO scores below 660 in non-GSE subprime securitizations had an LTV under 80%. The
data illustrates that non-agency securitized loans were much more likely to have more than one risk
factor, so called “risk-layering,” such as low FICO scores on top of small down payments.
GSE mortgages with Alt-A characteristics also performed significantly better than mortgages
packaged into non-GSE Alt-A securities. For example, among loans with an LTV above 90%, the GSE
pools have an average rate of serious delinquency of 5.7%,versus a rate of 15.5% for loans in private AltA securities.1053 These results are also, in large part, driven by differences in risk layering.

Others frame the situation differently. According to Ed Pinto, a consultant to the
mortgage-finance industry who was chief credit officer at Fannie Mae in the 1980s, GSEs
dominated the market for risky loans because of the high number of GSE loans that had FICO
scores below 660, a combined loan-to-value ratio of greater than 90%, or other characteristics.
Using these strict cutoffs that ignore risk layering and thus are only partly related to mortgage
performance (as well as a number of other assumptions), Pinto estimates that as of June 30,
2008, 49% of all mortgages in the country – 26.7 million mortgages – were risky mortgages that
he defines as subprime or Alt-A. Of these, Pinto counts 11.9 million or 45% that were purchased
or guaranteed by the GSEs.1054 In contrast, the GSEs categorize fewer than 3 million of their
loans as subprime or Alt-A.

1053

In the sample data provided by the Federal Reserve, Fannie Mae and Freddie Mac mortgages with LTVs above
90% had an average rate of serious delinquency of 5.7% in 2008. In public reports, the GSEs stated that the average
serious delinquency rates for loans with LTVs above 90% in their guarantee books was 5.8%.
1054
The 26.7 million loans include 6.7 million loans in subprime securitizations and another 2.1 million loans in AltA securitizations, for a total of 8.8 million mortgages in subprime or Alt-A pools. These Pinto calls “selfdenominated” subprime and Alt-A, respectively. To these, he adds another 8.8 million loans with FICO score below
660 which he labels “subprime by characteristic.” He also adds 6.3 million loans at the GSEs that are either interest
only loans, negative amortization loans, or loans with an LTV—including any second mortgage—greater than 90%
which he collectively refers to as “Alt-A by characteristic.” The last additions include an estimated 1.4 million
loans insured by the FHA and VA with an LTV greater than 90% - out of a total of roughly 5½ million FHA and VA
loans - and 1.3 million loans in bank portfolios that are inferred to have his defined “Alt-A characteristics”.

440

Importantly, the additional loans classified as subprime or Alt-A in Pinto’s analysis did
not perform nearly as poorly as loans in non-agency securities, regardless of their label. These
differences suggest that grouping all of these loans together is misleading. The performance data
assembled and analyzed by the FCIC show that non-GSE securitized loans experienced much
higher rates of delinquency than the GSE loans with similar characteristics
CRA: “Loans to people they might not lend to otherwise”
In addition to examining loans owned and guaranteed by the GSEs, Pinto also discussed the role of the
Community Reinvestment Act in causing the crisis, in particular, writing, “[t]he pain and hardship that

CRA has likely spawned are immeasurable.”1055
Despite this view, lenders actually made few subprime loans to meet their CRA requirements, two Fed
economists determined. Analyzing a database of nearly 14 million loans originated in 2006,1056 the
economists found that only 6% of all higher-cost loans (a rough proxy for subprime) had any connection
to the CRA – that is, they were loans to low- or moderate-income borrowers or in low- or moderateincome neighborhoods made by banks and thrifts (and their subsidiaries) covered by the CRA. Using
other data sources, they also found that CRA-related subprime loans appeared to perform better than other
subprime loans. “Taken together, the available evidence seems to run counter to the contention that the
CRA contributed in any substantive way to the current crisis,” they wrote.1057

1055

Cite

1056

The authors use the HMDA data which covers roughly 80% of the mortgage market in the United States – see
“Opportunities and Issues in Using HMDA data,” JRER 29(4) 2007 – Avery, Brevoort and Canner.

1057

Neil Bhutta and Glenn Canner, Did the CRA cause the mortgage market meltdown?, Federal Reserve Board of
Governors, March 2009.

441

Subsequent research has come to similar conclusions.1058 For example, two economists at the San
Francisco Fed, using a different methodology and data on the California mortgage market, found that
lending to low- and moderate-income communities was only a small portion of lending for CRA lenders,
even at the peak of the market. And, after accounting for characteristics of the loans and the borrowers,
such as income and credit score, the authors found that loans made by CRA-covered lenders in their CRA
assessment areas were half as likely to default as similar loans 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 suggests that the CRA, and particularly its emphasis on loans made within a lender’s
assessment area, helped to ensure responsible lending, even during a period of overall declines in
underwriting standards,” they wrote.1059
John Reed, former CEO of Citigroup, when asked whether he thought government policies such as the
Community Reinvestment Act played a role in the crisis, said that he didn’t believe banks would originate
“a bad mortgage because they thought the government policy allowed it” unless the bank could sell off
the mortgage to Fannie or Freddie, which had their own obligations in this arena. He did believe that
government housing policy played a role in the lack of oversight by regulators, saying, “the regulators
didn’t jump up and down and yell at the low-doc, no-doc subprime mortgage…because they felt that the
Congress had sort of pushed in that direction.”1060 When the FCIC asked Christopher Cruise, a mortgage
broker trainer, whether lending that he suggested was irresponsible was driven by the Community

1058

See also “The subprime crisis: How much did Lender Regulation Matter,” by Avery and Brevoort. “It is not hard
to see why the CRA and GSE affordable housing goals are raised as causes or contributors to the subprime crisis.
Both regulations favor lending to borrowers in lower-income Census tracts which accounted for a disproportionate
share of the growth in lending during the subprime buildup … and elevated levels of loan delinqueny. However a
more nuanced look at the data … suggests that this superficial association may be misleading.”

1059

Elizabeth Laderman and Carolina Reid, Lending in low and moderate income neighborhoods in California: The
Performance of CRA Lending During the Subprime Meltdown, November 26, 2008, Working paper to be presented
at the Federal Reserve System Conference on Housing and Mortgage Markets, Washington, DC, December 4, 2008.
1060

John Reed transcript

442

Reinvestment Act he responded, “If every CRA loan went bad it still wouldn’t have caused this crisis.”
1061

“You know, CRA could be a pain in the neck,” banker Lewis Ranieri told the FCIC. “But you know
what? It always, in my view, it always did much more good than it did anything. You know, we did
a lot. CRA made a big difference in communities… You were really putting money in the
communities in ways that really stabilized the communities and made a difference.” But lenders

including Countrywide used pro-homeownership policies as a “smokescreen” to do away with
underwriting standards such as requiring down payments, he said. “The danger is that it gives air
cover to all of this kind of madness that had nothing to do with the housing goal.”1062

Downgrades: “Never before”
Prior to 2004, the ratings of mortgage-backed securities at Moody’s were monitored by the same analysts
who had rated them in the first place.1063 In 2004, Nicolas Weill, Moody’s chief credit officer and team
managing director, was charged with creating a surveillance team to monitor previously rated deals.1064
By 2007, that team had increased from a few people to a couple of dozen.1065
By November 2006, the surveillance team began to see rising early payment defaults in mortgages
originated by Fremont Investment & Loan.1066 Throughout that month, the surveillance desk downgraded

1061

Cruise audio

1062

FCIC interview with Lewis Ranieri, July 30, 2010.

1063

Nicolas Weill, interview with the FCIC, May 11, 2010, p. 6 [ID# 4818-9291-8278].

1064

Nicolas Weill, interview with the FCIC, May 11, 2010, p. 6 [ID# 4818-9291-8278].

1065
1066

Nicolas Weill, interview with the FCIC, May 11, 2010, p. 14 [ID# 4818-9291-8278].
Nicolas Weill, interview with the FCIC, May 11, 2010, p. 11 [ID# 4818-9291-8278].

443

several securities with underlying Fremont collateral or put them on watch for future downgrades. 1067
“This was a very unusual situation as never before had we put on watch deals rated in the same calendar
year,”1068 Weill later wrote to Raymond McDaniel, the chairman and CEO of Moody’s Corporation, and
Brian Clarkson, the president of Moody’s Investors Service.
In early 2007, Moody’s issued a special report about early payment defaults. 1069 “Mortgages backing
securities issued in late 2005 and early 2006 have had sharply higher rates of foreclosure … than
previously issued securities at similar, early points in their lives,”1070 according to the report overseen by
Weill. These foreclosures were concentrated in subprime mortgage pools.1071 Additionally, more than
2.75% of the subprime mortgages securitized in the second quarter of 2006 were 60 days delinquent
within six months, more than double the 1.25% rate a year earlier.1072 The exact cause of the trouble was
still unclear to the ratings agency, though. “Moody’s is currently assessing whether this represents an

1067

See, for example, “Moody's downgrades and confirms two certificates from one Fremont deal from 2002,”
November 2, 2006 [ID# 4826-9348-9416], “Rating Action: Moody's has placed under review for possible
downgrade one class of MASTR Asset Backed Securities Trust 2006-FRE2 securitization,” November 14, 2006
[ID# 4827-2704-3848], “Moody's has placed four classes issued by Two Fremont Home Loan Trust Deals under
review for possible downgrade,” November 14, 2006 [ID# 4827-1026-6632], “Moody's has placed under review for
possible downgrade two classes of MASTR Asset Backed Securities Trust 2006-FRE1 securitization,” November
30, 2006 [ID# 4830-4581-0952].
1068

MOODY’S-COGR-0005422 – MOODY’S-COGR-0005424 Email from Nicolas Weill to Raymond McDaniel,
Brian Clarkson, July 4, 2007 [ID# 4812-5572-8903].

1069

“Early Defaults Rise in Mortgage Securitizations,” Moody’s structured finance special report, January 18, 2007
[ID# 4849-7525-6328].

1070

“Early Defaults Rise in Mortgage Securitizations,” Moody’s structured finance special report, January 18, 2007,
p. 1 [ID# 4849-7525-6328].

1071

“Early Defaults Rise in Mortgage Securitizations,” Moody’s structured finance special report, January 18, 2007,
p. 1 [ID# 4849-7525-6328].

1072

“Early Defaults Rise in Mortgage Securitizations,” Moody’s structured finance special report, January 18, 2007,
p. 3 [ID# 4849-7525-6328].

444

overall worsening of collateral credit quality or merely a shifting forward of eventual defaults which may
not significantly impact a pool's overall expected loss.”1073
For the next few months, the company published regular updates about the subprime mortgage market.1074
In a March publication, Moody’s CDO rating team discussed that downgrades of securities backed by
subprime loans could be “severe” for CDOs backed by these securities.1075 Negative rating actions had
been taken on 4.5% of the outstanding subprime mortgage securities rated Baa in just three months.1076
Then, on July 10, 2007, in an unprecedented move, Moody’s downgraded 399 subprime 2006 vintage
mortgage-backed securities and put an additional 32 securities on watch.1077 The $5.2 billion of securities
that were affected, all rated Baa and lower, accounted for 1.2% of the dollar volume and 6.8% of the
subprime securities that Moody’s rated in 2006 but a larger 19% of the subprime securities originally
rated Baa. 1078 For the time being, there were no downgrades on higher-rated tranches. Moody’s
attributed the downgrades to “aggressive underwriting combined with prolonged, slowing home price
appreciation” and noted that approximately 60% of the securities affected contained mortgages from one

1073

“Early Defaults Rise in Mortgage Securitizations,” Moody’s structured finance special report, January 18, 2007,
p. 1 [ID# 4849-7525-6328].

1074

See, for example, “Challenging Times for the US Subprime Mortgage Market,” March 7, 2007 [ID# 4833-18047752], “The Impact of Subprime Residential Mortgage-Backed Securities on Moody's-Rated Structured Finance
;CDOs: A Preliminary Review,” March 23, 2007 [ID# 4835-5082-8552]; “US Subprime Mortgage Market Update:
April 2007,” April 20, 2007 [ID# 4848-9459-1238]; “US Subprime Mortgage Market Update: June 2007,” June 7,
2007 [ID# 4816-9053-6198].

1075

“The Impact of Subprime Residential Mortgage-Backed Securities on Moody's-Rated Structured Finance
;CDOs: A Preliminary Review,” March 23, 2007, p. 8 [ID# 4835-5082-8552]
1076

“The Impact of Subprime Residential Mortgage-Backed Securities on Moody's-Rated Structured Finance
;CDOs: A Preliminary Review,” March 23, 2007, p. 4 [ID# 4835-5082-8552]
1077

“Moody’s Downgrades Subprime First-lien RMBS-Global Credit Research Announcement”, Moody’s Investors
Service, July 10, 2007 [ID# 4813-5639-2199].

1078

“Moody’s Downgrades Subprime First-lien RMBS-Global Credit Research Announcement”, Moody’s Investors
Service, July 10, 2007 [ID# 4813-5639-2199].

445

of four originators: Fremont Investment & Loan, Long Beach Mortgage Company, New Century
Mortgage Corporation, or WMC Mortgage Corp.1079
Weill later told the FCIC staff that Moody’s issued a mass announcement, rather than downgrading a few
securities at a time, to avoid creating confusion in the market.1080 A few days later, Standard & Poor’s
downgraded 498 similar tranches, including [XXX] that had been rated AAA. These initial downgrades
were remarkable not only because of the number of securities, but also because of the sharp rating cuts—
an average of four notches per security, when one or two notches was more routine. Among the tranches
downgraded in July 2007 were the bottom three mezzanine tranches (M9, M10, and M11) of CMLTI
2006-NC2, the case-study deal we have been tracking throughout the report. By that point, [XXX%] of
the original loans had prepaid but another [XXX%] were 90 or more days past due or in foreclosure.
The news of downgrades affected Bear Stearns Asset Management, which managed [seven] CDOs with a
combined [$18 billion] in mostly mortgage-related collateral. One of its CDOs, Tall Ships, had direct
exposure to the case-study deal, owning $8 million of the M7 and M8 tranches. BSAM’s High Grade
hedge fund also had [synthetic] exposure through a $10 million credit default swap position with Lehman
referencing the M8 tranche. And its Enhanced Leverage hedge fund owned parts of the equity in
Independence CDO [verify], which in turn owned the M9 tranche of CMLTI 2006-NC2. In addition,
these funds had exposure through their holdings of other CDOs that in turn owned tranches of CMLTI
2006- NC2. Investors across the world were assessing their own, and guessing at others’, exposure,
however indirect, to these assets.

Then, on October 11, Moody’s downgraded another 2,506 tranches ($33.4 billion) of subprime
mortgage-backed securities and placed 577 tranches ($23.8 billion) on watch for potential

1079

“Moody’s Downgrades Subprime First-lien RMBS-Global Credit Research Announcement”, Moody’s Investors
Service, July 10, 2007 [ID# 4813-5639-2199].

1080

Nicolas Weill, interview with the FCIC, May 11, 2010, p. 73 [ID# 4818-9291-8278].

446

downgrade.1081 Now, the securities downgraded and put on watch represented a total 13.4% of
the original dollar volume of all 2006 subprime mortgage-backed securities that Moody’s rated.
1082

Of the securities placed on watch in October, 48 tranches ($6.9 billion) were Aaa-rated and

529 ($16.9 billion) were Aa-rated.1083 All told, in the first 10 months of 2007, 92% of the
mortgage-backed security deals issued in 2006 had at least one tranche downgraded or put on
watch.1084
By this point in October, [XXX%] of the borrowers in CMLTI 2006-NC2 were seriously delinquent and
some homes had already been repossessed. The M4 through M8 tranches were downgraded as part of the
second wave of mass downgrades.1085 Five additional tranches would eventually be downgraded in April
2008.
Before it was over, Moody’s downgraded 83% of the 2006 Aaa mortgage-backed securities tranches and
all of the Baa tranches. For those issued in the second half of 2007, nearly all Aaa and Baa tranches were
downgraded. The downgrades were often severe. Of all tranches initially rated investment grade,
meaning rated Baa or higher, 76% of the 2006 vintage were downgraded to junk as were 89% of the 2007
vintage.

1081

“Moody’s Downgrades $33.4 billion of 2006 Subprime First-Lien RMBS and Affirms $280 billion Aaa’s and
Aa’s,” Moody’s Investors Service, October 11, 2007 [ID# 4825-5422-6184]; “October 11 Rating Actions Related to
2006 Subprime First-Lien RMBS,” Moody’s Structured Finance Special Report, October 17, 2007, p. 1-2 [ID#
4826-0409-9080].

1082

“Moody’s Downgrades $33.4 billion of 2006 Subprime First-Lien RMBS and Affirms $280 billion Aaa’s and
Aa’s,” Moody’s Investors Service, October 11, 2007.

1083

“Moody’s Downgrades $33.4 billion of 2006 Subprime First-Lien RMBS and Affirms $280 billion Aaa’s and
Aa’s,” Moody’s Investors Service, October 11, 2007.

1084

“October 11 Rating Actions Related to 2006 Subprime First-Lien RMBS,” Moody’s Structured Finance Special
Report, October 17, 2007, p. 2 [ID# 4826-0409-9080]

1085

“Moody’s Downgrades $33.4 billion of 2006 Subprime First-Lien RMBS and Affirms $280 billion Aaa’s and
Aa’s,” Moody’s Investors Service, October 11, 2007.

447

CDOs: “Climbing the wall of subprime worry”
In March 2007, in one of its by-then-frequent reports on the subprime market, Moody’s discussed CDOs
and said those with high concentrations of subprime mortgage-backed securities could incur “severe”
downgrades.1086 In an internal email five days later, Group Managing Director of U.S. Derivatives Yuri
Yoshizawa explained to McDaniel and to Executive Vice President of Derivatives Noel Kirnon that one
managing director at Credit Suisse First Boston “sees banks like Merrill, Citi, and UBS still furiously
doing transactions to clear out their warehouses …. He believes that they are creating and pricing the
CDOs in order to remove the assets from the warehouses, but that they are holding on to the CDOs …in
hopes that they will be able to sell them later.”1087 Several months later, in a review of the CDO market
entitled “Climbing the Wall of Subprime Worry,” Moody’s noted, “Some of the first quarter’s activity [in
2007] was the result of some arrangers feverishly working to clear inventory and reduce their balance
sheet exposure to the subprime class.” 1088 Even though Moody’s was aware that the investment banks
were dumping collateral out of the warehouses and into CDOs —possibly regardless of quality—the firm
continued to rate new CDOs using existing assumptions.
Former managing director Richard Michalek testified to the FCIC, “It was a case of, with respect to why
didn’t we stop and change our methodology, there is a very conservative culture at Moody’s, at least
while I was there, that suggested that the only thing worse than quickly getting a new methodology in

1086

“The Impact of Subprime Residential Mortgage-Backed Securities on Moody's-Rated Structured Finance CDOs:
A Preliminary Review,” March 23, 2007, p. 2 [ID# 4835-5082-8552].

1087

Email from Yuri Yoshizawa to Noel Kirnon and Raymond McDaniel, cc Eric Kolchinsky subject: “CSFB
Pipeline information,” March 28, 2007, from emails provided by Eric Kolchinsky

1088

“First Quarter 2007 U.S. CDO Review: Climbing the Wall of Subprime Worry,” May 31, 2007, p. 2 [ID# 48119868-0072]

448

place is quickly getting the wrong methodology in place and having to unwind that and to fail to consider
the unintended consequences.”1089
In July, McDaniel gave a presentation to the board on the company’s 2007 strategic plan. His slides
included bleak titles such as: “Spotlight on Mortgages: Quality Continues to Erode,” “House Prices Are
Falling…,” “Mortgage Payment Resets are Mounting,” and “1.3 MM Mortgage Defaults Forecast 200708.”1090 Despite all the evidence that the quality of the underlying mortgages might be declining, Moody’s
did not make any significant adjustments to CDO ratings assumptions until late September.1091 Out of $51
billion in CDOs that Moody’s rated after the mass downgrade of subprime mortgage-backed securities on
July 10, 2007, 88% were rated Aaa.1092
Moody’s had hoped that ratings downgrades could be staved off by mortgage modifications making
monthly payments more affordable so that borrowers might stay current. In mid-September, Eric
Kolchinsky, a team managing director for CDOs, learned from Nicolas Weill, the chief credit officer of
the structured finance group, that a survey of servicers’ indicated very few troubled mortgages were being
modified.1093
Worried that continuing to rate CDOs without adjusting for known deterioration in the underlying
securities could expose Moody’s to liability,1094 Kolchinsky notified Yoshizawa that the company should

1089

1090

MOODY’S-FCIC-0002561 “2007 MCO Strategic Plan Overview,” presentation by Ray McDaniel, July 2007
[ID# 4841-0803-7638].

1091

Chronology Prepared by Eric Kolchinsky [ID# 4813-3992-8070]

1092

From PSR. Need cite.

1093

Chronology Prepared by Eric Kolchinsky [ID# 4813-3992-8070]

1094

Chronology Prepared by Eric Kolchinsky [ID# 4813-3992-8070]; see also transcript of FCIC interview of Eric
Kolchinsky, April 27, 2010 [ID# 4828-9967-1046].

449

stop rating CDOs until the securities downgrades were completed.1095 Kolchinsky told the FCIC that
Yoshizawa “admonished” him for making the suggestion.1096
By the end of 2008, more than 90% of all tranches of CDOs had been downgraded. Moody’s downgraded
nearly all of the 2006 Aaa and all of the Baa CDO tranches. And, again, the downgrades were large -more than 80% of Aaa CDO bonds and more than 90% of Baa CDO bonds were eventually downgraded
to junk.

Remedies: “Based on incorrect assumptions”
As discussed in an earlier chapter, after the crisis unfolded, those with exposure to mortgages and
structured products—including investors, financial firms, and private mortgage insurance firms—would
closely examine representations and warranties made by mortgage originators and securities issuers.
When mortgages are securitized, sold, or insured, certain representations and warranties are made to
assure investors and insurers that the mortgages meet stated guidelines. For example, Fannie and Freddie,
where they have discovered breaches of representations and warranties, have sought to put back to
originators billions of dollars of mortgages that they purchased or guaranteed—demanding that the seller
buy back the loans. In addition, with much the same reasoning, private mortgage insurance companies
have denied claims to an unprecedented extent. As mortgage securities have lost value investors have
found significant deficiencies in the extent of securitizers’ due diligence on the mortgage pools
underlying the mortgage-backed securities as well as the adequacy of disclosure about the characteristics
of those deals.
Fannie and Freddie acquire or guarantee millions of loans each year. They delegate underwriting
authority to originators on the legal understanding—through representations and warranties— that the
1095

Chronology Prepared by Eric Kolchinsky [ID# 4813-3992-8070]; see also transcript of FCIC interview of Eric
Kolchinsky, April 27, 2010 [ID# 4828-9967-1046].

1096

Chronology Prepared by Eric Kolchinsky [ID# 4813-3992-8070]; see also transcript of FCIC interview of Eric
Kolchinsky, April 27, 2010 [ID# 4828-9967-1046].

450

loans meet specified criteria. They then check samples of the loans to ensure that these representations
and warranties are not breached.
If the loans turn out to be “ineligible” for purchase by the GSE, then the GSE has the right to “put back”
the loan to the originator or wholesaler from which it was acquired, demanding that the seller buy back
the loan—assuming of course that the seller has not gone bankrupt.1097 As a result of such sampling,
during the three years and eight months ending August 31, 2010 Freddie and Fannie put back loans
having unpaid balances totaling $15.6 billion and $19.2 billion, respectively, for a total of $34.8
billion.1098 These sums were the unpaid balances of more than 200,000 loans. So far, Freddie, has
received $9.1 billion from sellers,1099 and Fannie has received $11.8 billion.1100
The volumes are notable, being xx% of the losses that Fannie has recorded in losses on its single-family
guarantee book, and xx% of the losses that Freddie has recorded.
In testing to ensure compliance with its standards, Freddie reviews a small percentage of performing
loans and high percentages of foreclosed loans (including well over 90% of all loans that default in the

1097

Fannie, Freddie and private firms all buy whole loans from originators or home loan wholesalers, then guarantee
those loans. Each of these methods of acquisition presents a means where the GSE can earn or lose money
depending on the performance of the underlying loan. For these purposes a guarantee of a whole loan is considered
the equivalent of a purchase. Though not reflected on the GSE’s balance sheet, the GSE bears the full risk of loss.
If a loss occurs, the GSE pays on the guarantee and pursues collection against the borrower, of if it finds the loan did
not meet the agreed upon underwriting standards, against the originator.

On the PLS side, the right to put back the loan belongs not to the GSE which purchases a PLS, but to the Trustee of
the trust established to issue the PLS/RMBS. In this situation, the GSE must act through the Trustee, the holder of
the underlying mortgages for the benefit of the holders of the RMBS.
1098
Letter from Bingham, Freddie’s counsel dated September 21, 2010 (“Bingham Letter”). Letter from O’Melveny
& Meyers LLP, Fannie’s counsel (“O’Melveny Letter”), dated September 21, 2010

1099

Letter from Bingham, Freddie’s counsel dated September 21, 2010 (“Bingham Letter”). Letter from O’Melveny
& Meyers LLP, Fannie’s counsel (“O’Melveny Letter”), dated September 21, 2010 (as of August 6, 2010)

1100

451

first two years)1101 In total, Freddie reviewed $76.8 billion of loans (out of $1.51 trillion in loans acquired
or guaranteed) and found $21.7 billion to be ineligible.1102
Among the performing loans that were sampled, an increasing percentage were found to be ineligible over
the years, with the percentage rising from 10% for mortgages originated in 2005 to 23% in 2008. Still,
Freddie put back very few of these performing loans to the originators. Among mortgages originated
from 2005 to 2008, they found that 17% of the delinquent loans were ineligible as were 27% of the loans
in foreclosure . Most of these were put back to originators—again where originators were still in
operation. In addition, loans might not be put back if the reason for ineligibility was minor.1103
Overall, of the delinquent loans and loans in foreclosure sampled by Freddie, 20% were put back.1104 In
2009 and 2010 Freddie put back significant loan volumes to the following lenders: Countrywide, $1.9
billion; Wells Fargo, $1.2 billion; Chase Home Financial, $1.1 billion; Bank of America, $476 million
and Ally Financial, $453 million.1105
Using a method similar to Freddie’s to test for loan eligibility, Fannie reviewed between 2% and 5% of
the mortgages originated in each of those years—with larger sampling for delinquent loans. From 2007
through 2010, Fannie put back loans to the following large lenders: Bank of America, $6.9 billion; Wells
Fargo, $2.3 billion; JP Morgan Chase, $2.2 billion; Citigroup, $1.5 billion; Suntrust Bank, $898 million
and Ally Financial, $838 million. Fannie acquired $2.24 trillion in loans (11.8 million loans) between
2005 and 2008.

1101

Id. See also Staff interview of Frank Romano of Freddie

1102

Id.9/21/10 Hershman letter to Cohen, Tab 3.

1103

Staff interview of Frank Romano;

1104

Average loan size of approximately $222,000 per loan.

1105

Bingham Letter.
452

Similar to Fannie and Freddie, private mortgage insurance companies are turning back loans. This
insurance protects the holder of the mortgage if a homeowner defaults on a loan, even thought the
homeowner is generally responsible for the premiums. By the end of 2006, PMI companies insured a
total of $668 billion in potential mortgage losses.
With the increase in defaults and losses on the mortgages, the PMI companies have seen a spike in claims.
The seven largest PMI companies, with 98% of the market, have rejected approximately 25% of the
claims (or $6 billion of $24 billion) brought to them because of violations of origination guidelines,
improper employment and income reporting, and issues with property valuation.1106
Separate from the GSEs’ purchase and guarantee of mortgages, they also purchased $xx billions of dollars
of AAA- rated PLS, which have resulted in total losses of $xx billion for the GSEs.1107 While the GSEs
do not have access to the loan files on the underlying mortgages, they are grappling with understanding
why the securities have fared so much worse than expected. Frustrated with the lack of information from
the securities’ servicers and trustees as well as other holders of the securities, on July 12, 2010 the GSEs
through their regulator issued 64 subpoenas to various trustees and servicers in transactions where the
GSEs lost money. To the extent the GSEs find that the non-performing loans in the pools have violations,
the GSEs intend to demand that the trustee enforce the GSEs’ rights (including any rights to put loans

1106

Document production from United Guaranty Residential Insurance, MGIC, Genworth, RMIC, Triad, PMI, and
Radian. In netdocs, https://vault.netvoyage.com/neWeb2/goId.aspx?id=4814-7096-8071&open=Y,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4814-7096-8071&open=Y,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4827-9152-3336&open=Y,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4820-9126-6311&open=Y,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4820-0738-0231&open=Y,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4833-9806-1064&open=Y,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4842-9732-5319&open=Y,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4827-3710-9767&open=Y,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4838-5130-8040&open=Y,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4822-4447-7447&open=Y

A high percentage of these losses are believed to represent mark-to-market losses rather than actual
cash losses.
1107

453

back to the originator or wholesaler).1108 The GSEs are not expected to take further steps enforcing their
rights until early 2011.1109
The strategy being followed by the GSEs is based in contract law as opposed to securities law. Other
investors are filing lawsuits and winning settlements claiming they were misled by inaccurate or
incomplete prospectuses.
As of mid-2010, court actions embroiled almost all major loan originators, underwriters and bond
insurers—more than 400 crisis lawsuits related to breaches of representations and warranties, by one
estimate.1110 These lawsuits filed in the wake of the financial crisis include those alleging “untrue
statements of material fact” or “material misrepresentations” in registration statements and prospectuses
that were provided to investors that purchased securities. On the whole, these lawsuits allege violations of
the Securities Exchange Act of 1934 and the Securities Act of 1933.
Both private and government entities have gone to court. As one example, investment broker Charles
Schwab has sued units of Bank of America, Wells Fargo and UBS Securities. The Massachusetts
Attorney General’s Office settled charges against Morgan Stanley and Goldman Sachs, after accusing the
firms of inadequate disclosure in its mortgage-backed securities.1111 The investigations resulted in a
settlement from Morgan Stanley of $23.4 million and from Goldman Sachs of $9 million being paid to
Massachusetts authorities that had investments in securities from the firms.
As another example, the Federal Home Loan Bank of Chicago sued several defendants including Bank of
America, Credit Suisse Securities, Citigroup and Goldman Sachs over $3.3 billion investment in private
See letter from Covington $ Burling LLP, Freddie’s counsel, dated October 19, 2010. See also letter
from O’Melveny & Meyers LLP dated October 19,2010.

1108

1109

Id.

1110

Nera Economic Consulting; May 2010 Part VII of a NERA Insights Series; Credit Crisis Litigation Revisited:
Litigating the Alphabet of Structured Products

454

mortgage backed securities claiming that the defendants did not give accurate information about securities
for sale. Similarly, Cambridge Place Investment Management sued units of Morgan Stanley, Citigroup,
HSBC, Goldman Sachs, Barclays, and Bank of America among others, 1112 “on the basis of the
information contained in the applicable registration statement, prospectus, and prospective
supplements.”1113

Losses: “Who owns residential credit risk?”
As the ratings went, so would go losses. Through 2007 and into 2008, as the rating agencies downgraded
mortgage-backed securities and CDOs, and investors began to panic, market prices for these securities
would plunge. The drop in market prices for these securities reflected the higher probability of the
underlying mortgages actually defaulting, meaning that less cash would flow to the investors, as well as
the more generalized fear among investors that this market had become less liquid. Investors value
liquidity because they want the assurance that securities can be sold quickly to raise cash if necessary.
Potential investors worried they might get stuck holding these securities as market participants looked to
limit their exposure to the weakened mortgage market.
With the drop in market prices, accounting rules required many firms holding these securities to take
write downs, that is, lower the value of the assets on their books, even though they did not necessarily
intend to sell the securities right away. How exactly to determine the value of these assets would become
a contentious issue during the crisis as fewer and fewer trades took place. And further, the unrealized
losses would become realized losses – actual money lost – only if and when the securities were sold at the
lower price, or if cash from mortgage payments stopped flowing to the securities over time. Regardless
of whether the securities suffered realized losses, the write downs would often mean that financial firms
needed to raise additional capital to cover the unrealized losses.

1112

Cambridge Place v. Morgan Stanley et alia; Commonwealth of Massachusetts complaint 10 2741 filed 7/9/2010

1113

Cambridge Place page 28 #68

455

These accounting and capital rules received a good deal of criticism during the crisis, as firms argued that
the lower market prices did not reflect reasonable expectations of future realized losses. Joseph
Grundfest, when he was a member of the SEC's Committee on Improvements to Financial Reporting,
noted that at times, marking securities at market prices “creates situations where you have to go out and
raise physical capital in order to cover losses that as a practical matter were never really there.”1114 By this
logic, the value of some of the securities could eventually be written up as they turn out to perform better
than expected. But, not marking assets down to market values allows firms to postpone taking losses that
market participants view as likely. This might mean that the firms would not have sufficient capital to
absorb these losses when they are realized, a fundamental reason for the accounting rules.
As the mortgage market was crashing, some economists and analysts guessed that while unrealized losses
might be much higher, realized losses on subprime and Alt-A mortgages would total $200 to $300 billion;
by 2010, the figure would turn out not to be much more than that. Those numbers are small relative to the
$14 trillion U.S. economy. “Subprime mortgages themselves are a pretty small asset class,” Fed
Chairman Ben Bernanke told the FCIC, explaining how he and Treasury Secretary Hank Paulson had in
2007 under-estimated 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. But
what created the contagion, or one of the things that created the contagion, was that the subprime
mortgages were entangled in these huge securitized pools.”1115
Nonetheless, the large drop in market prices of the mortgage securities had large spillover effects to the
financial sector for three reasons. First, as discussed, when the prices of mortgage-backed securities and
CDOs fell, many of the holders of those securities would have to mark down the value of their holdings –
long before they experienced any actual defaults. That was true most notably for the holdings of the

1114
1115

CFO Magazine “How Far Can Fair Value Go?” May 6, 2008 http://cfo.com/article.cfm/11323562?f=search
Closed session

456

GSEs, which had purchased a combined [$XXX] billion in the AAA tranches of non-GSE mortgagebacked securities; they would mark down their holdings by [$XXX] billion in 2007 alone.
Second, rather than spreading the risks of losses among many investors, the securitization market had
concentrated them. “Who owns residential credit risk?,” two Lehman analysts asked in a September 2007
report. The answer looking forward: Three-quarters of subprime and Alt-A mortgages had been
securitized – and “[m]uch of the risk in these securitizations is in the investment-grade securities and has
been almost entirely transferred to AAA collateralized debt obligation (CDO) holders.”1116 A small group
of companies held the largest share of those super-senior and AAA CDOs – including Citigroup, Merrill
Lynch, and UBS, and the insurance companies that had guaranteed them, such as AIG and MBIA. It
would turn out that those companies held very little capital to protect against potential losses on those
securities. And it would turn out that most of those companies would be considered too big to fail by the
authorities in the midst of a financial crisis.
Published in April 2008 using data compiled in late 2007 before the bottom fell out of the U. S. subprime
market, the International Monetary Fund’s Global Stability Report also estimated where the declining
assets were held and how severe the write downs would be. All told, the IMF estimated that $10 trillion in
mortgage assets were held throughout the financial system. Of these, $3.8 trillion were GSE mortgagebacked securities that the IMF expected to suffer no losses. Another $4.7 trillion were estimated to be
prime and nonprime mortgages held largely by the banks and the GSEs. These were expected to suffer as
much as $115 billion in losses due to declines in market value. The remaining $1.5 trillion in assets were
estimated to be mortgage-backed securities and CDOs. Losses on those assets were expected to be a
much larger $450 billion. And, more troubling, as much as $260 billion of these write downs were

1116

Vikas Shilpiekandula and Olga Gorodetsky, Who Owns Residential Credit Risk?, Lehman Brothers Fixed
Income Research, September 7, 2007. The Lehman analysts pegged ultimate subprime and Alt-A losses at $200
billion. Those forecasts were based, the analysts said, on a scenario in which house prices fell an average 30%
across the country. “Although residential credit losses should increase by a significant amount, we believe they are
not overwhelming.”

457

expected to be borne by the banks. The rest of the losses from non-agency mortgage backed securities
were shared among institutions such as insurance companies, pension funds, the GSEs, and hedge
funds.1117 The report also expected another $380 billion in losses on commercial mortgage-backed
securities, CLOs, leveraged loans, and other loans and securities—with more than half coming from
commercial mortgage-backed securities. Again, banks were expected to bear much of the brunt.
Third, when the crisis began, uncertainty and leverage would promote contagion. Investors would realize
they didn’t know as much as they wanted to know about the assets that banks and investment banks held.
To an extent not understood by many prior to the crisis, hedge funds and investment banks had leveraged
themselves in the short-term repo markets, in part using mortgage-backed securities and CDOs as
collateral. Lenders would question the value of the assets those companies had posted as collateral at the
same time that they would question the value of those companies’ balance sheets.
Even the highest rated tranches of mortgage-backed securities were downgraded and large write downs
were recorded on financial institutions’ balance sheets based on declines in market value. However,
although this could not be known in 2007, most of the AAA tranches of mortgage-backed securities have
avoided actual losses in cash flow through 2010 and are likely to avoid realized losses going forward –
including, for example, those tranches held by the GSEs. Fannie Mae for example, wrote down their
$155 million initial investment in the A1 tranche of CMLTI-2006 NC2 by $25 million, reflecting a
decline in the market value of their holdings, even though the tranche has yet to suffer realized losses
from a loss in actual payments to the tranche.
Overall for tranches of mortgage-backed securities originally rated AAA, by the end of 2009, despite the
mass downgrades only about [10%] of Alt-A and [4%] of subprime securities had been “materially
impaired” – that is, they had either been downgraded to Ca or C, indicating that actual losses were
1117

IMF Global Stability Report April 2008 page 78; http://www.asiaing.com/global-financial-stability-report-april2008-imf.html

458

imminent, or they had already suffered principal losses. For the lower-rated BBB tranches, [9x%] of AltA and [9x%] of subprime were impaired. In total, by the end of 2009, $320 billion worth of subprime and
Alt-A tranches had been “materially impaired” – including [$XXX] billion originally rated AAA. The
outcome would be far worse for CDO investors whose fate largely depended on the performance of
lower-rated mortgage-backed securities. Over 90% of Baa CDO bonds and 80% of Aaa CDO bonds were
ultimately impaired.1118 While the value of some of the highly-rated mortgage-backed assets may turn out
to be better than current market prices suggest, the CDOs created over the housing boom unequivocally
turned out to be a poor investment.

1118

From PSR. Need cite.

459

CHAPTER CONCLUSIONS HERE

460

Part III: The Financial Crisis

Contents
Early 2007: Subprime concerns spread 461
Goldman: “Let’s be aggressive distributing things”

465

Bear Stearns’s hedge funds: “Looks pretty damn ugly”

469

Rating agencies are told: “Investors Don’t Want Rating Downgrades” 477
AIG: “We’re f***ed, basically”

480

Chapter 1: Early 2007: Subprime concerns spread
Over the course of 2007, the collapse of the housing bubble and the abrupt shutdown of the subprime
lending business led to losses for many financial institutions, runs on money market funds, and,
ultimately, tighter access to credit and higher interest rates for many consumers and businesses. Early
evidence of the coming storm was the decline, beginning in November, 2006, of the ABX index for
lower-rated, BBB- tranches of mortgage-backed securities, which was viewed by investors as a sort of
Dow Jones Index for the subprime market. The index fell 1.5% in November.1119
That small drop reflected Moody’s downgrade of selected tranches in one selected deal issued by one
selected mortgage originator: Fremont. That’s how skittish the subprime market had become. Then, in
December, the same index fell another 3% after Ownit Mortgage Solutions and Sebring Capital, two
mortgage companies that had been well-known names during the boom, ceased operations. Senior risk

1119

Nomura Fixed Income Research, CDO/CDS Update 12/18/06. The figures refer to the BBB- index of the
ABX.HE 06-2, which is a derivative referencing subprime mortgage-backed securities issued in the six months
leading up to June 2006. Launched by Markit in January 2006, each ABX index references 20 RMBS. Each index
vintage consists of five individual subindices, each referencing exposures to the same 20 underlying subprime
mortgage securitizations at different rating levels: AAA, AA, A, BBB, BBB-. Therefore, each ABX index reflects
the trading price of credit default swaps on RMBS within a certain rating level for a 6-month vintage.

461

officers of the five largest investment banks told the SEC that they expected to see further failures and
consolidation in the subprime mortgage sector in 2007. “[T]here is broad recognition that with the
refinancing and real estate booms over, the business model of many of the smaller subprime originators is
no longer viable,” SEC analysts informed Deputy Director Erik Sirri in a January 4, 2007 email.1120
Soon, the evidence was pouring in, with more of the mortgage companies that had pioneered subprime
lending – some of the largest in the nation – reporting alarming losses, then failing. In January, Mortgage
Lenders Network announced it had stopped funding mortgages and accepting new applications. In
February, New Century reported bigger-than-expected mortgage credit losses and HSBC, the largest
subprime lender in the U.S., announced a $1.4 billion quarterly provision for losses. In March, Fremont
stopped originating subprime loans after suffering losses and receiving a cease and desist order from the
FDIC. In April, New Century filed for bankruptcy.
These institutions had relied for their operating cash on short-term funding through commercial paper,
bank-provided lines of credit, and the “repurchase agreement” (repo) market. But commercial paper
buyers and banks became unwilling to provide this cash in 2007, and the repo market became more
demanding about the quality of collateral. While the housing market was heating up over the preceding
years, repo lenders had been willing to accept some amount of “mortgage risk” in their collateral; by early
2007, they had extended billions of dollars of repo loans backed by subprime and Alt-A mortgage
securities. But now, as the news worsened, these repo lenders would become less and less willing to
accept this “nontraditional” collateral. They also insisted on shorter and shorter maturities, increasingly
just one day – an inherently destabilizing factor in itself, but indicative of the lenders’ increasing and
understandable lack of confidence.

1120

SEC, Risk Management Reviews of Consolidated Supervised Entities, memo to Erik Sirri and others, January 4,
2007. SEC_TM_FCIC_002442.

462

In the first months of 2007, the investment banks took measures to reduce their subprime exposures.
Goldman Sachs was the earliest to move; regulators later highlighted that decision as differentiating
Goldman from its peers.1121 So did the some commercial banks and thrifts, many of whom were now
recording substantial losses in their subprime lending business. Some institutions, including Citigroup
and Merrill Lynch, reduced exposure in some areas but increased it in others. In short, banks that had
been busy for nearly four years creating and selling subprime-backed collateralized debt obligations
(CDOs) scrambled in about that many months to sell or hedge whatever they had accumulated in their
inventories. Goldman Sachs, Citigroup, Merrill Lynch, and others dumped these products into some of
the most toxic CDOs ever engineered – and then sometimes struggled to sell them, because some
formerly dependable buyers had already seen enough and refused to buy any more mortgage-related
products, period. Citigroup and Merrill Lynch, particularly, were forced to retain larger and larger
quantities of “super-senior” CDO tranches. The bankers could always hope – and many apparently even
believed – that all would turn out well with these super-seniors, which were, in theory, the safest of all
those tranches. Traders were referring to the subprime mortgage as e coli bacteria that was now infecting
markets in bewildering new ways (cite to come).
With buyers and sellers holding very divergent views on the assets’ value, trades become scarce and
setting prices in the markets for these subprime-backed instruments became difficult.
Government officials and supervisors certainly knew about the deterioration in the subprime markets but
misjudged the risks posed to the financial system. In January, the SEC noted that investment banks had
credit exposure to struggling and failing subprime lenders but believed there was no reason for concern.
In March, the SEC reported these banks did not expect material losses.1122 The Treasury and the Federal
Reserve insisted throughout the spring and early summer that the subprime collapse would have limited

1121

Senior Supervisors Group report.

1122

463

economic impacts. Testifying on March 28 before the Joint Economic Committee in Congress, Fed
Chairman Ben Bernanke said, “At this juncture, however, the impact on the broader economy and
financial markets of the problems in the subprime market seems likely to be contained.”1123 The same
day, Treasury Secretary Hank Paulson told a House Appropriations subcommittee that “from the
standpoint of the overall economy, my bottom line is we’re watching it closely but it appears to be
contained.”1124
The supervisors of the commercial banks continued to focus on the traditional lending activities, missing
the risks posed by all the mortgage-related CDOs the largest banks had accumulated. In a confidential
survey in April, the Fed noted only limited subprime exposures at the largest commercial banks. The
survey, however, identified only loans and mortgage-backed securities on the banks’ balance sheets – and
not all of them. The bankers did not mention the tens of billions of dollars in exposures that Citigroup and
others had taken in the super-senior tranches of CDOs, because these were “super-safe” investments—
even though very few investors would buy them. The banks’ credit derivatives and liquidity commitments
maintained off the balance sheet were left out of the banks’ response to the Fed’s survey, under the
mistaken theory that these assets were effectively quarantined. For example, Citigroup did not include
$25 billion in liquidity puts it had written on commercial paper issued by CDOs, although these puts
meant Citigroup had the obligation to purchase the commercial paper if the holders could not find buyers
in the rapidly deteriorating market. The survey aside, the regulators generally knew about these
exposures but apparently assumed that they would remain safe—that risk had been effectively and
efficiently distributed, no matter what happened next.

1123
1124

464

Goldman: “Let’s be aggressive distributing things”
In December, following the decline in ABX BBB indices and having experienced 10 consecutive days of
trading losses on the mortgage desk, executives at Goldman Sachs, the biggest investment bank, decided
to reduce the firm’s risk of loss if the subprime market continued to decline.1125 As it marked down the
value of its mortgage-related products to reflect the lower ABX prices, Goldman began posting daily
losses for this inventory.1126
On December 13, 2006 Goldman analysts delivered an internal report on “the recent volatility in the
subprime mortgage market” to Chief Financial Officer David Viniar and Chief Risk Officer Craig
Broderick. The next day, Viniar called a meeting to discuss the situation and everyone decided to get
“closer to home”: sell what could be sold as is, repackage and sell everything else.1127 Kevin Gasvoda,
the managing director for Goldman’s Fixed Income, Currency, and Commodities business line, instructed
the sales team to sell ABS and CDO positions even if they had to take a loss: “Pls refocus on retained new
issue bond positions and move them out. There will be big opportunities the next several months and we
don’t want to be hamstrung based on old inventory. Refocus efforts and move stuff out even if you have
to take a small loss.” At the same time, Goldman also wanted to take advantage of good opportunities, as
xx said “keep powder dry and look around the market hard.” 1128 In a December 15 email, Viniar
described the new strategy to Tom Montag, the co-head of global securities: “On ABX, the position is
reasonably sensible but is just too big. Might have to spend a little to size it appropriately. On everything
1125

See April 27, 2010 Testimony of David Viniar to the Senate Permanent Subcommittee on Investigations, at 3-4.

1126

See April 27, 2010 Testimony of David Viniar to the Senate Permanent Subcommittee on Investigations, at 3-4.

1127

See April 27, 2010 Testimony of David Viniar to the Senate Permanent Subcommittee on Investigations, at 4.

1128

In a prior email in the same conversation, Goldman mortgage sales chief Dan Sparks had described a December
14 meeting in which executives discussed six types of subprime exposure: (1) credit derivatives, (2) loans on
Goldman’s balance sheet, (3) residual positions from MBS created by Goldman, (4) MBS and other securities held
in the “warehouse” with the intention of putting them into future CDOs, (5) early payment defaults on subprime
loans, and (6) loans held in the “loan warehouse” with the intention of putting them into future MBS. Sparks said
the group agreed to reduce exposures, carefully track market prices of securities held by Goldman, and “be ready for
the good opportunities that are coming.”

465

else my basic message was let’s be aggressive distributing things because there will be very good
opportunities as the market goes into what is likely to be even greater distress and we want to be in
position to take advantage of them.”1129
Subsequent emails suggest that the “everything else” meant mortgage-related assets. On December 20, in
an internal email with broad distribution, Goldman’s Stacy Bash-Polley [title tk] noted that the firm,
unlike some of the others, had been able to find buyers for the “super-senior” and “equity” tranches of
CDOs, but the “mezzanine” tranches – those that had earned the lowest levels within the rating agencies’
investment grades – remained the biggest challenge. The “best target,” she said, would be to put them in
other CDOs: “We have been thinking collectively as a group about how to help move some of the risk.
While we have made great progress moving the tail risks-ssr and equity- we think it is critical to focus on
the mezz risk that has been built up over the past few months… Given some of the feedback we have
received so far [from investors,] it seems that cdo’s maybe the best target for moving some of this risk but
clearly in limited size (and timing right now not ideal).”
It was getting harder and harder to find clients interested in buying these increasingly toxic assets. Back in
October, Goldman Sachs traders had noted that some investors were “too smart to buy this kind of junk”
and complained that they were being asked to “distribute junk nobody was dumb enough to take the first
time around.” Two months later, in a December 28 email discussing a list of customers to target for the
year, Goldman’s Fabrice Tourre [title tk] said, “[F]ocus efforts on buy and hold rating-based buyers rather
than sophisticated HFs that will be on same side of trade as GS.” HFs are hedge funds, and the “same of
side of trade” as Goldman was the selling or shorting side—meaning the side that expected the mortgage
market to continue to decline. In January, Dan Sparks, the head of Goldman’s Mortgage department,
extolled Goldman’s success in dumping their toxic inventory, writing that the team had “structured like
mad and traveled the world, and worked their tails off to make some lemonade from some big old

1129

Permanent Subcommittee on Investigations, Exhibit 3.

466

lemons.” Tourre acknowledged that there was “more and more leverage in system,” and that he was
“standing in middle of complex, highly levered, exotic trades he created w/o understanding the
implications of the monstrosities.”
On February 11, Goldman CEO Lloyd Blankfein questioned co-head of Global Securities Tom Montag
about the $20 million in losses incurred on residual positions from old deals and asked, “Could/should we
have cleaned up these books before and are we doing enough right now to sell off cats and dogs in other
books throughout the division?”
The numbers suggest that the answer was yes. Even given a $20 million write-off and billions in
subprime exposure still retained, Goldman was doing just fine. In the three months through February,
2007, its mortgage business earned $226 million, a record for that unit (but only ??% of Goldman’s total
revenues); the mortgage revenues were driven primarily by short positions on credit default swaps,
including a $10 billion short position on the telltale ABX BBB Index, whose drop the previous November
had been the red flag that got Goldman’s attention.
In the ensuing months, Goldman reduced mortgage risk in several ways while continuing to create and
sell mortgage-related products to its clients. From December through xx of 2007, it created and sold $xx
billion in CDOs, using them to unload much of its own remaining inventory of other CDO securities – the
toxic ones – and mortgage-backed securities. Goldman also produced $xx billion worth of synthetic
CDOs for its clients. [will reference the Timberwolf deal, will put these numbers in the context of how
many cash and synthetic deals were getting done by all institutions in the market]
The firms took short positions worth $xx billion on some of these cash and synthetic securities using
credit default swaps; it also took short positions on the ABX indices and on some of the financial firms
with whom it did business. And it “marked” or valued mortgage-related securities at prices that were
significantly lower than other companies.

467

Everyone at Goldman understood that the $226 million profit for the mortgage business was not the
whole story. The daily mortgage “value-at-risk” measure, or VaR, which tracks potential losses a firm
would experience if the market moved unexpectedly, increased in the three months through February.
According to SEC reports, by February Goldman’s company-wide VaR reached an all-time high.1130 The
dominant driver of the increase in VaR was the one-sided bet on the mortgage market continuing to
decline. Preferring to be risk-neutral, between March and May, the mortgage-securities desk reduced its
short position on the ABX Index; between June and August, it again reversed course, increasing its short
position by purchasing protection on mortgage-related assets.
Like every market participant, Goldman “marked” its securities – that is, put a value on them for the
record – based in part on surveys of how other institutions dealing in these securities valued the assets, or
dealers’ marks, and actual trades in the marketplace. As this crisis unfolded, Goldman consistently set its
marks on the questionable mortgage-related investments at significantly lower levels than other
companies’ valuations. It knew that those lower marks would adversely affect those other companies,
who might be its own clients. Trading an asset with Goldman at the lower mark would require the
company to mark all of its similar assets at those same lower marks. And, Goldman’s marks would get
picked up by its competitors in dealer surveys. As a result, Goldman’s marks could indirectly cause the
other companies to record “mark-to-market” losses, meaning a lower reported value of their assets.
The markdowns of these assets could also require companies to reduce their repo borrowings or post
additional collateral to counterparties to whom they had sold credit default swap protection. In a May 11
email, Craig Broderick, Goldman’s Chief Risk Officer, responsible for tracking how much of the
company’s money was at risk, noted to colleagues that the mortgage group was “in the process of
considering making significant downward adjustments to the marks on their mortgage portfolio esp CDOs
and CDO squared. This will potentially have a big [profit and loss] impact on us, but also to our clients

1130

468

due to the marks and associated margin calls on repos, derivatives, and other products. We need to survey
our clients and take a shot at determining the most vulnerable clients, knock on implications, etc. This is
getting lots of 30th floor attention right now.”1131
Broderick was right about the impact of its marks on clients and counterparties, including American
Insurance Group (AIG). But the first significant dispute about these marks began in May 2007, and
concerned two high-flying, mortgage-focused hedge funds run by Bear Stearns Asset Management
(BSAM).

Bear Stearns’s hedge funds: “Looks pretty damn ugly”
Bear Stearns started its asset management business in the 1990s. This was basic strategy for the industry.
Every investment bank and most of the large commercial banks – Citi, Bank of America, JP Morgan –
had an asset management business within their massive structures. Asset management brought in steady
fee income, allowed the banks to offer new products to customers, and required little capital.
In 2003, Ralph Cioffi, a former Bear Stearns fixed-income salesman, and Matthew Tannin, who had
structured CDOs at the firm, suggested to BSAM’s management the creation of a hedge fund focused on
various securitization products. This fund, called the High-Grade Structured Credit Strategies Fund,
would invest in low-risk, high-grade debt securities, such as AAA- and AA- rated tranches of
collateralized debt obligations (CDO), funded by low-cost, short-term repo money. In 2003, this was a
promising market with seemingly manageable risks. The fund could plausibly seek to provide an annual
return to investors of [??%.] Within three years, High-Grade would become BSAM’s largest hedge fund,
with more than $1.5 billion provided by wealthy individuals and institutional investors, including
employee benefit plans and corporations. Although Bear Stearns owned BSAM and initially capitalized it
with $20 billion, Bear’s management exercised little supervision over its business.

1131

PSI, Exhibit 84.

469

By January 2007, internal BSAM risk-exposure reports showed the fund’s collateral to be approximately
60% subprime mortgage-backed CDOs. Like many hedge funds, High Grade was leveraged. For every
dollar obtained from investors, the fund borrowed between eight and 10 more. Such leveraging can
significantly increase profits when the investment rises, but losses are that much steeper, too. The fund
had ten large repo counterparties, including Barclays, Goldman Sachs, Lehman Brothers, Merrill Lynch,
Citigroup, Deutsche Bank, and JP Morgan. It was therefore highly dependent on the largest financial
institutions, which provided both financing through the repo market and most of the mortgage-related
CDOs and other securities that the hedge fund purchased.
That is, the banks loaned High-Grade the money to purchase the securities that these same banks were
selling.1132 This financing arrangement made Ralph Cioffi “a very popular fellow with most Wall Street
firms,”1133 in the words of Thomas Marano, head of Bear Stearns’ mortgage trading desk. Cioffi was also
very popular with his supervisors, because High-Grade generated profits of 9.46% in 2005 and 10.68% in
2006.1134 Cioffi was rewarded with annual compensation worth $xx million dollars from 20xx to 20xx.
Tannin, his lead manager, was awarded multi-million dollar compensation of $xx over the same time
period. Both managers invested some of their own money in the funds, and used this as a selling point to
others.1135
In August 2006, encouraged by Cioffi’s success with High-Grade, BSAM started a second, more
aggressive and higher-risk fund, the High-Grade Structured Credit Strategies Enhanced Leverage Fund.

1132

FCIC Interview with Alan Schwartz.

1133

FCIC Interview with Thomas Marano.

1134

BSC-FCIC 00000690.

1135

SEC Complaint at 5.

470

The Enhanced fund would be leveraged at 12:1, with returns projected to be commensurately high.1136 But
the timing for the Enhanced fund was bad. Shortly after the fund opened for business, the ABX BBBindex started to falter, falling 4% in the last three months of 2006; the index then plunged 8% in January
and 25% in February. The market’s confidence followed suit. Investors began to bail out of their
investments. Cioffi and Tannin stepped up their marketing efforts. On March 12, they conducted a
conference call to assure investors that both hedge funds were in good shape, and they continued to use
the investment of their own money as evidence of their confidence. Tannin even claimed he was
increasing his investment, although he never did. Two weeks after the conference call, Cioffi redeemed
$2 million of his own investment in his funds, according to an SEC complaint.1137
Despite avowals of confidence, Cioffi and Tannin were in full red-alert mode. They tried to sell the toxic
ABS CDO securities about which everyone was increasingly concerned. Of course they had little success
selling them directly on the market, but there was another way. On May 24, BSAM, acting as a CDO
manager, launched a $4 billion “CDO-squared” deal comprised mostly of ABS CDO assets purchased
from the High-Grade and Enhanced funds.1138 Super-senior tranches, theoretically the safest of the lot,
worth $3.2 billion were sold as commercial paper to short-term investors such as money market mutual
funds. Critically, Bank of America guaranteed those deals with a traditional liquidity put– for a fee, of
course. Later in the year, when commercial paper investors refused to roll over this particular paper, Bank
of America had to step in and ultimately lost $xx billion on the deal. [We are discussing this with BSAM
and BofA in the next two weeks.]

1136

SEC Complaint; see also Merrill Lynch analysis, “Bear Stearns Asset Mgm’t: What Went Wrong.” BAC-FCIC000054648. Virtually every Bear Stearns executive familiar with the Bear Stearns Hedge Funds agreed that the
leverage for the High Grade Fund was in the 8 to 10 times range; BSC-FCIC 00000690.

1137

SEC complaint.

1138

The CDO was called High Grade Structured Credit CDO 2007-1. Underwritten by Credit Suisse, it was the
largest ABS CDO issued in 2007.

471

“19% is doomsday”
Nearly all hedge funds provide their investors with market value reports at least monthly based on
computed “mark-to-market” prices for the fund’s various investments. Industry standards generally
called for valuing readily traded assets, such as stocks, at the current trading price, while assets in very
slow markets were marked by surveying price quotes from other dealers, factoring in other pricing
information, and arriving at a final net asset value. And in the market for mortgage-backed investments,
this was a supremely important exercise, because the market values were used to inform investors and to
calculate their total fund value for internal risk management purposes, and because these assets were held
as collateral for repo and other lenders. Crucially, if the value of a hedge fund’s portfolio declined, repo
and other lenders might require more collateral.
Dealer marks were slow to keep up with changes in the ABX indices. While the ABX BBB- index
actually recovered some of the earlier losses in March, rebounding 6%, dealer marks finally started to
reflect the lower values. On Thursday, April 19, in preparation for an investor call the following week,
BSAM analysts informed Cioffi and Tannin that, in their view, the value of the funds’ portfolios had
declined sharply. On Sunday, Tannin sent an email from his personal account to Cioffi’s personal email
account arguing both hedge funds should be closed and liquidated: “Looks pretty damn ugly…. If we
believe the runs [the analyst] has been doing are ANYWHERE CLOSE to accurate, I think we should
close the Funds now…. [I]f [the runs] are correct then the entire sub-prime market is toast…” But by the
following Wednesday, Cioffi and Tannin were back on the same page. At the beginning of the
conference call, Tannin told investors, “[T]he key sort of big picture point for us at this point is our
confidence that the structured credit market and the sub-prime market in particular, has not systemically
broken down… we’re very comfortable with exactly where we are.” Cioffi also assured investors that the
funds would likely finish the year with positive returns. In April, the two hedge funds had attracted $23
million in new investor funds, but others continued to pull money out. In April alone, the funds received
more than [$?] in redemption requests, including Cioffi’s own $2 million withdrawal.
472

On April 7, 2007, according to Rich Marin, BSAM’s former Chairman and CEO, BSAM received marks
on its mortgage assets from Goldman, Citigroup and Lehman that were all in the 96 cents to 98 cents on
the dollar range, suggesting that the value of these assets had only declined slightly. Also in April,
JPMorgan told Bear Stearns’ co-president Alan Schwartz that the bank would be asking the BSAM hedge
funds to post additional collateral to support its repo borrowing.1139
In May, the situation took a turn for the worse. Lehman and Citigroup provided marks in April that would
have—on their own—suggested a 6.75% drop in the value of the fund. Then Goldman Sachs sent marks
that were 50 cents to 60 cents on the dollar – a stunning development. According to Marin, averaging
these Goldman marks with the other dealers’ marks would yield a startling 19% drop in the Enhanced
Leverage Fund’s value. Goldman disputes Marin’s account and told the FCIC its marks covered only
about $10 million of positions, so they could not have caused a 19% drop in the Enhanced Leverage
Fund’s value. [staff is still collecting information]
On May 13, Cioffi admitted to Tannin it was “somewhat certain” that the Enhanced Leverage Fund would
have to be liquidated if investors continued pulling out their money at the current rate. On May 31, Cioffi
argued to BSAM’s pricing committee that Goldman’s marks were out of line with the other dealer quotes
and should be tossed out. Committee members challenged him, suggesting that his only reason for
dropping Goldman marks from the calculation was his fear that the lower numbers would tank the fund.
After the meeting, Cioffi emailed one committee member: “There is no market . . . its [sic] all academic
anyway -19% [value] is doomsday.”1140

1139

Notably, as one of only two tri-party repo clearing banks, JP Morgan had more information about BSAM’s
lending obligations than most other market participants or regulators did. As discussed in greater detail below, this
superior market knowledge later put JP Morgan in a position to step in and purchase Bear Stearns virtually
overnight. (See Daryll Hendricks MFR).

1140

473

The pricing committee over-ruled Cioffi, Goldman’s marks stayed in the mix, and news of the 19% drop
in the end-of-April value for the Enhanced Leverage Fund had the predictable impact on investors. Their
requests for redemptions increased. And margin calls increased from the fund’s repo lenders, including
JP Morgan, which had been the first to call the previous month.
“Canary in the mine shaft”
When JP Morgan called Bear co-president Alan Schwartz in April with its margin call, Schwartz was
concerned that neither High-Grade nor Enhanced had sufficient cash on hand to post the requested
collateral. In early June, he met with the 10 repo counterparties to the BSAM funds to negotiate a grace
period to allow BSAM to raise capital.1141 As noted, some of these very same firms had sold the funds
some of the same CDOs and other securities that were turning out to be such bad assets.1142 Now all 10
refused Schwartz’s appeal and instead increased their margin calls.1143 As a direct result, the two funds
had to sell bonds at distressed prices in order to raise cash.1144 Selling the bonds led to a complete loss of
confidence by the investors, whose requests for redemptions accelerated.1145
On June 7, BSAM threw the gate, suspending investor redemptions from the High-Grade and Enhanced
funds – a drastic step. According to Bear Stearns’ then co-president Warren Spector, the idea was to
instill confidence in the funds’ repo lenders and avoid a run that could leave the funds bankrupt.1146 The
strategy backfired. Shortly after the suspension, Merrill Lynch seized more than $850 million in collateral

1141

Barclays Bank Plc v. Bear Stearns Asset Management Inc., 07-11400, page 42, paragraph 175.

1142

Barclays Bank Plc v. Bear Stearns Asset Management Inc., 07-11400, page 42, paragraph 175.

1143

FCIC Interview with Alan Schwartz; Barclays Bank Plc v. Bear Stearns Asset Management Inc., 07-11400, page
54, paragraphs 227 – 229.

1144

FCIC Interview with Alan Schwartz; Barclays Bank Plc v. Bear Stearns Asset Management Inc., 07-11400, page
54, paragraphs 227 – 229.

1145

See Upton interview & Schwartz interview.

1146

FCIC Interview with Warren Spector.

474

for its outstanding repo loans. Auctioning this seized collateral, Merrill was only able to sell certain
portions – and at deep discounts to face value.1147 [requesting further information on this sale.] Other
repo lenders were increasing their collateral requirements or refusing to roll over their loans.1148 This run
on both hedge funds left BSAM with limited options. It also left Bear Stearns itself with limited options.
Although it owned the asset management business, its equity positions in BSAM’s two failed hedge funds
were relatively small. Initially, Bear Stearns had invested $20 million total, and in June Warren Spector
approved an additional $25 million investment into High-Grade without review by Bear’s CEO or Board
of Directors—to CEO Cayne’s subsequent alarm when he learned about it.
Bear Stearns had no legal obligation to rescue either the funds or their repo lenders. However, those
lenders were the same large investment banks that Bear Stearns dealt with on a daily basis.1149 Moreover,
any failure of entities related in any way to Bear Stearns could and ultimately did raise investors’
concerns about the firm itself.
Thomas Marano, head of its mortgage trading desk, recalled to FCIC staff that the constant barrage of
margin calls had created chaos. In mid-June, Bear Stearns dispatched him to engineer a solution with
BSAM CEO Richard Marin.1150 Marano now worked to understand the basics of the portfolio, including

1147

Merrill Lynch analysis, “Bear Stearns Asset Mgm’t: What Went Wrong.” BAC-FCIC-000054648; FCIC
Interview with Paul Friedman. While most of the Bear Stearns executives interviewed by FCIC staff did not recall
the percentage discount at which the collateral seized by Merrill Lynch was auctioned, they did believe that it was
material. (Collecting more info on the haircut)
1148

“While the High Grade fund was not in default/had not missed any margin calls, creditors were cutting off its
liquidity by increasing haircuts or not rolling repo facilities.” SEC_TM_FCIC_1053310; FCIC Interview with
Robert Upton.

1149

FCIC Interview with Robert Upton; FCIC Interview with Thomas Marano; FCIC Interview with Warren
Spector.

1150

FCIC Interview with Warren Spector.

475

what could be done in a worst-case scenario in which significant amounts of assets had to be sold.1151
Marano and Marin’s conclusion: High-Grade still had positive value, but Enhanced Leverage did not.
Based on that analysis, Bear Stearns committed up to $3.2 billion – and ultimately loaned $1.6 billion – to
take-out the High Grade Fund repo lenders and become the sole repo lender to its own fund.1152
Enhanced Leverage was on its own. Bear Stearns executives did not universally support providing
financing to the High Grade fund. CEO Jimmy Cayne and Earl Hedin (former senior managing director
of Bear Stearns and BSAM) were opposed, because they did not want to increase shareholder liability.
However, some of Bear Stearns’s other executives did not expect to lose money on the bailout.1153 They
were wrong, and Cayne and Hedin were right. By July, the two hedge funds had shrunk almost to
nothing: High-Grade Fund was down 90%; Enhanced Leverage Fund, 99%. On July 31, both filed for
bankruptcy.1154 Bear Stearns seized the collateral for its loan to the High Grade Fund and moved it onto
its own books, where it remained until a substantial portion was written off in November.1155 [We have
sent a request to BSAM’s current owner, JPMC, for details on the hedge funds’ holdings and redemption
requests by investors.]
Looking back, Marano told the FCIC, “We caught a lot of flak for allowing the funds to fail, but we had
no option.”1156 In an internal email in June, Bill Jamison of Federated Investors, one of the largest mutual
fund companies, referred to the Bear Stearns hedge funds as the “canary in the mine shaft” and predicted

1151

FCIC Interview with Thomas Marano. 4/19/2010.

1152

Email from Thomas Marano to Warren Spector. BSC-FCIC-e00118978.

1153

FCIC Interview with Alan Schwartz.

1154

In re Bear Stearns High-Grade Structured Credit Strategies Master Fund, Ltd. (US Bankruptcy Court SDNY,
2007).

1155

FCIC Interview with Samuel Molinaro; FCIC Interview with Alan Schwartz.

1156

FCIC Interview with Tom Marano, 4/19/2010.

476

more market turmoil.1157 [other counterparties will be added] He was right. As the two funds were
collapsing, short-term secured lending tightened across the board. Many repo lenders sharpened their
focus on the valuation of any collateral with potential subprime exposures, and on the relative exposures
of different financial institutions. They required increased margins on loans to certain institutions with
certain types of collateral; they often required Treasury securities; in many cases, they demanded shorter
lending terms.1158 Clearly, the AAA-rated mortgage-backed securities and ABS CDOs were not really
AAA anymore. They were not the “super-safe” investments that investors – and some dealers – had only
recently believed.
On August xx, Jimmy Cayne called Bear Stearns co-president Warren Spector into his office and asked
him to resign.

Rating agencies are told: “Investors Don’t Want Rating Downgrades”
While Bear Stearns Asset Management was wrestling with its two ailing flagship hedge funds, the three
major credit rating agencies finally joined investors in admitting that subprime mortgage-backed
securities would not perform as advertised. On July 10, 2007, they issued comprehensive rating
downgrades and credit watch warnings on an array of residential mortgage-backed securities (RMBS).
These rating announcements foreshadowed the actual losses to come.
The raw details provided in the press releases reveal some of the challenges the agencies faced in dealing
with these securities. S&P announced that it had placed 612 RMBS tranches backed by US subprime
collateral on negative “CreditWatch,” affecting $7.3 billion of securities. (This designation often means
that a given bond will be downgraded within days. Such was the case here.) S&P warned that 60 ABS
CDOs, or about 13.5% of the outstanding US cash flow and hybrid ABS CDO transactions that they had

1157

Internal email from Bill Jamison of Federated (June 21, 2007). FEDFCIC 0000131.

1158

JPM Morgan, “Worldwide Securities Services Risk Review”, Directors Risk Policy Committee (September 18,
2007). JPM-FCIC 00000213; FCIC Interview with Michael Alix.

477

reviewed, had some exposure to the 612 subprime RMBS tranches placed on CreditWatch. S&P promised
to review every deal in its ratings database for adverse effects, with the likelihood that eight to 10 of the
60 cash CDOs and 100% of synthetic CDO transactions that they had already analyzed would be
downgraded. In the afternoon, Moody’s downgraded 399 RMBS tranches issued in 2006 backed by US
subprime collateral and put an additional 32 tranches on watch. These Moody’s downgrades affected
approximately $5.2 billion in securities. The following day, Moody’s placed 184 tranches of CDOs
backed primarily by RMBS, with original face value of approximately $5 billion, on watch for possible
downgrade. Two days after its original announcement, S&P downgraded 498 of the 612 tranches it had
placed on negative CreditWatch. S&P stated that its actions were based upon “poor collateral
performance, our expectation of increasing losses on the underlying collateral pools…. The levels of loss
continue to exceed historical precedents and our initial expectations.” Fitch Ratings, the smallest of the
three major credit rating agencies, announced similar downgrades.
These unanimous opinions and actions by the rating agencies were very sudden and very meaningful for
all who understood the implications. While the specific securities downgraded – the riskiest tranches of
the RMBS – were only a small fraction of the RMBS universe (less than 2% of RMBS issued in
20061159,1160), investors knew that more downgrades on CDOs and less risky tranches might come. Many
investors were also critical of the rating agencies, lambasting them for their belated reaction to the
troubles in the subprime market. By July 2007, housing prices had already fallen about 4% nationally
from their peak at the beginning of 2006.
On the July 10 conference call with S&P, Steve Eisman of FrontPoint Partners, a hedge fund, harangued
Tom Warrack, managing director of S&P’s RMBS group. This is the transcript of one exchange:

1159

S&P July 10, 2007, teleconference transcript, p. 2; Moody’s July 12, 2007, teleconference presentation, p.12.

1160

First-lien RMBS were mortgage-back bonds contains home mortgage whereby the bank had the first lien on the
property. Baa or below securities were carved out of the RMBS to provide investors with differing levels of risk and
return.

478

Eisman: I’d like to know “why now?” I mean, the news has been out on subprime now for many, many
months. The delinquencies have been a disaster now for many, many months. (Your) ratings have been
called into question now for many, many months. I’d like to understand why you’re making this move
today when you – and why didn’t you do this many, many months ago.
Warrack: Yes, it’s a good question. It takes a period of time for these deals to begin to show their true
performance. We have been surveying these transactions actively on a regular basis beginning in 2005
and 2006. We believe that the performance that we’ve been able to observe now warrants action. And
that–Eisman: If I may press that for a moment, I mean, I track this market every single day. The performance
has been a disaster now for several months. I mean, it can’t be that all of a sudden the performance has
reached a level where you’ve woken up. I’d like to understand why now when you could’ve made this
move many, many months ago. I mean, the paper just deteriorates every single month like clockwork. I
mean, you need to have a better answer than the one you just gave.
Warrick: So our answer remains that we took action as soon as possible given the information at hand.
The ratings agencies’ downgrades, in tandem with the problems at Bear Stearns’s hedge funds, had the
predictable chilling effect on the markets. The ABX BBB- index fell another 33% in July, confirming
and guaranteeing even more problems for holders of mortgage securities. In the same inexorable,
vicious-cycle dynamic that had taken down the Bear Stearns funds the previous month, repo lenders
increasingly required other borrowers, including many hedge funds, who had put up mortgage-backed
securities as collateral, to put up more, because their value was no longer clear – or if it was clear, it was
depressed. Many of these borrowers were forced to sell assets to meet these margin calls, and each sale
had the potential to further depress prices. If at all possible, the borrowers sold other assets for which
prices were readily available, pushing prices downward in those other markets. [will add quotes from
interviews]
479

AIG: “We’re f***ed, basically”
Of all the possible losers in the rout that was looming by the summer of 2007, American Insurance Group
should have been the most concerned. By that time, after several years of aggressive growth, AIG’s
Financial Products subsidiary had written $78 billion in over-the-counter credit default swap (CDS)
protection on super-senior tranches of multi-sector ABS CDOs. Notwithstanding the term “multi-sector,”
the subsidiary wrote increasing volumes of CDS contracts on CDOs backed largely by U.S. subprime
residential mortgages. Although management had taken note of the peaking housing market and made a
decision to stop writing CDS on super-senior tranches of subprime CDOs over a year before, in reality it
continued to write similar new deals and it did not do anything to reduce or hedge its exposure. On the
day that the agencies started to downgrade the securities, AIG had the dubious distinction of holding the
largest exposure in the world to the super-senior tranches of subprime CDOs.
In a phone call the next day, July 11, Financial Products executive Andrew Forster told Alan Frost, the
executive vice president, that he had to analyze exposures because “every f***ing … rating agency we’ve
spoken to … [came] out with more downgrades” and that he was even more concerned than before:
“About a month ago I was like, you know, suicidal…the problem that we’re going to face is that we’re
going to have just enormous downgrades on the stuff we got.....Everyone tells me that it’s trading and it’s
two points lower and all the rest of it and how come you can’t mark your book. So it’s definitely going to
give it renewed focus. I mean we can’t… we have to mark it. It’s, it’s, uh, we’re [UNINTEL] f***ed
basically.”
Forster was likely worried most of AIG’ credit default swaps required posting collateral to the purchasers,
should the market value of the referenced mortgage-backed securities decline by a certain amount, or if
rating agencies downgraded AIG’s long-term debt.1161 That is, collateral calls could therefore be triggered
even if there were no actual cash losses in, for example, the super-senior tranche upon which the
1161

AIG 2007 Form 10K pg, 164; Memorandum to File From AIG FSD CFO Elias Habayeb at PWC-FCIC000101;
GS 00001—GS 00062; AIG-FCIC00384254—AIG-FCIC00384295.

480

protection had been written.1162 Remarkably, top AIG executives including CEO Martin Sullivan, CFO
Steven Bensinger, Chief Risk Officer Robert Lewis, Chief Credit Officer Kevin McGinn, and even
Financial Services Division CFO Elias Habayeb told FCIC investigators that they did not even know
about these terms until the collateral calls started rolling in during July.1163 Regulators at the Office of
Thrift Supervision, who supervised AIG on a consolidated basis, didn’t know either. Alan Frost did know
about the terms and said they were standard for the industry. He said that other executives at AIG FP,
including Joe Cassano, the Financial Products division CEO, also knew about these terms.
And the counterparties knew, of course. On the evening of July 26, Goldman Sachs, which held the
largest portion – $21 billion – of AIG’s total of $78 billion super-senior credit default swaps, brought
news of the first collateral call in the form of an email from Goldman salesman Andrew Davilman to
Frost:
Davilman: Sorry to bother you on vacation. Margin call coming your way. Want to give you a heads up.
Frost, eighteen minutes later: On what?
Davilman, one minute later: 20bb of supersenior
The next day, Goldman made the collateral call official by forwarding an invoice requesting $1.8
billion.1164 On the same day, Goldman purchased $100 million of protection– in the form of credit default
swaps – against the possibility AIG may default on its obligations.

1162

CDS transactions between AIG and Goldman – which accounted for approximately 27% of AIG’s multi-sector
CDS portfolio - were governed by an International Swap Dealers Association (ISDA) Master Agreement (“Master
Agreement”) and an ISDA Credit Support Annex (“CSA”), which the parties executed on 8/19/03. The Master
Agreement included general terms, obligations and definitions for swaps executed between the parties and the CSA
required the parties to post collateral under certain circumstances short of a credit event. Upon agreed trigger events
and/or on agreed valuation dates, collateral payment obligations, or “credit support obligations,” are determined by
calculating the current “exposure” value of the swap (i.e., the present value of the transaction if it were terminated).

1163
1164

AIG-FCIC00370077 (7/26/07 email); AIG-SEC2035262 (8/2/07 email); Get collateral invoice from Goldman.

481

The $1.8 billion invoice cast a pall over Frost’s vacation. He was stunned. He assured Davilman and Dan
Sparks, the head of Goldman’s mortgage trading desk, that there was no need for a collateral demand.
AIG’s models showed there would no defaults on any of the bond payments AIG’s swaps insured. 1165
The Goldman executives considered those models irrelevant, because the contracts required collateral to
be posted in the event of a decline in market value, irrespective of any long-term cash losses. 1166
Goldman estimated that the bonds had declined in market value by xx%.
So, first Bear Stearns’ hedge funds and now AIG were getting hit by Goldman’s aggressive marks on
mortgage-backed securities. Like Ralph Cioffi and his colleagues at the Bear Stearns funds, Frost and his
colleagues at AIG now disputed Goldman’s marks. On July 30, Andrew Forster told another AIG trader
that “[AIG] would be in fine shape if Goldman wasn’t hanging its head out there…” The margin call was
“something that hit out of the blue and a f***ing number that’s well bigger than we ever planned for.”
Forster said that Goldman’s prices were “ridiculous,” that some AA paper was trading at much higher
marks. He said that relative to an initial value of 100 cents on the dollar the marks “could be anything
from 80 to sort of, you know, 95.”

In testimony to the FCIC, Goldman said it had stood ready to sell mortgage-backed securities at its own
marks. AIG’s Forster testified that he would not buy the bonds at even 90 cents on the dollar because the
bonds might decline further in value. Another reason not to buy the bonds at any such price: AIG would
be required to value its own portfolio of similar assets at the same price. Forster said, “in the current
environment I still wouldn’t buy them… because they could probably go low… we can’t mark any of our
positions, and obviously that’s what saves us having this enormous mark to market. If we start buying the

1165

Sparks MFR at ___.

1166

Dan Sparks interview.

482

physical bonds back then any accountant is going to turn around and say, well, John, you know you
traded at 90, you must be able to mark your bonds then.” 1167
At first, AIG refused to post the cash collateral to Goldman Sachs. Within a week, Goldman reduced its
demand by one-third down, from $1.8 billion to $1.2 billion. 1168 Thinking back on the initial demand,
Cassano recalled that Goldman Co-CEO Michael Sherwood told him that Goldman “didn’t cover
ourselves in glory” during this period.1169 AIG still disputed Goldman’s marks and balked at posting the
money. 1170 Tough negotiations followed. According to an email to Forster from his colleague Tom Athan,
describing a conference call with Goldman executives on August 1, the Goldman executives said that
“this has gone to the ‘highest levels’ at GS and they feel that the [contract] has to work or they cannot do
synthetic trades anymore across the firm in these types of instruments.” 1171 Many times, Athan added,
the Goldman executives called the collateral call a “test case.”
Goldman Sachs and AIG would continue to dispute Goldman’s marks, even as AIG would continue to
post collateral that would fall short of Goldman’s demands and even as Goldman would continue to
purchase CDS contracts against the possibility of AIG’s default. Over the next 14 months, more such
“test cases” resulting in collateral calls would cost AIG tens of billions of dollars and help to lead to one
of the biggest government bailouts in American history.
ue to subprime defaults, if any at all. Panic was spreading.

1167

AIG-SEC 1361819-20. Emphasis added.

1168

AIG-SEC2035262 (8/2/07 email); AIG-SEC1913380 (8/8/07 email).

1169

MFR of Joseph Cassano (June 25, 2010) at 3.

1170

AIG-SEC2035262 (8/2/07 email); AIG-SEC1913380 (8/8/07 email).

1171

AIG-SEC9990006.

483

484

CHAPTER CONCLUSIONS HERE

Part III, Chapter 2: Investors “run” asset-backed commercial paper

Contents
July 30: Investors “run” asset-backed commercial paper 485
IKB of Germany: $20 billion of CDOs financed short-term
Countrywide: “That’s our 9/11”

487

490

BNP Paribas: “The ringing of the bell”

495

Federal Reserve: “Prepared to act as needed” 497
SIVs: “An oasis of calm” disturbed 498
Money funds and other investors: “TK”

500

Throughout the summer of 2007, the bills for conference calls soared on Wall Street and throughout the
financial industry. Provocative emails were exchanged. Despite Secretary Paulson’s reassurance in a
July 26 interview with Bloomberg saying, “I don’t think it [the subprime mess] poses any threat to the
overall economy,” research departments and unnerved investors participating in any aspect of the markets
looked under every rock for hidden or latent subprime exposure. In late July, they found it in the market
for asset-backed commercial paper (ABCP), a crucial but usually boring backwater of the financial sector.
As we have seen, this kind of commercial paper had evolved rapidly from the 1980s, when it allowed
companies to post high-quality, short-term assets such as receivables in return for quick cash infusions.
The leading lenders of this cash, notably the money market mutual funds, were, for the most part, highly
risk-averse and short-term oriented by nature. But the market quickly evolved and these funds started
accepting notes backed by longer-term assets that would prove far less stable than trade receivables. By
mid-2007, among these longer-term assets were hundreds of billions of dollars’ worth of mortgage-related
485

assets. The $1.2 trillion ABCP market included $68 billion in paper issued by CDOs; $104 billion issued
by structured investment vehicles, or SIVs; and $218 billion in single-seller programs, through which
many mortgage companies financed their mortgages awaiting securitization. With these and other
mechanisms, the asset-backed commercial paper market accommodated many complex financial
arrangements that would, in the end, allow relatively small amounts of subprime e coli to jeopardize the
entire financial system. The rating agencies proved unable to anticipate how these money market
structures would perform; when released on the market, all received top investment-grade ratings from
S&P and Moody’s.
In many cases, the reason they earned those ratings were the contractual “liquidity puts” from commercial
banks – insurance, in effect. Financing long-term securities with short-term paper requires frequent
refinancing, or rollovers. Simply put, you pay off the debt of the maturing paper with a new loan using
new paper. If the money market funds and other investors refuse to roll over the paper when it comes due,
the banks backing the liquidity puts could be obliged to buy the paper until it can be rolled over again.
Citigroup and other big banks liked the asset-backed commercial paper market because it provided a
relatively cheap way to originate and fund loans for their clients while avoiding the need to hold the loans
on their balance sheets. Under regulatory capital rules, regulators generally required banks to hold 8% of
on-balance sheet assets as capital—4% in the case of residential mortgage loans—to protect against
unexpected losses. The more capital required, the lower the return on capital for shareholders. But when
banks created asset-backed commercial paper programs, they put the assets into specially designed,
limited-purpose corporations that the accounting rules allowed them to consider “off-balance sheet.” The
capital charge for these off-balance sheet programs was 0.8% if the bank provided a liquidity put and 0%
otherwise. When the mortgage securities market dried up and money market mutual funds became
skittish about broad categories of ABCP, these banks were required under these liquidity puts to support
the ABCP and bring assets onto their balance sheets after all, leading to tremendous losses.

486

IKB of Germany: $20 billion of CDOs financed short-term
The first big casualty of the run on ABCP was a German bank, IKB Deutsche Industriebank AG. Since its
foundation in 1924, IKB’s business had been lending to mid-size German businesses. In 2001,
management decided to diversify and expand into other business lines, at first buying US-structured
finance securities backed by credit card receivables, business loans, auto loans, and mortgages, always
sticking to those the rating agencies had determined to be investment grade.
In 2002, IKB created a special off-balance-sheet ABCP program, which it called Rhineland, to purchase a
portfolio of those securities. By March 31, 2007, IKB held €6.8 billion ($10.2 billion) worth of these
structured finance products on its balance sheet. In comparison, Rhineland owned €12.7 billion ($20
billion) of assets, 95% of which were CDOs and CLOs. And at least €8 billion ($12 billion) of that was
protected by IKB through liquidity puts. Importantly, at the time, German regulators did not require IKB
to hold any capital to offset potential losses from its Rhineland commitments. 1172 IKB’s strategy was
known as “securities arbitrage” because it involved financing higher yielding long-term assets with less
expensive short-term commercial paper.
Even as late as June, 2007, when so many were bailing out of the market, IKB was planning to expand its
off-balance sheet holdings in the structured credit products. The German bank was willing to take those
exposures by taking “long” positions in mortgage-related derivatives. This rare attitude made this
commercial bank quite popular among the investment banks and hedge funds that were desperate to take
the “short” side.
When Goldman’s Fabrice Tourre was looking for buyers on which to unload new CDOs, his eyes lit on
the German bank. In early 2007, Tourre created a synthetic CDO, Abacus 2007-AC1, for which a hedge
fund, Paulson & Co., had intentionally picked low-quality assets, according to an SEC case. A Paulson
1172

As noted, in the US, there was a minimal capital charge for liquidity puts equal to 10% of the base 8%, or 0.8%.
For example, Citigroup would have held $200 million in capital against potential losses on the $25 billion in
liquidity put exposure that it had accumulated on CDOs it had issued.

487

employee said bluntly that IKB and other “long” investors were out-gunned. “[T]he market is not pricing
the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies,
CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’
investors have neither the analytical tools nor the institutional framework to take action before the losses
that one could anticipate based [on] the ‘news’ available everywhere are actually realized.”1173
The Abacus deal alone would lose [$XXX] for IKB.
A number of American investors held Rhineland’s asset-backed commercial paper in mid-2007, including
the Montana Board of Investments, the city of Oakland, California, and the Robbinsdale Area School
District in suburban Minneapolis. On July 20, IKB reassured these investors that the rating agencies’
recently announced downgrades would have only a limited impact on its business. This reassurance was
contradicted [??] days later, when Goldman Sachs, which regularly helped Rhineland raise money in the
commercial paper market, asked IKB for detailed information regarding all of its investments. Assessing
this portfolio, Goldman needed only [??] days to inform IKB that it would not sell any more of
Rhineland’s ABCP to its clients. On Friday, July 27, Deutsche Bank, recognizing that the ABCP markets
would soon abandon Rhineland paper and IKB would have to fund the paper itself, cut its derivative
trading credit lines to IKB. Deutsche also alerted the German bank regulator to IKB’s critical state. With
the regulator’s encouragement, IKB’s largest shareholder, KfW Bankengruppe, snapped into action and
announced on July 30 that it would bail out IKB. A few days later, Rhineland was forced to exercise its
liquidity puts with IKB. This meant that Rhineland’s commercial paper investors were able to get rid of
the paper prior to suffering losses, with KfW instead taking the hit – eventually a 95% expected loss from
the Rhineland liquidity puts.

1173

Securities And Exchange Commission (plaintiff) vs. Goldman Sachs & Co. and Fabrice Tourre (defendants)
Securities Fraud Complaint, Unites States District Court, Southern District of New York,

488

Even though global money market investors escaped the IKB episode unscathed, it alerted anyone who
might still be unaware of the potential problems with subprime mortgage assets. Before long, short-term,
risk-averse investors took losses on their subprime exposures and panic seized the short-term funding
markets, even those that were not exposed to risky mortgages. State Street’s Steve Meier stated in
testimony before the FCIC, “Come August of 2007, there was a recognition, I’d say an acute recognition,
that potentially some of the asset-backed commercial paper conduits could have exposure to those areas.
As a result, investors in general – without even looking into the underlying assets – decided ‘I don’t want
to be in any asset-backed commercial paper, I don’t want to invest in a fund that may have those
positions.’ ” [will add market statistics, and will add additional analysis and reactions by other policy
makers and regulators]
At a press roundtable on August 1, Secretary Paulson had an exchange with a reporter suggesting that
despite the market turmoil he still thought that the subprime crisis would not threaten the broader
economy.
Question: Mr. Secretary, with markets tumbling around the world over the last 24 hours, we’re
obliged to ask for a comment or observation on what may be going on there. You stated clearly
in recent weeks and months that you think the housing market’s near a bottom, that the collapse
of the sub-prime markets is contained. Yet markets continue to fall, companies report their
profits are shrinking because of the effects from the housing market. Have you seen anything
that’s changed your view on what’s going on?
Secretary Paulson: No…When I said the housing market, that there had been a major correction
and the housing market was at or near the bottom, I also have said that I thought this would not
resolve itself any time soon, and that it would take a reasonably good period of time for the subprime issues to move through the economy as mortgages reset. But that as, even though this, and
it is a cause of concern, the impact on individual homeowners, and we care a lot about that, but I

489

said as an economic matter I believe this was largely contained because we have a diverse and
healthy economy…
We talked about the sub-prime. There are some excesses there. We’ve also seen excesses in
terms of other lending behavior. Some of the loans to fund leveraged buy-outs. These loans have
not had traditional covenants. So now the market is focused on this. There’s a wakeup call and
there’s a, as I’ve said, an adjustment to this repricing of risk. But I see the underlying economies
being very healthy.1174

Countrywide: “That’s our 9/11”
On August 2, three days after the IKB rescue, Countrywide Financial Corporation CEO Angelo Mozilo
realized that his company was unable to roll its commercial paper or borrow on the repo market. “When
we talk about [August 2] at Countrywide, that’s our 9/11,” 1175 he said. “We worked seven days a week
trying to figure this thing out and trying to work with the banks. Our repurchase lines were coming due
billions and billions of dollars. We had worked night and day to secure and renew these repurchase lines
which was very critical to us once we realized the commercial paper market was shut down.” 1176
Mozilo emailed Lyle Gramley, a former Fed Governor and a former Countrywide director, “Fear in the
credit markets is now tending towards panic. There is little to 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 into the secondary markets or are subject to egregious discounts.”1177
On August 2, despite the internal turmoil, Countrywide CFO Eric Sieracki told investors that it had
“significant short-term funding liquidity cushions” and “ample liquidity sources of our bank… It is
1174

http://www.treasury.gov/press/releases/hp525.htm

1175

Transcript of Deposition of Angelo Mozilo by the SEC, 11/9/2007 at 150:24.

1176

Transcript of Deposition of Angelo Mozilo by the SEC, 11/9/2007 at 36:4-23.

1177

8/1/07 Mozilo email to Lyle Gramley (cc Michael Perry, IndyMac), BAC-FCIC-E-0000661408-09.

490

important to note that the company has experienced no disruption in financing its ongoing daily
operations, including placement of commercial paper.”1178 Both Moody’s and S&P reaffirmed their
respective A3 and A ratings and their stable outlook on the company. “Countrywide’s improved
diversification, which includes material, annuity-like income streams from banking and insurance
operations, increases its earnings stability,” Moody’s wrote. “Liquidity provided by a growing deposit
base at Countrywide Bank and access to Federal Home Loan Bank advances should help the company
weather current reduced liquidity in the US mortgage market.” 1179
The ratings agencies and the company itself would quickly reverse their positions. On August 6, Mozilo
reported to the board during a specially-convened meeting that “the secondary market for virtually all
classes of mortgage securities (both prime and non-prime) had unexpectedly and with almost no warning
seized up and [the] Company was unable to sell high-quality mortgage-backed securities.”1180 Executive
David Sambol told the board that Countrywide needed to “quickly pursue alternative financing
arrangements for the Company’s loan funding and inventory” given the possibility that the company
could lose all access to the commercial paper market.1181 Sambol said that “management can only plan on
a week by week basis due to the tenuous nature of the situation.”1182 Mozilo reported that although he
continued to negotiate with banks to try and secure alternative sources of liquidity, the “unprecedented
and unanticipated” absence of a secondary market could force the company to draw down on its back-up

1178

Mark DeCambre. “Countrywide Defends Liquidity.” TheStreet.com, 8/2/07. Available at
http://www.thestreet.com/story/10372054/countrywide-defends-liquidity.html.

1179

“Countrywide Financial ratings confirmed on co’s sound performance - Moody’s.” Forbes. 8/3/07, available at
http://www.forbes.com/feeds/afx/2007/08/03/afx3984073.html .

1180

8/6/2007 Minutes of a Special Telephonic Meeting of the Board of Directors of Countrywide Financial
Corporation at BAC-FCIC-0000080557-61 at 57.

1181

8/6/2007 Minutes of a Special Telephonic Meeting of the Board of Directors of Countrywide Financial
Corporation at BAC-FCIC-0000080557-61 at 58.

1182

8/6/2007 Minutes of a Special Telephonic Meeting of the Board of Directors of Countrywide Financial
Corporation at BAC-FCIC-0000080557-61 at 58.

491

credit lines.1183 The same day, the company stated in a public disclosure that it had “highly reliable shortterm funding liquidity” of $46.2 billion.” 1184
Eight days later, on August 14, Countrywide released its July 2007 operational results, reporting that
foreclosures and delinquencies had reached a five-year high and loan production had fallen by 14%
during the preceding month. A company spokesman told the Los Angeles Times that layoffs would be
considered. 1185 Also that day, Federal Reserve staff, who had supervised Countrywide’s holding company
until the bank switched to a thrift charter in March 2007, sent a confidential memo to the Board of
Governors warning about the mortgage lender’s financial condition: “The company is heavily reliant on
an originate-to-distribute model, and, given current market conditions, the firm is unable to securitize or
sell any of its non-conforming mortgages… Countrywide’s short-term funding strategy relied heavily on
commercial paper (CP) and, especially, on ABCP. In current market conditions, the viability of that
strategy is questionable….The company has a considerable volume of mortgage-backed securities on its
books. Those securities are generally not agency-backed, but rather are mostly backed by loans
originated by Countrywide itself. The ability of the company to use those securities as collateral in [repo
transactions] is consequently uncertain in the current market environment. The company may thus find it
very difficult to obtain funding on normal terms and may not have time to make changes to its operations.
As a result, it could face severe liquidity pressures. Those liquidity pressures conceivably could lead
eventually to possible insolvency.” 1186

1183

8/6/2007 Minutes of a Special Telephonic Meeting of the Board of Directors of Countrywide Financial
Corporation at BAC-FCIC-0000080557-61 at 59.

1184

8/6/07 Countrywide Form 8-K, Exhibit 99.1.

1185

8/14/07 Countrywide Press Release. See also E. Scott Reckard. “Lender reports risking defaults: Countrywide
home foreclosures and delinquencies surge to five-year highs in July. Mortgage stocks tumble.”

1186

8/14/07 Federal Reserve Memo re Background on Countrywide Financial Corporation. FCIC-149538-63 at 14.

492

According to the memo, Countrywide told its regulator, the Office of Thrift Supervision, that it needed
assistance from the government because the liquidity pressures facing the company “conceivably could
lead eventually to possible insolvency.”
“Conceivably…eventually…possible insolvency….” The words capture the tenor of the times.
Countrywide asked the OTS if the Federal Reserve could provide assistance through regulatory relief,
perhaps by waiving a Fed rule and allowing Countrywide’s thrift subsidiary to support its holding
company, perhaps through discount-window lending, which would require the Fed to accept risky
mortgage-backed securities as collateral, something it never had done and would not do–until the
following spring. The Fed’s staff recommended that it not intervene in Countrywide’s problem:
“Substantial statutory requirements would have to be met before the Board could authorize lending to the
holding company or mortgage subsidiary; … the Federal Reserve had not lent to a nonbank in many
decades; and … such lending in the current circumstances seemed highly improbable.” 1187
The Fed decided not to act. The following day, with no available sources of funding on the horizon,
Countrywide gave notice to its lenders that the company intended to draw down $11.5 billion on back-up
lines of credit. Mozilo and his team knew that their decision could lead to ratings downgrades. In the
press release announcing the decision, Countrywide reported that it had “materially tightened its
underwriting standards” and would reduce the company’s reliance on credit markets.1188
That same day, Merrill Lynch analyst Kenneth Bruce issued a report changing his view from only two
days earlier, when he had reaffirmed a “buy” rating. Bruce now issued a “sell” rating with a “negative”
outlook, noting that Merrill Lynch’s “view has changed, materially” because of the pressures
Countrywide faced in financing its mortgage-backed securities in both the asset-backed commercial paper
and repo markets. “We cannot understate the importance of liquidity for a specialty finance company like

1187

8/14/07 Federal Reserve Memo re Background on Countrywide Financial Corporation. FCIC-149538-63 at 14.

1188

Countrywide Press Announcement, August 16, 2007, “Countrywide Supplements Funding Liquidity Position.”

493

CFC,” he wrote, referring to Countrywide’s stock ticker. “If enough financial pressure is placed on CFC,
or if the market loses confidence in its ability to function properly, then the model can break, leading to
an effective insolvency… If liquidations occur in a weak market, then it is possible for CFC to go
bankrupt.”1189
Bruce wrote that this had been a “gut-wrenching call.” Moody’s downgraded the company’s senior
unsecured debt ratings to the lowest tier of investment grade. 1190 Countrywide shares fell 11%, closing at
$18.95. For the year, CFC stock was down 60%. With all of the bad news, an old-fashioned bank run
ensued. Depositors crowded its southern California bank branches. The Los Angeles Times reported, “A
flood of spooked customers seeking to withdraw their certificates of deposit and money-market accounts
overwhelmed the small staff…The Countrywide employees were forced to resort to taking down names
and asking people to wait it out or come back later.”1191
Six days later, after the markets closed, Bank of America announced a $2 billion equity investment for a
16% stake in the Countrywide.1192 The investment represented a vote of confidence in Countrywide, and
immediately fueled rumors that the nation’s biggest bank would acquire the mortgage lender. In public,
both companies denied the rumors, and Mozilo stressed that his company was well-positioned for the
future. He told the press that “there was never a question about our survival,” and that Bank of America’s
investment was “win-win.” He boasted that the investment reinforced the fact that Countrywide was one
of the “strongest and best-run companies in the country.”1193

1189

Bruce, Kenneth. “Liquidity is the Achilles heel.” Merrill Lynch Analyst Report. 8/15/07, pg 4

1190

Moody’s Investors Service, August 16, 2007, “Moody’s lowers Countrywide debt to Baa3.”

1191

E. Scott Reckart. “The Mortgage Meltdown: A rush to pull out cash; Unsure about the future of home-loan giant
Countrywide, bank customers line up to withdraw money.” Los Angeles Times. 8/07/07
1192

“Bank of America Takes Countrywide Stake.” The Associated Press. 8/22/07.

1193

8/23/2007 CNBC Video of Maria Bartiromo interview with Angelo Mozilo, available online at
http://www.cnbc.com/id/15840232?video=481763309&play=1 (last retrieved 9/22/2010).

494

In October, Countrywide reported a $2 billion pretax loss, its first quarterly loss in 25 years. Confronting
increased future default estimates and rising net-charge offs, Countrywide raised provisions for loan
losses from the $38 million allocated in the third quarter of 2006 to $934 million one year later.1194 The
year closed with the company’s first annual net loss in over three decades. On January 11, 2008, Bank of
America announced a definitive agreement to purchase Countrywide for approximately $4 billion.1195
Bank of America said in a press release that the newly combined entity would stop originating subprime
loans and would expand programs to help distressed borrowers.

BNP Paribas: “The ringing of the bell”
Meanwhile, the emerging problems in the U.S. markets hit the largest French bank. On August 9, BNP
Paribas SA suspended redemptions from three investment funds that had plunged 20% in less than two
weeks. Total assets in those funds were $2.2 billion, with a third of that amount in subprime securities
rated AA or higher. The bank also said it would also stop calculating a fair market value for the funds
because “the complete evaporation of liquidity in certain market segments of the U.S. securitization
market has made it impossible to value certain assets fairly regardless of their quality or credit rating.” 1196
In retrospect, many investors regarded the suspension of these three French funds as the true beginning of
the unprecedented liquidity crisis in the money markets. Paul McCulley of Pimco told the FCIC that
August 9 “was the ringing of the bell” for short-term funding markets. “It was very obvious in the
summer of 2007 that a run on the asset-backed commercial paper was underway,” he said. “The buyers
went on a buyer strike and simply weren’t rolling.” That is, they stopped rolling over their commercial
paper and demanded payment of the amount due. On that one day, the spreads for overnight lending of A-

1194

Countrywide, October 26, 2007, PRNewswire-FirstCall, earnings release, pg 3

1195

Bank of America website. www.bankofamerica.com, Press Releases. 01/11/08.

1196

Cite to public BNP Paribas statement

495

1 rated asset-backed commercial paper rose 20 basis points, from 5.36% to 5.56%, the highest level since
March 2001. 1197

Throughout that summer, investors increasingly shunned ABCP securities. In August alone, that market
shrank by $190 billion, or 20 percent, and it would shrink by another $120 billion through year’s end.
ABCP programs that typically had just one issuer – “single-seller” programs – were deemed the most
unsuitable of all and fell over the summer from $35 billion to $4.25 billion. 1198 And the ABCP that did
sell had significantly shorter maturities, reflecting creditors’ desire to reassess their counterparties’
creditworthiness as frequently as possible. The percentage of ABCPs issued for 1-4 day maturities rose
from 60% of all asset-backed commercial paper at the beginning of August to 75% at the end of the
month. 1199 Just about the only positive news was the relative confidence in the general financial sector.
The market for commercial paper issued by banks and other financial institutions did momentarily shrink
in August by 5.5% but rose to record levels by the end of the year. [This phenomenon will be explained
through interviews.]
Given the ubiquity of commercial paper as both a funding source and an investment opportunity,
disruptions in this market quickly spilled over to other parts of the money market. In a flight to quality,
cautious investors dumped their securities and increased their holdings in the apparently safer money
1197

Mark Pittman, “Commercial Paper Yields Soar to Highest Since 2001,” August 9, 2007, available at
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=amnaMTq9t2xY (accessed August 13, 2010).
1198

Covitz, Liang, and Suarez (2009).

1199

Confirm numbers

496

market mutual funds and the refuge of last resort, U.S. Treasuries. Domestic money market funds reached
a record high of $2.66 trillion in assets and Treasuries rallied. 1200 Many market participants were
struggling to understand the extent of their own liquidity supports–and banks therefore became less
willing to lend to each other. The TED spread, the difference in the three-month London Interbank
Offered Rate (LIBOR) and the rate on three-month U.S. Treasury bills, rose. LIBOR is a measure of the
rate that banks are willing to lend to each other and therefore reflects a degree of credit risk. In contrast,
U.S. Treasury bills are considered risk-free. Therefore the spread, or difference, between the two rates is
a measure of the perceived uncertainty and credit risk when lending to other banks. Beginning on that
pivotal day, August 9, the spreads began to rise from their historical range of 20 to 60 basis points and
peaked at 240 basis points later in August; in 2008, they would peak much higher.

Federal Reserve: “Prepared to act as needed”
The panic in the commercial paper and interbank markets was met by government action. The day after
BNP Paribas’s August 9 suspension of redemptions, the Federal Reserve announced that it would
“provid[e] liquidity as necessary to facilitate the orderly functioning of financial markets.” 1201 The
European Central Bank infused €95 billion into the overnight lending markets.1202 On August 17, the Fed
cut the discount rate by 50 basis points–from 6.25 percent to 5.25 percent. This would be the first of many
1200

Insert reference to ICI data – August 2007 MMMF flows and assets; Cite (Treasuries statement)

1201

“FOMC Statement: The Federal Reserve is providing liquidity to facilitate the orderly functioning of financial
markets,” Federal Reserve press release, August 10, 2007, available at
http://www.federalreserve.gov/newsevents/press/monetary/20070810a.htm (accessed August 20, 2010).

1202

Cite

497

such cuts aimed at increasing liquidity in the market. The Fed also extended the term of discount window
lending to 30 days (from the usual overnight or very short-term) in an effort to offer banking institutions a
more stable source of funds. 1203 On the same day, the Fed’s Federal Open Market Committee released a
statement acknowledging the continued deterioration of the financial markets and promising that the
FOMC “is prepared to act as needed to mitigate the adverse effects on the economy arising from the
disruptions in financial markets.” 1204

SIVs: “An oasis of calm” disturbed
In late August, the turmoil in asset-backed commercial paper markets spread into a corner where
subprime exposures were not dominant – the market for structured investment vehicles, or SIVs.
Compared to some of the other complicated short-term financing schemes, SIVs had a reasonably long
operating history in some tough times. In a report issued on August 15, 2007, S&P noted: “These
investment vehicles have weathered the difficult credit conditions of 1990-1991, the Long-Term Capital
Management collapse, and the Sept. 11, 2001 terrorist attacks. SIVs responded to each event by
diversifying into multiple funding markets, such as Europe and the U.S., and by having access to the best
available liquidity sources, including banks and easily traded assets.” 1205
Moody’s had come to the same conclusion on July 20, noting that SIVs had been “an oasis of calm in the
storm.”
Unlike other asset-backed commercial paper programs, SIVs were primarily funded through mediumterm notes–bonds maturing in one to five years. Short-term commercial paper therefore accounted for
only about one-quarter of their funding. This feature, combined with a requirement SIVs hold significant
1203

“Federal Reserve Board discount rate action,” Federal Reserve press release, August 17, 2007, available at
http://www.federalreserve.gov/newsevents/press/monetary/20070817a.htm (accessed August 20, 2010).

1204

“FOMC statement,” Federal Reserve press release, August 17, 2007, available at
http://www.federalreserve.gov/newsevents/press/monetary/20070817b.htm (accessed August 20, 2010).

1205

S&P, Structured Investment Vehicle Ratings Are Weathering the Current Market Disruptions, 8/15/07.

498

amounts of highly liquid assets, allowed them to operate without much liquidity support from the banks.
And assets had to be “marked to market” daily or weekly, which investors believed would give managers
the needed information to adjust to market changes.
Not all SIVs were alike. Some, like the ones sponsored by Citigroup (which had introduced the first SIVs
in 1988), mostly invested in relatively safe assets like bank debt, while others focused on mortgagebacked securities and CDOs. Many had the advantage of being sponsored by banks, which were more
likely to bail out a failing SIV to maintain relationships with frequent clients who had invested in this
debt.
By 2007, a total of 34 SIVs had $400 billion in assets. Only about a quarter of that sum – about $100
billion – was invested in mortgage-backed securities or CDOs. Still, in 2007, even high-quality assets that
had nothing to do with the mortgage market were declining in market value [will provide numbers and
detail]. The strict mark-to-market requirements forced each SIV to recognize those losses in real time,
pushing them closer to operational limits that would force restructuring and possibly liquidation. [will
improve this explanation and provide details] Managers labored to avoid the need to sell assets at market
prices that they hoped were only temporarily depressed. On September 5, Moody’s stated, “…the blow to
confidence in the global financial system means that what was once liquid is now illiquid, and good
collateral cannot be sold or financed at anything approaching its true value.”
Ultimately, even SIVs, a formerly reliable class of structures that selected high quality assets, were caught
up in the emerging contagion. [substantially more detail to be added to this paragraph] Not surprisingly,
the first to fail, like Cheyne, had concentrations in subprime and ABS CDOs. Soon to follow were others
not sponsored by banks, because investors believed they were the least likely to be saved. After that,
sector-wide ABCP runs and depressed market values destroyed the safer SIVs. Sponsors restructured and
rescued some of these prior to default. Others did default, with severe losses. In some cases, investors
had to wait a year to receive payment and ultimately recouped only a portion of their investment. As of

499

fall 2010, not a single SIV remained in operation. The subprime imbroglio had brought to its knees a
historically resilient market in which the specific vehicles had incurred very modest and localized losses
due to subprime defaults, if any at all. Panic was spreading.

Money funds and other investors: “TK”
The next dominos in line were the money-market funds, most of them sponsored by investment banks,
bank holding companies, or “mutual fund complexes” such as Fidelity, Vanguard, and Federated. While
money-market funds are not insured by the federal government, but investors tend to overlook this fact
and treat them as the equivalent of safe bank deposits. They expect that their principal investment will
maintain its value while generating a competitive return. Under SEC regulations, funds that serve retail
investors are required to keep two sets of accounting books, one reflecting book value, meaning xx, and
the other the mark-to-market value (the “shadow price,” in money-market parlance). However, they do
not have to disclose the shadow price unless that value has fallen by 0.5% below $1 per share. In other
words, there is a very small cushion for price movements before the net asset value of one of these funds
with a $1 “NAV” has fallen below $0.995 per share. When a fund does report a market value of less than
$0.995 per share, that event is known as “breaking the buck.” For a money-market fund manager,
breaking the buck generally means the collapse of the fund.
The 0.5% loss threshold is so low that the default of even one security in a fund’s portfolio can have
profound consequences. For example, if just 5% of the portfolio is in an investment that loses just 10% of
its value, the mark-to-market valuation for that money-market mutual fund may break the buck. Thus, a
fund manager cannot afford to take big risks with the fund’s investments—but SIVs were considered very
safe investments, because they always had been—so they were widely held by the money funds. In the
fall, investors became concerned and looked through their funds’ portfolios for any sign of SIV
commercial paper. They found it. Some SIVs with falling values were bailed out by their sponsors, but
others were not. Therefore dozens of money market funds faced losses on their SIV investments (and
other asset-backed commercial paper as well, of course). The sponsors of these money market funds
500

stepped in to prevent those losses from causing the funds to “break the buck.” At least 44 sponsors,
including Bank of America, US Bancorp, and SunTrust, purchased the SIV assets from their money
market funds.1206 Propping up a fund does not violate SEC rules,1207and this [$XX] billion of combined
support was a welcome backstop for the money-market fund business and its retail investors.
Columbia Fund folds after a $20 billion withdrawal
Similar dramas played out in the less-regulated sector of the money market known as enhanced cash
funds, and some of these funds did actually break the buck. These funds focus not on retail investors but
on a limited number of institutions and sophisticated, wealthy investors who can put up at least $25
million. Enhanced cash funds are structured under the hedge fund exemptions in the securities laws and
fall outside most SEC regulations and disclosure requirements. Because these funds have much higher
investment thresholds than retail money market funds, and because these enhanced funds do not have to

1206

The SEC indicated it is aware of at least 44 money market funds that were supported by affiliates because of
SIV investments. SEC Proposed Money Fund Rule, footnote #38; On November 13, 2007, Bank of America
committed to provide as much as $600 million to its money market funds holding asset-backed commercial paper.
Other fund advisers, including Legg Mason, US Bancorp, SEI, and SunTrust also committed in November and
December 2007 to support their money market funds to ensure that investors did not lose money if their funds fell
below a $1 net asset value. In order to prevent two money market funds from breaking the buck, Sun Trust
purchased $1.4 billion in securities issued by SIVs from their STI Classic Prime Quality Money Market Fund and
the STI Classic Institutional Cash Management Money Market Fund. The company expected to recognize a loss as
a result of these asset purchases of between $225 and $250 million. In November 2007, U.S. Bancorp represented it
would commit capital to its First American Prime Obligations Fund in the event that securities issued by the Cheyne
SIV held by the fund resulted in a loss.

1207

While SEC rules normally prohibit a fund from selling securities to an affiliate, even if the purpose is to provide
liquidity to the fund or prevent it from breaking the buck, there is an exception provided in SEC Rule 17a-9 for cash
purchases of certain distressed money market fund assets by an affiliate at a price “equal to the greater of the
amortized cost of the security or its market price (in each case, including accrued interest).” Funds that secured
support from an affiliate through a transaction authorized by Rule 17a-9 did not require SEC approval, or a noaction letter. For some non-2a-7 funds, such as bank common and collective investment funds, other rules apply
that limit the ability of a bank to purchase assets out of a bank-run fund. 12 CFR 9.18(b)(8) – self-dealing and
conflicts of interest limitations. A bank is authorized to purchase a defaulted investment held by a fund “if, in the
judgment of the bank, the cost of segregating the investment is excessive in light of the market value of the
investment. If a bank elects to purchase a defaulted investment, it shall do so at the greater of market value or the
sum of cost and accrued unpaid interest.” 12 CFR 9.18(b)(8)(iii).

501

comply with the disclosures and other requirements associated with the retail funds, investors expect
somewhat riskier investing and higher returns for their money. Nonetheless, enhanced funds also operate
with an overall objective of maintaining a $1 market value and never breaking the buck. For these funds,
too, SIVs had therefore been deemed a good investment. But, as it turned out, for these funds, too, they
were not. Just as the precipitous decline of the SIVs prompted the sponsors of retail money-market funds
to prop them up, so too the sponsors of some of the high-powered enhanced cash funds stepped in to
rescue them for the benefit of their well-heeled investors.
The largest enhanced cash fund in the country was Strategic Cash Portfolio, run by Bank of America
Corporation’s Columbia Management subsidiary and boasting $40 billion in assets at its peak. Despite its
size, however, the fund had just a few investors. Amid all the concern about subprime-related securities,
in November 2007, one of them withdrew $20 billion.1208 Reportedly, that investor was the Government
of Kuwait. [cite] In order to stem a precipitous run on Strategic Cash, the managers temporarily halted all
redemptions. Subsequently, Bank of America’s holding company used its own cash to support the fund’s
$1 market value. In addition, the bank offered different deals to different investors who wanted to exit the
fund but couldn’t because redemptions had been halted. For example, some investors were ”invited” to
cash out at about $0.994 per share, which kept the fund from technically breaking the buck.
Other enhanced cash funds did not obtain sponsor support and were forced to liquidate at prices below
their $1.00 target price. During a three-week period in August 2007, State Street’s Global Advisers’ $1.4
billion Limited Duration Fund lost 37% of its value, thanks to its concentrated investment in subprime
mortgage-backed securities and derivatives, and to investor redemptions. Other funds that had been
advised by State Street and investors in the Limited Duration Fund began to redeem shares. In order to
accommodate these redemptions, the fund redeemed its most liquid holdings, further concentrating the
fund in illiquid, mortgage -related securities.

1208

It has never been publicly disclosed who the investor was.

502

The SEC and the State of Massachusetts ultimately sued State Street, alleging misrepresentations about
risks associated with what was touted as a conservative money market fund, particularly its concentration
in subprime investments. State Street settled the cases in February 2010 with terms of xx and xx.
Another short-term enhanced cash fund that ran aground with its mortgage-related investments in late
2007 was the $5 billion GE Asset Management Trust Enhanced Cash Trust. In June of that year, the GEsponsored fund had 50% of its assets in residential mortgage securities, with additional holdings in creditcard securities and corporate bonds. Most of the investors were GE’s own pension and employee benefit
assets, but the fund also had outside investors. All lost money. When the fund closed in November 2007
after reportedly losing $200 million, investors redeemed their interests at $0.96, meaning that it broke the
buck.
The State of Florida fund experiences a run on its $27 billion fund
The losses on SIVs and other investments that held mortgage-related securities also dealt a severe blow to
“local-government investment pools” across the country, some of which had billions of dollars invested in
these securities. LGIPs, like the enhanced cash funds that appeal to wealthy investors, are typically not
limited in the riskiness of their assets, but like money-market and even enhanced cash funds, they do seek
to maintain at least a $1 market value. This enables their participants to withdraw their funds on short
notice without losses. This pooling mechanism provides local municipalities, school districts, and other
government agencies with economies of scale, investment diversification, and liquidity that the smaller
entities would be unlikely to achieve on their own. In some jurisdictions and for certain government
entities, participation in the pertinent pool is mandatory; in others it is optional.
At the beginning of the liquidity crisis, 100 LGIPs in 45 states held combined assets of over $250 billion
[need to confirm date and $ amt]. With $27 billion in assets, Florida’s was the largest in xx, 200xx. (It
was also just one of 35 pools managed by states to help local governments manage surplus funds.) As
stated in an investigation by the Florida Legislature, “The pool [was] intended to operate like a highly
503

liquid, low-risk money market fund, with securities like cash, certificates of deposit, cash, U.S. Treasury
bills, and bonds issued by other U.S. government agencies comprising the fund.” 1209
That wasn’t the way the fund was actually run. In the summer of 2007, Tracs Financial reported that the
Florida LGIP was among the highest yielding LGIPs in the country, both on a daily and monthly
basis.1210The return was [XX%]. In order to achieve this distinction, Florida’s managers were investing in
instruments yielding as much as 6.7% in a rate environment in which typical money ma rket investments
were yielding about 5%.1211 By November, the Florida LGIP had invested at least $1.5 billion in securities
that no longer met the state’s top credit rating requirement of xx, due to the rating agency downgrades. It
had more than $2 billion in SIVs and other distressed securities, of which about $725 million had already
defaulted. Further exacerbating its problem, the Florida LGIP had also bought $650 million in
Countrywide certificates of deposit with maturities that stretched out as far as June 2008.
In early November, following a series of articles in Bloomberg and other news services about Florida’s
LGIP, the fund suffered a run by concerned constituent agencies wanting out. Within two weeks, they had
withdrawn $8 billion.121239 Orange and Pinellas Counties pulled out their entire investments. On
November 29, the fund’s managers stopped all withdrawals. This prohibition lasted only [??how long].
Florida had assumed that SIVs would remain as stable as they had always been. It was the hardest hit of
all the LGIPs, but other state pools also took losses from their SIVs, as well as other mortgage- and
subprime-tainted holdings. In that Tracs Financial report on the LGIPs in the summer of 2007, the highest
yielding fund was Connecticut’s at 5.43%. It turned out that 10% of that pool was invested in CDO

1209

The Florida Legislature, Office of Program Policy Analysis and Government Accountability, Research
Memorandum, “The SBA [State Board of Administration] is Correcting Problems Relating to its Oversight of the
Local Government Investment Pool” (March 31, 2009) (“OPPGA Report”), pg. 2.
1210

Bloomberg, Public School Funds Hit by SIV Debts Hidden in Investment Pools (November 15, 2007).

1211

NEED CITE – typical yield in August 2007 for MMF investments.

1212

Florida School Fund Rocked by $8 Billion Pullout (November 28, 2007).

504

commercial paper backed by subprime mortgages.1213 Two percent was invested in the Cheyne Finance
SIV, which was the first SIV whose rating was downgraded, on August 29. When Cheyne failed on
October 17, the Connecticut LGIP lost about $xx.
All told, an estimated xx state agencies and municipalities lost money through investments in SIVs. For
those state agencies and municipalities that relied upon these funds maintaining a $1 NAV and returning
principal with some interest, these losses were substantial.

4822-2501-1207, v. 1

1213

Bloomberg, Public School Funds article (November 15, 2007).

505

CHAPTER CONCLUSIONS HERE

506

Part III, Chapter 3: Fall and Winter 2007: Financial firms report billions in subprime
losses

III. THE FINANCIAL CRISIS

Error! Bookmark not defined.

3. Fall and Winter 2007: Financial firms report billions in subprime losses

507

Merrill Lynch: “Dawning awareness over the course of the summer” Error! Bookmark not defined.
Citigroup: “That would not in any way have excited my attention”

Error! Bookmark not defined.

AIG and Goldman: “A gesture of goodwill” 516
Federal Reserve: “The discount window wasn’t working”
Monoline insurers: “We never expected losses”

556

561

Auction Rate Securities: “ ” 566

Overview
While a handful of banks were bailing out their money market funds and commercial paper
programs in the fall of 2007, the financial sector as a whole faced a much larger problem: the
billions of dollars in mortgage-related write-downs on loans, securities, and derivatives, with no
end in sight. By the end of the year, Citigroup had written down $41 billion in mortgage-related
assets; Merrill Lynch, $24.7 billion; Bank of America, $15 billion; Morgan Stanley, $12.6
billion; JPMorgan, $9.7 billion; and Bear Stearns, $2.3 billion.1214[Add Wachovia and WaMu.]

1214

Wachovia/Wamu

507

Insurance companies, hedge funds and other financial institutions collectively had taken
additional mortgage-related losses of approximately $100 billion.1215 [Need to check]
The large writedowns strained the banks’ capital and cash reserves. Further, market participants
remained concerned about where the e coli – to use Chairman Bernanke’s term – might still be
hiding, and they began discriminating between firms 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; the cost of protection against default on their obligations stood at $176,000 and
$119,000 for every $10 million, respectively, while the cost for the relatively stronger Goldman
Sachs stood at $68,000.1216 [Need to confirm these numbers.]

Merrill Lynch: “Dawning awareness over the course of the summer”
On October 24, Merrill Lynch stunned investors when it announced that third quarter earnings
would include a $6.9 billion loss on CDOs and $1 billion on subprime mortgages--$7.9 billion
total, the largest write-down in Wall Street history to that point, and nearly twice the $4.5 billion
loss that the company had warned investors to expect just three weeks earlier.1217 Six days later,
embattled CEO Stanley O’Neal, a 21-year Merrill veteran, resigned under pressure.1218
Much of this write-down came from the firm’s significant holdings of the super-senior tranches
of mortgage related CDOs that Merrill had previously thought to be extremely safe. Marketwide,
1215
1216

Figures refer to credit default swaps on five-year senior debt.

1217

3Q07 Earnings Press Release,
http://sec.gov/Archives/edgar/data/65100/000115752307010139/a5526482ex99_1.txt. 3Q07 Earnings Call
transcript. Available: https://vault.netvoyage.com/neWeb2/goId.aspx?id=4834-6259-7126&open=Y. (ok)

1218

http://sec.gov/Archives/edgar/data/65100/000095012307014495/y41570exv99w1.htm (ok)

508

a total of $387.90 billion in CDOs had been created in 2006 and $281.25 billion in 2007.1219
Merrill had accounted for $55.3 billion and $35.89 billion, respectively.1220,1221 As late as fall,
2006, its management had been “bullish on growth” and “bullish on [the subprime] asset
class.”1222 In September 2006, Merrill had even acquired subprime loan originator First Franklin
for $1.3 billion--a move that puzzled analysts who saw the subprime and Alt-A markets souring
in a hurry. 1223 By late that year, the signs of trouble were becoming difficult for even for Merrill
to ignore. Two mortgage originators to whom the firm had extended credit lines – Mortgage
Lenders Network and Ownit, in which Merrill also had a small equity stake – failed, leaving the
bank with no choice but to seize the collateral backing those loans--$1.5 billion from Mortgage
Lenders, $1.2 billion from Ownit.1224
After sensing that the mortgage market was turning, Merrill, like many others in the market,
started packaging its existing inventory of mortgage loans and securities into CDOs for sale with
new vigor. Their goal was to reduce their risk by getting those loans and securities off their
balance sheet. Yet, Merrill found that it could not sell the super senior tranches of those CDOs at

1219

“Pioneer Helped Merrill Move Into CDOs,” Serena Ng and Carrick Mollenkamp, Wall Street Journal, October 25, 2007.

1220

“Pioneer Helped Merrill Move Into CDOs,” Serena Ng and Carrick Mollenkamp, Wall Street Journal, October 25, 2007.

1221

10/21/07 Presentation to the ML Board of Directors – Leveraged Finance and Mortgage/CDO Review; BAC-ML-CDO-000077035-073 at

073.
1222

10/21/07 Presentation to Merrill Lynch & Co. Board of Directors – Leveraged Finance and Mortgage/CDO Review; BAC-ML-CD)000077035-89, at 061.

1223
1224

2/2/07 SEC OPSRA memo, SEC_TM_FCIC_002447-451.

509

acceptable prices and that it had to “take down senior tranches into inventory in order to execute
deals” 1225 – leading to the accumulation of tens of billions of dollars of those tranches on
Merrill’s books. Dow Kim, then the co-president of Merrill’s investment banking segment, told
FCIC staff that the buildup of the retained super-senior tranches in the CDO positions was
actually part of a strategy begun in late 2006 to reduce the firm’s current inventory of subprime
and Alt-A mortgages. Sell the lower-rated CDO tranches, retain the super-senior tranches: those
had been his instructions to his managers at the end 2006, Kim told the FCIC. He argued that this
strategy would reduce overall credit risk. After all, the super-senior tranches were theoretically
the safest pieces of those investments. 1226 To some degree, however, the strategy was
involuntary: his people were having trouble selling these investments, and some they even sold
at a loss. 1227 (As previously explained, because the super-seniors were theoretically the safest of
the tranches, they offered a lower return—too low for many investors, all things considered.)
Initially, the strategy seemed to work. By May, the amount of mortgage loans and securities to
be packaged into CDOs had declined to $3.5 billion from $12.8 billion in March. According to a
September 2007 internal Merrill presentation, net retained super senior CDO tranches had
increased from $9.3 billion in September 2006 to $25.4 billion by March 2007 and to $28.9
billion by May.1228 But, as the mortgage market came under increasing pressure and as market
value of even super senior tranches crumpled, the strategy would come back to haunt the firm.

1225

10/21/07 Presentation to Merrill Lynch & Co. Board of Directors – Leveraged Finance and Mortgage/CDO
Review; BAC-ML-CD)-000077035-89, at 061.

1226

Kim MFR at 8.

1227

10/21/07 Presentation, BAC-ML-CDO-000077073-77085, at 77061.

1228

510

Merrill’s first-quarter results for 2007— net revenues of $9.9 billion—were its second-highest
quarterly net revenue ever, including a record for the Fixed Income, Currencies and
Commodities business, which housed the retained CDO positions. 1229 In that quarter’s
conference call with analysts, then-CFO Jeffrey Edwards indicated that Merrill’s results would
not be adversely affected by the dislocation in the subprime market because “revenues from
subprime mortgage-related activities comprise[d] less than 1% of our net revenues” over the last
five quarters, and because Merrill’s “risk management capabilities are better than ever, and
crucial to our success in navigating turbulent markets.” He provided further assurances, stating,
“[W]e believe the issues in this narrow slice of the market remain contained and have not
negatively impacted other sectors.” 1230
However, neither Edwards nor anyone else representing Merrill on that call disclosed the large
increase in retained super senior CDO tranches or one of the reasons for it: the difficulty of
selling those tranches, even at a loss—this in the face of specific questions about the subject.
In July, Merrill followed its strong first-quarter report with another for the second quarter that
included “very strong net revenues, net earnings and earnings per diluted share for the second
quarter of 2007, which enabled the company to achieve record net revenues, net earnings and net
earnings per diluted share for the first half of 2007.” During this conference call, UBS analyst
Glenn Schorr listened to Edwards’s prepared remarks, and then asked the CFO to provide some
“color around myth versus reality” on Merrill’s exposure to retained ABS CDO positions.1231 As
1229

4/19/07 Merrill Press Release at 1.

1230

4/19/07 confernce call transcript at 3.

1231

7/17/2007 Merrill Earnings Call Transcript.

511

he had three months earlier, Edwards stressed Merrill’s risk management and the fact that the
CDO business was a small part of Merrill’s overall business. He said that there had been
significant reductions in Merrill’s retained exposures to lower-rated segments of the market,
although he failed to indicate that the total amount of Merrill’s retained CDOs had reached
$30.4 billion by June.
Deutsche Bank analyst Mike Mayo asked Edwards to disclose the level of assets related to
subprime mortgages CDOs, and any inventory of mortgage-backed securities to be packaged into
CDOs—that is, how much of the firm’s capital was at risk from these assets?
Analyst Mike Mayo could not get an answer. Edwards responded, “[W]e don’t disclose our
capital allocations against any specific or even broader group.” 1232
On July 22, after many months of accumulating the super-senior tranches, Merrill’s board would
first be officially informed about the buildup. At a presentation to the Merrill Board’s Finance
Committee Dale Lattanzio, co-head of the American branch of the Fixed Income, Currency, and
Commodities business, reported a “net” exposure of $32 billion in CDO-related assets,
essentially all of them rated AAA, with exposure to the lower-rated asset class significantly
reduced.1233 This “net” exposure was the amount of retained CDO positions after subtracting the
amount of hedges - guarantees in one form or another - that Merrill purchased to pass along its
ultimate risk to third parties willing to provide that insurance and take that risk for a fee. AIG
and the small club of monoline insurers were the main suppliers of these guarantees, commonly

1232

7/17/2007 Merrill Earnings Call Transcript.

1233

BAC-FCIC-0000078547-579, at 553-554. (can’t find)

512

done as credit default swaps. In July 2007, Merrill had begun to increase the amount of credit
default swap protection to offset the retained CDO positions. Its hedges to protect against
possible losses on the retained CDOs and other assets totaled $95.9 billion by the fall of 2007.1234
Lattanzio told the committee, “[Management] decided in the beginning of this year to
significantly reduce exposure to lower-rated assets in the sub-prime asset class and instead
migrate exposure to senior and super senior tranches.”1235 Edwards did not see any problems
here. As Dow Kim explained to FCIC investigators, “Everyone at the firm and most people in
the industry felt that super-senior was super safe.”1236
Deposed CEO Stanley O’Neal told FCIC investigators he had not known that the company was
retaining the super-senior tranches of the CDOs until Lattanzio’s presentation to the Merrill
Board’s Finance Committee in July of 2007.1237 He was surprised, if only because he had been
under the impression that Merrill’s mortgage-backed-assets business had been driven by the
demand: he had assumed that if there were no new customers, there would be no new offerings.
If customers demanded the CDOs, why would Merrill have to retain CDO tranches on the
balance sheet?1238 O’Neal was surprised about the retained positions but stated that the
presentation, analyses and estimation of potential losses were not sufficient to raise alarm
bells.”1239 Lattanzio’s report indicated that the retained positions had experienced only $73
1234

SEC_TM_FCIC002551.

1235

July 22, 2007 Minutes of the Finance Committee. BAC-FCIC-0000078554. ABS/CDO Update, July 2007.
BAC-ML-CDO-000076862-884

1236

MFR of Dow Kim Interview with FCIC, at 8.

1237

O’Neal MFR at 3-4.

1238

O’Neal MFR at 4. (ID# 4829-1444-3527) (ok)

1239

O’Neal MFR at 4.

513

million in losses so far. 1240 These losses would balloon over the next months as the market value
of the super senior tranches plummeted. Regarding the risk the super senior tranches
represented, O’Neal told the FCIC that after the July presentation, the losses increased over the
next three months. “I had a dawning awareness over the course of the summer and through
September as the size of the losses were being estimated.”1241
On October 21, the Merrill Board of Directors was given a detailed account of how the firm
found itself with what was by that time $15.2 billion in net exposure to the super-senior
tranches—down from a peak in July of $32.2 billion because the firm had increasingly hedged,
written-off, and sold its exposure. On October 24, Merrill announced its third-quarter earnings: a
stunning $7.9 billion mortgage-related write-down for the third quarter, yielding a net loss of
$2.3 billion. Merrill also reported--for the first time--its net $15.2 billion net exposure to retained
CDO positions. Still, in the conference call with analysts, CEO O’Neal and CFO Edwards
refused to disclose the gross exposures, excluding the hedges from the monolines and AIG.
Responding to a request for a precise breakdown of positions sold and hedged in an attempt to
reduce Merrill’s exposure, Edwards replied, “I just don’t want to get into the details behind
that.”1242 Pressed, he added, “[L]et me just say that what we have provided again we think is
extraordinarily high level of disclosure and it should be sufficient.”1243 Deutsche Bank analyst
Mike Mayo tried again, but his request for additional information was rejected. According to the
SEC, by September 2007, Merrill had accumulated $55 billion of “gross” retained CDO

1240

July 2007 Presentation to the Finance Committee. BAC-ML-CDO-000076871.

1241

O’Neal MFR at 7. (ID# 4829-1444-3527) (ok)

1242

October 24, 2007 Merrill Earnings Call Transcript.

1243

October 24, 2007 Merrill Earnings Call Transcript.

514

positions, almost four times the $15.2 billion of “net” CDO positions reported during the October
24 conference call.1244
On October 30, when O’Neal resigned as CEO, he left with a severance package worth $161.5
million. 1245 – on top of the $91.4 million in total compensation he earned in 2006 when his
company was still expanding its mortgage banking operations. Dow Kim, who oversaw the
strategy that left Merrill with billions in losses, had left in May 2007 after being paid $40 million
for his work in 2006.
By late 2007, the viability of the monoline insurers from whom Merrill had purchased almost
$100 billion in hedges had come into question, and the ratings agencies were downgrading them,
as we will see in more detail shortly. The SEC had told Merrill that it would impose a punitive
capital charge on the firm if it purchased additional credit default protection from the monolines.
Recognizing that the monolines might not be good for all the protection purchased, Merrill
would begin to put aside loss allowances as a result.. On January 17, 2008, Merrill took a $2.6
billion charge,1246 the first of a series of write-offs against the guarantees purchased from the
financially troubled monolines, eventually totaling $13 billion. 1247,1248
In the five quarters following the record-setting write-down of $7.9 billion for the third quarter of
2007—Merrill Lynch would report more than $25 billion of additional subprime-related write-

1244

SEC_TM_FCIC_002550.

1245

http://www.bloomberg.com/apps/news?sid=aPxzn5U8zNBo&pid=newsarchive (ok); 10/30/07 Press Release at 1;

March 14, 2008 Proxy at 32-33.
1246
1247

1/17/08 press release at 1.

1248

Writedowns from CDOs, other retained and warehouse, and subprime.

515

downs to add to the $13 billion of losses associated with the hedges with the monolines.1249 John
Thain, the former head of the New York Stock Exchange who took over from Stanley O’Neal as
Merrill CEO, 1250 would last just long enough to finalize the sale of the firm to Bank of America
in January, 2009.

Citigroup: “That would not in any way have excited my attention”
Five days after Stan O’Neal’s October 30 departure from Merrill Lynch, Citigroup announced
that it would be taking an $8 to $11 billion loss on its subprime mortgage related holdings and
that Chuck Prince was resigning as its CEO.1251 O’Neal told the FCIC that he had not learned
about the extent of Merrill’s toxic subprime exposures until July 2007. Similarly, Prince stated
that he was not aware until September 2007 that Citigroup’s total subprime exposure was $55
billion, not less than $13 billion, as the company had represented for months. Nor was he
apparently aware that included within that exposure was $43 billion in liquidity puts and supersenior tranches of CDOs, despite the fact that the firm had written the last of the $25 billion in
puts a year and half ago and had started to shell out billions of dollars because of the puts two
months before. And even after Prince, the Board, and key executives like Robert Rubin,
Chairman of the Executive Committee of the Board, learned of the puts and CDOs, it would be
another eight weeks before the company would publicly announce the full extent of its subprime
exposure and losses.

1249

Writedowns from CDOs, other retained and warehouse, and subprime.

1250

http://sec.gov/Archives/edgar/data/65100/000095012307014495/y41570exv99w1.htm;
http://sec.gov/Archives/edgar/data/65100/000095012307015698/y42801exv99w1.htm (ok)
1251

“Robert E. Rubin to Serve as Chairman of the Board of Citi; Sir Win Bischoff to Serve as Acting Chief
Executive Officer; Charles Prince Elects to Retire from Citi,” Citigroup press release, November 4, 2007, available
at http://www.citigroup.com/citi/press/2007/071104a.htm.

516

Like Merrill, Citigroup had aggressively packaged and sold subprime related CDOs for years,
even as the housing market flagged in late 2006 and the early months of 2007. Like Merrill, the
firm had held on to some super senior tranches of those CDOs assuming that they carried little
risk. In other cases, Citigroup sold those tranches with liquidity puts, which would force them
onto the firm’s balance sheet if market conditions soured. And like Merrill when the mortgage
market began to unravel, Citigroup’s management belatedly learned of the risks and losses that
the firm faced, and even more belatedly shared this news with the public.
Despite the fact that the subprime-related losses had cost him his job, Prince told the FCIC that
even in hindsight it was difficult for him to criticize any of his team’s decisions.1252 He explained,
“If someone had elevated to my level that we were putting on a $2 trillion balance sheet, $40
billion of triple A-rated, zero-risk paper, that would not in any way have excited my attention….
[I]t wouldn’t have been useful for someone to come to me and say, ‘Now, we have got $2 trillion
on the balance sheet of assets. I want to point out to you there is a one in a billion chance that
this $40 billion could go south.’ That would not have been useful information. There is nothing I
can do with that, because there is that level of chance on everything.”1253
Certainly, Citigroup was a large and complex organization. That $2 trillion on the balance sheet
– and $1.3 trillion off-balance sheet – in 2007 was divvied up among 2,000-plus operating
subsidiaries.1254 Prince insisted that Citigroup was not “too big to manage,”1255 but it was also an
1252

Charles O. Prince, former Chairman and CEO of Citigroup, interview with the FCIC, March 17, 2010, pp. 191194, transcript available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4849-5576-9861&open=Y
1253

Charles O. Prince, former Chairman and CEO of Citigroup, interview with the FCIC, March 17, 2010, p. 153,
transcript available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4849-5576-9861&open=Y

1254

Citigroup 2007 10-K, Exhibit 21.01, Citigroup Inc. Principal Subsidiaries as of December 31, 2007, available at
http://www.sec.gov/Archives/edgar/data/831001/000119312508036445/dex2101.htm. Off-balance sheet figure
calculated by FCIC staff.

517

organization in which one unit would decide to reduce risk in the mortgage arena while another
unit increased it, an organization in which senior management would not be notified of $43
billion in concentrated exposure – 2% of the company’s balance sheet – because it was perceived
to be “zero-risk paper.”1256 And, with the firm’s total capital standing at $120 billion at the end
of 2006, it turned out that a $43 billion exposure to assets in a declining market did indeed
matter.
The risks associated with these assets should not have come as a surprise to Citigroup’s
management. The FCIC in its investigation found two occasions in which Citigroup executives
highlighted the risks the company was taking in 2006. First, Citigroup’s Financial Control
Group noted that the liquidity puts had been priced too cheaply considering the risks. In
particular, it noted that the committee that approved the transactions had not considered the risk
that all of the deals could fail to “roll at the same time”, creating a $25 billion cash demand for
Citibank. An undated and unattributed internal document (believed to have been drafted in
2006) also suggested that there was a potential conflict of interest in that the investment bankers
on the CDO desk were paid for generating the deals but were not penalized for any losses. The
memo states, “There is a potential conflict of interest in pricing the liquidity put cheap so that
more CDO equities can be sold and more structuring fee to be generated.”1257 However,
Citigroup’s risk management did not take any action at any point to mitigate the risk it was
1255

Chuck Prince testimony before the Financial Crisis Inquiry Commission, hearing on “Subprime Lending and
Securitization and Government-Sponsored Enterprises (GSEs),” Session 1: Citigroup Senior Management, April 8,
2010, p. 11 of transcript, available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4843-1996-8262&open=Y

1256

Charles O. Prince, former Chairman and CEO of Citigroup, interview with the FCIC, March 17, 2010, p. 153,
transcript available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4849-5576-9861&open=Y. Citigroup’s
2007 10-K indicates that total assets as of December 31, 2007 were $2.188 trillion; $43 billion is 1.97% of the
balance sheet.
1257

CITI 00004244, Citigroup liquidity put discussion.

518

taking in the liquidity puts. Other banks that offered liquidity puts on CDOs, such as Societe
Generale, had protected themselves by buying insurance in the form of credit default swaps from
other counterparties such as AIG Financial Products.
Second, in early 2006, an executive in the securitization unit – which bought mortgages from
other companies and bundled them into mortgage-backed securities for sale to investors – took
note of reports of rising delinquencies in the subprime market. That executive, Susan Mills,
Managing Director of the Mortgage Finance Group, created a surveillance group to track the
quality of individual loans that her unit purchased.1258,1259 By mid-2006, Mills’s group was seeing
deterioration in the quality of loans and an increase in early payment defaults.1260 From 2005 to
2007, Mills recalled before the FCIC, the early payment default rates tripled from 2 percent to 5
or 6 percent.1261 In response, the securitization unit slowed down its purchase of loans, demanded
higher quality mortgages, and conducted more extensive due diligence on the pools of loans that

1258

FCIC interview of Susan Mills, head of Mortgage Finance, February 3, 2010, MFR available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4810-5008-2822&open=Y

1259

Financial Industry Regulatory Authority (FINRA) interview of James Xanthos, March 24, 2009, available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4847-5896-4487&open=Y

1260

FCIC interview of Susan Mills, head of Mortgage Finance, February 3, 2010, MFR available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4810-5008-2822&open=Y; Susan Mills testimony before the
FCIC, hearing on “Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs),” Session
2: Subprime Origination and Securitization, April 7, 2010, p. 213 of transcript, available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4842-8641-3830&open=Y
1261

Susan Mills testimony before the FCIC, hearing on “Subprime Lending and Securitization and GovernmentSponsored Enterprises (GSEs),” Session 2: Subprime Origination and Securitization, April 7, 2010, p. 212 of
transcript, available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4842-8641-3830&open=Y

519

it did purchase.1262 However, neither Mills nor other members of the unit shared any of this
information with other divisions in Citigroup, including the CDO desk.1263
“No dialogue across businesses”
Citigroup’s mortgage-backed securities structuring desk and CDO desk ran different businesses,
but were subject to very similar mortgage-related risks. Unlike the securitization desk that
packaged mortgage-backed securities from whole loans and sold them on the secondary market,
the CDO desk underwrote CDO offerings – that is, the desk designed the CDO, bought the
collateral, which included mortgage-related securities, and then sold commercial paper and other
instruments to investors backed by the mortgage principal and interest payments going to the
CDO. In order to more easily sell commercial paper backed by the most senior tranches of the
CDOs, Citigroup wrote liquidity puts and provided other assurances to prospective buyers that,
if worse-came-to-worst, Citigroup would buy the commercial paper from those investors. When
Citigroup had reached its internal risk limits and could write no more liquidity puts, it had simply
retained the most senior tranches rather than sell them at unfavorable prices.
Late 2006: Citigroup’s securitization unit began exercising more caution in its purchases of
subprime loans. Early 2007: Citigroup’s CDO desk increased its purchases of mortgage
securities because it saw the distressed market as a buying opportunity.1264 Later that year, in a
meeting in November 2007, after Citi had revealed to the public its full exposure to subprime
1262

FCIC interview of Susan Mills, head of Mortgage Finance, February 3, 2010, MFR available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4810-5008-2822&open=Y

1263

FCIC interview of Susan Mills, head of Mortgage Finance, February 3, 2010, MFR available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4810-5008-2822&open=Y

1264

FCIC interview of Murray Barnes, former Managing Director of Independent Risk, March 2, 2010, MFR
available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4829-6661-6325&open=Y

520

mortgages, several of Citigroup’s supervisors, including the Federal Reserve, the OCC, and the
SEC, would meet with representatives of the firm’s senior management, including Chief Risk
Officer David Bushnell and Chairman of the Executive Committee Robert Rubin.1265 The
supervisors observed: “[E]ffective communication across businesses was lacking. Management
acknowledged that, in looking back, it should have made the mortgage deterioration known
throughout the firm. The Global Consumer Group saw signs of sub-prime issues and avoided
losses, as did mortgage backed securities traders, but CDO structures business did so belatedly –
no dialogue across businesses.”1266
The co-heads of the CDO desk told the FCIC that they first saw weaknesses in the underlying
market in the first quarter of 2007.1267 In February, management decided to slow down on
purchases of mortgage securities for inventory for CDO production for two reasons: the business
was nearing its existing risk limits on inventory, and the market for CDOs was “sluggish”
anyway.1268 Shortly thereafter, however, the CDO desk changed its collective mind and

1265

FCIC interview with David Bushnell, former Chief Risk Officer, Citigroup, April 1, 2010, transcript available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4848-1644-8005&open=Y

1266

Notes on Senior Supervisors’ Meeting with Firms, meeting between Citigroup and Federal Reserve Bank of
New York, Federal Reserve Board, Office of the Comptroller of the Currency, Securities and Exchange
Commission, UK Financial Services Authority, and Japan FSA, November 19, 2007,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4834-2280-6791&open=Y.

1267

FCIC staff interviews of Janice Warne, February 2, 2010, MFR available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4846-3994-8294&open=Y, and Nestor Dominguez, March 2,
2010, MFR available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4828-8279-5781&open=Y.
1268

FCIC interview with Nestor Dominguez, March 2, 2010, MFR available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4828-8279-5781&open=Y.

521

accelerated its purchases of inventory. Nestor Dominguez explained, “In April 2007, the RMBS
market started to rally.” 1269
Murray Barnes, an Independent Risk managing director at Citigroup, approved the CDO
business’s request to temporarily increase its limits on purchasing CDO collateral. “In
hindsight,” he observed, “rather than looking at [the cheap collateral] as an opportunity, we
should have reassessed our assumptions and whether that was a sign of the ….market showing
strains…. To the extent that we took losses on those positions in the third and fourth quarters
because the market froze and we couldn’t sell those positions, yes that was a mistake…. There
was a… complacency that our past ability to distribute risk would continue.”
And, in the first half of 2007, the risk-management division also increased the CDO desk’s limits
for retaining the most senior tranches from $30 billion to $35 billion. Unlike at Merrill, however,
the increase in retained positions was not part of a broader effort to reduce overall exposure to
risky mortgage assets. Both traders and risk managers at Citi simply believed that the supersenior tranches carried little risk.1270 On this subject, that report prepared in November by the
Citigroup supervisors continued, “An acknowledgement of the risk in its Super Senior AAA
CDO exposure was perhaps Citigroup’s ‘biggest miss.’ The original business model was to
distribute all CDO risk. However, management found that it was unable to distribute the supersenior tranches at favorable prices. As management felt comfortable with the credit risk of these
tranches, it began to retain large positions on the balance sheet…. As the sub-prime market

1269

FCIC interview with Nestor Dominguez, March 2, 2010, MFR available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4828-8279-5781&open=Y. [Quotes to unrecorded MFR. Need
to check quote with Dominguez.]
1270

FCIC interview of Murray Barnes, former Managing Director of Independent Risk, March 2, 2010, MFR
available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4829-6661-6325&open=Y.

522

began to deteriorate, the risk perceived in these tranches increased, causing large writedowns.”1271 Ultimately, losses at Citi from mortgages, residential mortgage-backed securities and
mortgage-related CDOs would total approximately $51 billion.
The decision to increase the super-senior retention risk limits was okayed by Barnes, with
approval from his superior, Ellen “Bebe” Duke. Both Duke and Barnes reported to David
Bushnell, the Chief Risk Officer. Bushnell—whom Chuck Prince referred to as “the best risk
manager on Wall Street”[source to hearing]—told the FCIC that he did not recall specifically
approving the increase in those limits but that, in general, the risk management function did
approve higher risk limits when a business line was growing.1272 He described a “firm-wide
initiative” to increase Citigroup’s structured products business: “[Risk management was aware]
that risk limits were wanted to be, were needed to be, increased by the business.”1273
Perhaps the most remarkable fact about the conflicting strategies employed by the securitization
and CDO desks is that their respective risk officers attended the same weekly independent risk
meetings.1274 Duke recalled for the FCIC a risk meeting in the fall of 2007 during which the
contradictory strategies were discussed.1275 This was fully six months after the conflict arose.
1271

1272

Charles O. Prince, former Chairman and CEO of Citigroup, interview with the FCIC, March 17, 2010, p. 120,
transcript available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4849-5576-9861&open=Y

1273

David Bushnell, former Chief Risk Officer of Citigroup, interview with FCIC, April 1, 2010, p. 126, transcript
available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4848-1644-8005&open=Y.

1274

Ellen “Bebe” Duke, Citigroup Independent Risk, March 18, 2010, MFR available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4810-5913-9077&open=Y.

1275

Ellen “Bebe” Duke, Citigroup Independent Risk, March 18, 2010, MFR available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4810-5913-9077&open=Y.

523

Even so, Duke was not particularly concerned when the issue did finally come up, because she
and her unit assumed that the two other units had different quality collateral and thus conducted
their businesses differently. Duke acknowledged that her assumption had been wrong and
admitted, “We were seduced by structuring and failed to look at the underlying collateral.”1276
That failure to look at the underlying collateral was, according to Barnes, the risk officer
assigned to the CDO desk, due to a lack of “ability” to see loan performance data, such as
delinquencies and early payment defaults, on the underlying mortgage pools comprising the
CDOs.1277 All the while, the surveillance unit in Citigroup’s securitization desk had the extensive
database of underlying loan performance data that could have served to inform the decisions
made by the CDO desk.1278 Barnes reflected: “Risk management tended to be managed along
business lines. In hindsight, it would have been better to look across risk factors…. I was two
offices away from my colleague who covered the [securitization] business, but I didn’t
understand the nuances of what was happening to the underlying loans…. One massive regret is
that we didn’t reach out to the consumer bank to get the pulse of mortgage origination. An
industry-wide problem is that we didn’t have the tools to understand the underlying
collateral.”1279 But of course, they did.
“That has never happened since the Depression”
1276

Ellen “Bebe” Duke, Citigroup Independent Risk, March 18, 2010, MFR available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4810-5913-9077&open=Y.

1277

FCIC interview of Murray Barnes, former Managing Director of Independent Risk, March 2, 2010, MFR
available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4829-6661-6325&open=Y

1278

Financial Industry Regulatory Authority (FINRA) interview of James Xanthos, March 24, 2009, available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4847-5896-4487&open=Y

1279

FCIC interview of Murray Barnes, former Managing Director of Independent Risk, March 2, 2010, MFR
available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4829-6661-6325&open=Y. [Quotes to unrecorded
MFR. Need to check quote with Barnes.]

524

Prince and Rubin told the commission they believed up until the fall of 2007 that any downside
risk to the mortgage-backed securities business was minuscule, a crack too small to bring down
the dike and flood the whole empire. But they appeared to come to that conclusion without
giving the matter much consideration.[cite] Robert Rubin, chairman of the executive committee
and a “very important member of [the] board,”1280 told FCIC staff, “I don’t think anybody
focused on the CDOs. This was one business in a vast enterprise, and until the trouble developed,
it wasn’t one that had any particular profile. In the RMBS, every firm on the street had enormous
mortgage trading operations, and unless somebody came to the board and said we've got a
problem, or there is something substantially wrong someplace, the board had people who – you
know, Tom Maheras was in charge of trading. Tom was an extremely well regarded trading
figure on the street. In fact, he was chairman, I am pretty sure of this, I know he was, actually, of
the Treasury Advisory Committee, whatever that was called. And this is what traders do, they
handle these kinds of problems.” Recall that Maheras told the FCIC that he spent less than 1% of
his time thinking about or dealing with the CDO business that would ultimately cause massive
losses for the company.1281,1282
Citigroup’s risk management function was simply not concerned about the risks that the housing
market could pose to the firm.. According to CEO Prince, Bushnell, his chief risk officer, and
others told him, in effect, “ ‘Gosh, housing prices would have to go down 30% nationwide for us

1280

Transcript of FCIC staff interview of Robert Rubin, former Chairman of the Executive Committee and adviser,
March 11, 2010.
1281

1282

FCIC staff interview of Thomas Maheras, former Co-CEO of Citi Markets & Banking, March 10, 2010, pp. 250253.

525

to have, not a problem with [mortgage-backed securities] CDOs, but for us to have problems,’
and that has never happened since the Depression.’”1283Housing prices would be down much less
than 30% before Citigroup had problems.
“I think we’ve had good risk management”
By [month] 2007, national house prices had fallen xx%, delinquencies in subprime mortgages
had risen xx%, and the subprime ABX index (the de facto “Dow Jones” for this market) had
fallen xx%. Yet, Citigroup still did not expect that the liquidity puts could be triggered and it
was not concerned about the value of its retained super-senior tranches of CDOs. On June 4,
2007, Citigroup made a presentation to the Securities and Exchange Commission about subprime
exposure in its CDO business. The presentation noted that Citigroup did not factor two positions
into its overall subprime exposure for the CDO desk: $14.6 billion in super-senior tranches and
$23.2 billion in liquidity puts.1284 The presentation explained that the liquidity puts were not a
concern: “[T]he risk of default is extremely unlikely… [and] certain market events must also
occur for us to be required to fund. Therefore, we view these positions to be even less risky than
the Super Senior Book.”1285
Just a few short weeks later, the July 2007 collapse of the two Bear Stearns hedge funds spelled
trouble. Following the failure of the hedge funds, commercial paper written against three

1283

FCIC interview with Chuck Prince.

1284

Presentation to the Securities and Exchange Commission Regarding Overall CDO Business and Subprime
Exposure, June 2007, CITI 00007657 – 00007690, p. CITI 00007673, available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4841-9122-7909&open=Y

1285

526

Citigroup-underwritten CDOs for which Bear Stearns Asset Management was the asset manager
and on which Citi had issued liquidity puts began losing value and the interest rates began rising.
The liquidity puts would be triggered if interest rates on the asset-backed commercial paper rose
above a certain level.
Citigroup’s national bank regulator, the Office of the Comptroller of the Currency (OCC), knew
about the liquidity puts since Citigroup first issued them in 2003 but didn’t express concerns.
Then, by the summer of 2007, the OCC became concerned that Citigroup would have to buy the
commercial paper, OCC Examiner-in-Charge John Lyons told the FCIC. Doing so would drain
$25 billion of the company’s cash and expose it to possible balance-sheet losses at a time when
markets were increasingly in distress. But, looking at the rising rates on the commercial paper
backing the three BSAM-managed CDOs, Lyons also said Citigroup did not have the option to
wait until further interest rate rises actually triggered the liquidity puts. Large mutual funds that
had bought the commercial paper were important customers, and so in July Citigroup purchased
$2.5 billion of paper. “It was to address the reputation risk and the potential loss of large fund
providers to the company…They were large depositors in the corporation. There was an implied
threat that if Citibank didn’t step up, they would pull their other funds….There was a fear within
the company there would be a deposit run.”1286 Over the next six months, Citigroup purchased
all $25 billion of the commercial paper that had been subject to its liquidity puts.1287
On July 20, Citigroup held an earnings call to discuss its second quarter performance. CFO Gary
Crittenden specifically discusses the company’s subprime exposures, noting that Citigroup had

1286

Interview with John Lyons at 7:21, 8:45.

1287

Interrogatory response from Paul, Weiss, Rifkind, Wharton & Garrison LLP on behalf of Citigroup, response to
Interrogatory #18, March 1, 2010, letter available at

527

reduced its exposure from $24 billion at the end of 2006 to $13 billion at the end of the second
quarter of 2007.1288 Crittenden did not make any mention of the subprime exposure related to
super-senior tranches or liquidity puts. He explained: “I think our risk team did a nice job of
anticipating that this was going to be a difficult environment, and so set about in a pretty
concentrated effort to reduce our exposure [to CDOs and other subprime-related assets] over the
last six months.”1289 A week later, on a July 27 investor call, Crittenden reiterated his point:
“Subprime exposure of CDOs has actually gone down over the course of the last six months or
so. So I think we’ve had good risk management that has been anticipating some market
dislocation here, and that had helped contain some of the risk that we have.”1290
By August, Citigroup’s CDO desk was re-valuing the super-senior tranches that it held as market
conditions worsened, despite the absence of an effective model to do so. Rather, CDO desk
bankers marked the value of the securities to market using traders’ marks, which were generally
at or near par (the original face value of the securities), despite the fact that market demand at
those prices was weak to nonexistent.1291 However, as the market congealed, then froze, the
paucity of actual market prices for these tranches necessitated the development of a model of
some sort.1292 The New York Fed later noted that “the model for Super Senior CDOs, based on
1288

Citigroup, Inc. Q2 2007 earnings call presentation, July 20, 2007, 10:00 a.m., transcript available at
http://seekingalpha.com/article/41799-citigroup-q2-2007-earnings-call-transcript?

1289

Citigroup, Inc. Q2 2007 earnings call Q&A, July 20, 2007, 10:00 a.m., transcript available at
http://seekingalpha.com/article/41799-citigroup-q2-2007-earnings-call-transcript?part=qanda

1290

Securities and Exchange Commission v. Citigroup Inc., 1:10-cv-01277, Complaint, July 29, 2010,
http://www.sec.gov/litigation/complaints/2010/comp21605.pdf

1291

FCIC staff interviews with Murray Barnes, March 2, 2010, Ellen “Bebe” Duke, March 18, 2010; FCIC interview
with Chris Larson, former Examiner with the Federal Reserve Board of New York, March 1, 2010.

1292

FCIC interview of Murray Barnes, former Managing Director of Independent Risk, March 2, 2010, MFR
available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4829-6661-6325&open=Y

528

fundamental economic factors, could not be fully validated by Citigroup’s current validation
methodologies yet it was relied upon for reporting exposures.”1293
CDO risk-management officer Murray Barnes told the FCIC that sometime that summer he had
met with the co-heads of the CDO desk to express concern about possible losses on both the
unsold CDO inventory and the retained super-senior tranches. The message got through. Nestor
Dominguez told the FCIC, “[W]e began extensive discussions about the implications of the…
dramatic decline of the underlying subprime markets, and how that would feed into the super
senior positions.”1294 Also at this time—and for the first time--such concerns reached Thomas
Maheras, the co-head of Citigroup’s investment bank.1295 He justified his lack of prior knowledge
of the $xx billion in inventory and super-senior tranches in these terms: “The entire CDO
business in [fiscal year 2006], its best year ever, comprised under 2 percent of [the investment
bank’s] revenues. I believe that the business was appropriately supervised by experienced and
highly competent managers and by an independent risk group and that I was properly apprised of
the general nature of our work in this area and its attendant risks.”1296

1293

FCIC-Citi-000198, letter from the Federal Reserve Board of New York to Vikram Pandit and the Board of the
Directors of Citigroup, April 15, 2008, p. 10.
1294

Nestor Dominguez, testimony before the FCIC, hearing on “Subprime Lending and Securitization and
Government-Sponsored Enterprises (GSEs),” Session 3: Citigroup Subprime-Related Structured Products and Risk
Management, April 7, 2010, p. 281 of transcript, available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4842-8641-3830&open=Y

1295

Thomas Maheras, former co-head of Citi Markets & Banking, interview with the FCIC, March 10, 2010, p. 76,
available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4852-0736-2565&open=Y

1296

Thomas Maheras, testimony before the FCIC, hearing on “Subprime Lending and Securitization and
Government-Sponsored Enterprises (GSEs),” Session 3: Citigroup Subprime-Related Structured Products and Risk
Management, April 7, 2010, p. 268 of transcript, available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4842-8641-3830&open=Y

529

The exact dates are not certain, but other sectors of Citigroup’s senior management also heard
about the growing mark-to-market losses on those super-senior tranches in “late August, early
September,” to cite Chief Risk Officer Bushnell, well after Citigroup had been compelled to buy
the commercial paper backing the senior tranches of the CDO managed by BSAM. The context
was a discussion of the upcoming third-quarter results. As reported, this is also when Chairman
and CEO Prince first heard about the super-senior CDO tranches: “[I]t wasn’t presented at the
time in a startling fashion…. [but] then it got bigger and bigger and bigger, obviously, over the
next 30 days.”1297 In late August, Citigroup’s valuation models suggested that losses on the
super-senior tranches might range from $15 million to $2 billion.1298 This number was
recalculated as $300 to $500 million in mid-September as the valuation methodology was
refined.1299 In the weeks ahead, those numbers would skyrocket.
“DEFCON calls”
To get a handle on the company’s potential losses from the CDOs and liquidity puts, starting on
September 9, Prince convened a series of meetings, and later nightly “DEFCON calls,” with
members of his senior management team, including Rubin, Maheras and Bushnell as well as Lou
Kaden, the chief administrative officer and Gary Crittenden, the chief financial officer.1300 Rubin
was in Korea during the first meeting , but was updated on the discussions that took place by
1297

Id. p. 81.

1298

Securities and Exchange Commission v. Citigroup Inc., 1:10-cv-01277, Complaint, July 29, 2010,
http://www.sec.gov/litigation/complaints/2010/comp21605.pdf

1299

Securities and Exchange Commission v. Citigroup Inc., 1:10-cv-01277, Complaint, July 29, 2010,
http://www.sec.gov/litigation/complaints/2010/comp21605.pdf

1300

Thomas Maheras, former co-head of Citi Markets & Banking, interview with the FCIC, March 10, 2010, p. 165,
available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4852-0736-2565&open=Y; see also Thomas
Maheras, former co-head of Citi Markets & Banking, interview with the FCIC, March 10, 2010, p. 165, available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4852-0736-2565&open=Y

530

Kaden.1301 Rubin later emailed CEO Prince: “According to Lou, Tom [Maheras] never did
provide a clear and direct answer on the super seniors. If that is so, and the meeting did not bring
that to a head, isn’t that deeply troubling not as to what happened – that is a different question
that is also troubling – but as to providing full and clear information and analysis now.”1302
Prince disagreed, saying, “I thought, for first mtg, it was good. We weren’t trying to get to final
answers.”1303
A second meeting was scheduled for September 12 – after Rubin was back in the country – and
management’s focus shifted squarely to the CDOs. This meeting was attended by the same
senior executives and it marked the first time Rubin recalled hearing of the super-senior and
liquidity-put exposure.1304 Rubin later commented, “As far as I was concerned they were all one
thing, because if there was a put back to Citi under any circumstance, however remote that
circumstance might be, you hadn’t fully disposed of the risk.”1305 And, of course, the
circumstance was not remote, since billions of dollars in subprime mortgage assets had already
been “put back” to Citi.
Chuck Prince told the FCIC that Thomas Maheras repeatedly assured him throughout the
meetings and the DEFCON calls that the super-seniors posed no risk to Citigroup, even as the
1301

Id. pp. 141-42; CITI-FCIC-E 00036374 Chuck Prince email to Robert Rubin re Thomas Maheras and super
seniors, September 9, 2007.

1302

CITI-FCIC-E 00036374 Chuck Prince email to Robert Rubin re Thomas Maheras and super seniors, September
9, 2007.

1303

CITI-FCIC-E 00036374 Chuck Prince email to Robert Rubin re Thomas Maheras and super seniors, September
9, 2007.

1304

Robert Rubin, former chairman of the executive committee, Citigroup, March 11, 2010, pp. 68-73, available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4811-1378-7397&open=Y

1305

Robert Rubin, former chairman of the executive committee, Citigroup, March 11, 2010, p. 74, available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4811-1378-7397&open=Y

531

market deteriorated, and that he, Prince, recalled becoming more and more uneasy with Maheras’
assessment. “Tom had said and said till his last day at work [October 11]: ‘We are never going to
lose a penny on these super seniors. We are never going to lose a penny on these super
seniors….’ And as we went along and I was more and more uncomfortable with this and more
and more uncomfortable with Tom’s conclusions on ultimate valuations, that is when I really
began to have some very serious concerns about what was going to happen.”1306
Despite Prince’s concerns, Citigroup publicly remained silent about the additional subprime
exposure from the super-senior positions and liquidity puts. On October 1, 2007, Citigroup preannounced its third-quarter earnings and predicted that the company’s net income could fall as
much as 60% from the third quarter of 2006. It also disclosed an estimated $1 billion in write
downs on subprime inventory for the CDO desk and unsold tranches.1307 The press release did
not mention any estimates of Citigroup’s remaining subprime exposures that could cause further
losses.
On October 11, 2007, the rating agencies initiated a series of rolling downgrades on thousands of
securities. CEO Prince told the FCIC that the rating downgrades effectively turned the
supposedly AAA securities into “junk.”1308 He indicated that the day of these downgrades was
the “canary in the coal mine” for Citigroup and “the precipitating event in the financial crisis.”1309
The same day, Prince restructured the investment bank, leading to the resignation of Maheras
1306

Transcript of FCIC staff interview of Chuck Prince, March 17, 2010, pp. 83-84.

1307

“October 1, 2007 Recorded Call Transcript” and cover email, CITI-FCIC-E 00016495 – 00016505,
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4822-0738-9445&open=Y and
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4849-9253-8373&open=Y
1308

Transcript of FCIC staff interview of Chuck Prince, March 17, 2010, p. 82.

1309

Transcript of FCIC staff interview of Chuck Prince, March 17, 2010, pp. 117, 119.

532

and the termination of Randy Barker, Maheras’s subordinate who had responsibility for the fixed
income unit that housed the CDO desk.1310
Four days later, the issue of the super-senior CDOs and liquidity puts was raised specifically to
the Board of Director’s Corporate Audit and Risk Management Committee meeting and to the
full Board.1311 [add main attendees from meeting minutes] A presentation concluded that “total
sub-prime exposure in [the investment bank] was $13bn with an additional $16bn in Direct
Super Senior and $27bn in Liquidity and Par Puts.”1312 Aggregated together, Citigroup’s
subprime exposure was $56 billion. The calculation was straight forward but, during an analysts’
conference call later that day CFO Gary Crittenden omitted mention of the super-senior and
liquidity-put related exposure and told participants that Citigroup had under $13 billion in
subprime exposure.1313
A week later, on Saturday, October 27, Prince learned from Crittenden that the company would
have to report subprime-related losses of $8 to $11 billion,, and on Monday he immediately
tendered his resignation to the Board.1314 He later reflected, “When I drove home and Gary called
me and told me it wasn’t going to be two or 300 million but it was going to be 8 billion – I will

1310

Thomas Maheras, former co-head of Citi Markets & Banking, interview with the FCIC, March 10, 2010, pp.
200-209, available at https://vault.netvoyage.com/neWeb2/goId.aspx?id=4852-0736-2565&open=Y

1311

CITI-FCIC 00000673, minutes of a meeting of the Corporate Audit and Risk Management Committee, October
15, 2007, https://vault.netvoyage.com/neWeb2/goId.aspx?id=4819-6602-4709&open=Y.

1312

CITI-FCIC 00002793, “Risk Management Review: An Update to the Corporate Audit and Risk Management
Committee,” October 15, 2007, p. CITI-FCIC 00002794.

1313

CITI-FCIC 00002793, “Risk Management Review: An Update to the Corporate Audit and Risk Management
Committee,” October 15, 2007, p. CITI-FCIC 00002794.

1314

Transcript of FCIC staff interview of Chuck Prince, March 17, 2010, p. 208.

533

never forget that call. I continued driving, and I got home, I walked in the door, I told my wife, I
said here’s what I just heard and if this turns out to be true, I am resigning.”1315
On November 4, Citigroup revealed the accurate subprime exposure – now estimated at $55
billion – and it disclosed the subprime-related losses.1316 While Prince resigned, he remained on
Citigroup’s payroll until the end of the year, and the Board of Directors gave him a generous
parting compensation package: $11.9 million in cash and $24 million in stock, bringing his total
compensation to $79 million from 2004 to 2008.1317 Citigroup’s stock declined 4.9%. An
analyst’s report the next day summed up investor reaction: “We are disappointed with the lack of
previous disclosure surrounding the extent of the company’s CDO exposure…. [W]e find
management’s previous disclosures surrounding subprime exposure as deceptive at best.
Specifically, while management appears to have accurately portrayed its secured lending
exposure of less than $13 billion on the 3Q07 conference call, by leaving out the additional (and
much more substantial) $43 billion in subprime CDO exposure within other areas of the
business, we feel mislead.”1318 The Federal Reserve Bank of New York would later conclude,
“[T]here was little communications on the extensive level of subprime exposure posed by Super
Senior CDO…. Senior management, as well as the independent Risk Management function

1315

Page 195 of Prince interview transcript, March 17, 2010

1316

“Citi’s Sub-Prime Related Exposure in Securities and Banking,” Citigroup press release, November 4, 2007,
available at http://www.citigroup.com/citi/press/2007/071104b.htm

1317

Citigroup 2008 Proxy Statement, p. 73-74.

1318

Buckingham Analyst Report, November 5, 2007.

534

charged with monitoring responsibilities, did not properly identify and analyze these risks in a
timely fashion.”1319
Citigroup’s poor performance in the third quarter led to extensive restructuring in the investment
bank. By the end of 2007, approximately 100 people had been laid off of the CDO desk,
including co-head Nestor Dominguez, leaving only a skeletal staff behind to wind down the
business.1320 A new chief risk officer replaced David Bushnell in November 2007, and Chuck
Prince’s replacements as chairman and CEO – Richard Parsons and Vikram Pandit – were
announced in December. Robert Rubin would stay on board until January of 2009 – having been
paid over $50 million from 2004 to 2009.

AIG and Goldman: “A gesture of goodwill”
From the first Goldman email that interrupted AIG’s Alan Frost while he was on vacation on
July 26, 2007, the collateral dispute between Goldman and AIG captured nearly the full attention
of the senior management of both companies. For fourteen months, Goldman pressed its case
and sent AIG a formal demand letter every single business day. It would pursue AIG relentlessly
with demands for collateral based on marks that were initially well below those of other firms –
while AIG and its management struggled to come to grips with a burgeoning crisis facing the
firm.

1319

FCIC-Citi-000198, letter from the Federal Reserve Board of New York to Vikram Pandit and the Board of
Directors of Citigroup, April 15, 2008, at 8, https://vault.netvoyage.com/neWeb2/goId.aspx?id=4843-93478661&open=Y.
1320

FCIC interview with Nestor Dominguez, March 2, 2010, MFR available at
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4828-8279-5781&open=Y.

535

“Rule Number 1”
The initial collateral call was a shock to AIG executives. As noted, many members of AIG’s
most senior management, including CEO Martin Sullivan, CFO Steven Bensinger and CRO
Robert Lewis, as well as executives of the Financial Products subsidiary, had not even known
there were collateral call provisions in the credit default swaps with Goldman.
They did know there were enormous exposures. In 2005, AIG Financial Products had tripled its
exposure to CDOs backed in large part by subprime and Alt-A loans.1321 By 2007, AIG Financial
Products had written $78 billion worth of credit default swaps on super-senior tranches of CDOs,
with Goldman Sachs accounting for $21 billion of the swaps. By comparison, the parent
company’s total reported capital was $95.8 billion at the end of 2007.
While the exposures were enormous, executives said they had never been concerned – the swaps
were considered to be practically “risk-free.” Vice President of Accounting Policy Joseph St.
Denis had always considered that “there could never be losses on the [super-senior] CDS.”.”[33]
He was not alone. Then came that first collateral call. St. Denis told FCIC staff that he was so
“stunned” when he got the news, that he “had to sit down.”[32] Even Gene Park, the executive
who had insisted eighteen months earlier that AIG stop writing the swaps, was surprised by the
collateral provisions.[29] He told the FCIC that “rule Number 1 at AIG FP” was to never post
collateral.[30] This was particularly important in the credit default swap business, he said,
because it was the only un-hedged business that AIG ran.[31]
But Jake Sun, general counsel of the Financial Products subsidiary, who reviewed the swap
contracts before they were executed, told the FCIC that the provisions were standard both at AIG

536

and in the industry.[34] Alan Frost, who first learned about the collateral call, agreed and
confirmed that other financial institutions also commonly did deals with collateral posting
provisions. [35] Pierre Micottis, the Paris-based head of the AIG Financial Products’ Enterprise
Risk Management department, told the FCIC that collateral provisions were indeed common in
derivatives contracts – but surprising in the super-senior CDS contracts, which were considered
safe investments. Moreover, the two largest monoline guarantors, MBIA and Ambac, which
were regulated by state insurance supervisors in New York and Wisconsin, did not permit such
collateral terms in their contracts.1322
However, there they were in the Goldman contracts. As disturbing as the senior AIG executives’
surprise at the collateral provisions was their firm’s inability to determine the validity of
Goldman’s numbers. AIG Financial Products did not have its own model to estimate the value
of the CDS portfolio. It had never tried to determine the market value of the CDS, nor had it
ever tried to hedge the company’s exposure to them. Executives did not think there was a need
to hedge. Gene Park explained that this view was based in part on the belief that AIG would
only have to pay CDS counterparties if there were actual losses incurred by the holders of the
super senior tranches.1323 He also said that purchasing a hedge from UBS was considered but
that Andrew Forster, the head of credit trading at AIG Financial Products, rejected it because the
cost was more than the fees AIGFP was receiving for the CDS protection it wrote. “We’re not
going to pay a dime for this,” Forster told Park.1324

1322

Dinallo MFR; Micottis MFR.

1323

Park MFR at 121-125.

1324

Park MFR at 133.

537

Therefore, AIG Financial Products relied on an actuarial model that did not provide a tool for
monitoring the market value of the CDS. The model was developed by Gary Gorton, then a
professor at the Wharton School of Finance who worked as a consultant to AIG Financial
Products starting in 1996 and was close to its CEO, Joe Cassano.1325 The Gorton model had
determined with 99.85% confidence that the owners of the super-senior tranches of the CDOs
AIG Financial Products insured would never suffer real economic losses, even in an economy as
troubled as the worst post-World War II recessionary scenario. AIG Financial Products was not
alone in trusting the Gorton model. The company’s auditors, PricewaterhouseCoopers (“PwC”),
concluded that “The risk of default on [AIG Financial Products’] portfolio has been effectively
removed and as a result from a risk management perspective, there are no substantive economic
risks in the portfolio and as a result the fair value of the liability stream on these positions from a
risk management perspective could reasonably be considered to be zero.”1326
Speaking with the FCIC, Financial Products CEO Joe Cassano was adamant that the “CDS
book”—all the tens of billions of dollars in swaps--was “effectively hedged.” He said that the
fact that the CDS contracts were written only on the super senior tranches of top-rated securities
with high “attachment points” (essentially, the percentage of loans in the underlying CDO that
would have to default in order for losses to reach the super senior tranche, forcing AIG to pay
out on the credit default swap contract), and the fact that the bulk of the exposure came from
loans made before 2006 (since underwriting standards had deteriorated by that year), assured that
the company AIG could never suffer losses on the swaps.1327 Indeed, according to Gene Park,
1325

Transcript of Gene Park Interview at 50. Available on NetDocs here:
https://vault.netvoyage.com/neWeb2/goId.aspx?id=4845-7976-0902&open=Y

1326

11/7/07 PwC memo re 3Q07 review of SSCDS portfolio (PwC-FCIC 000224-240) at PwC-FCIC 000225.

1327

Cassano MFR.

538

Cassano put a halt to a $150 million hedge using the ABX index. As Park explained, “Joe
stopped that because after we put on the first 150 … the market moved against us … we were
losing money on the 150 million … Joe said ‘ You know, I don’t think the world is going to
blow up … I don’t want to spend that money. Stop it’ “.

Ultimately, any hedges that Cassano felt were built into the portfolio (he called them “structural
hedges”) meant to protect against economic losses were irrelevant. While there was a very small
likelihood that AIGFP would suffer actual economic losses as a result of massive defaults on the
underlying securities, triggering AIGFP’s coverage, the key provisions in the swap contracts
with counterparties required AIG to pay collateral if the market value of the underlying securities
dropped, or if rating agencies lowered AIG’s debt rating. That was a totally different danger than
massive defaults in the underlying securities.

AIG’s inability to determine a market value proved to be a serious handicap in its dispute with
Goldman Sachs, which, according to the investment bank, priced all of its positions on a daily
basis. Despite the limited transparency in the market in the summer of 2007, Goldman used
what information there was to estimate what it considered to be realistic prices for the securities
at issue. Much of the price information came from the public derivatives indices – the ABX and
TABX – which investors could use to track the performance of a group of credit default swaps
based on subprime loans. Looking at those indices, Goldman gauged the changes in pricing for
investments similar to the ones underlying AIG’s credit default swaps. In addition to finding
public information about comparable securities from public indices, Goldman also spoke with
539

other companies to see what values they assigned to the securities. Finally, Goldman looked to
its own experience: in most cases, when the bank bought credit protection on an investment, it
turned around and sold credit protection on the same investment to other counterparties. These
deals yielded more information.1328
AIG also received quotes from other dealers but had only the Gorton model for predicting the
likelihood that defaults in the underlying securities would be so severe as to hit the super senior
“attachment point” – that is, the point at which all lower-ranking tranches would be wiped out,
leaving the super-seniors exposed to loss. The model did not provide a tool for determining the
“market value” of underlying securities. When AIG initially received Goldman’s marks, it was
caught by surprise. “That was just something that hit out of the blue,” Jon Liebergall, an AIG
Financial Products executive, said during a July 30 telephone conversation with Forster. “It’s a
f**king** number that’s well bigger than we ever planned for.”1329And, as Forster had
recognized, if AIG agreed to the low marks, it would also have to acknowledge that its own
assets had lost value. That would result in a massive hit to its earnings and capital.
Goldman “was not budging” on the issue of demanding collateral, according to Tom Athan, a
managing director at AIG Financial Products. “I played almost every card I had, legal wording,
market practice, intent of the language, meaning of the [contract], and also stressed the potential

1328

Goldman’s submissions to the FCIC on its valuation and pricing related to collateral calls made to AIG are
available on Goldman Sachs’s website. See: http://www2.goldmansachs.com/our-firm/on-the-issues/responsesfcic.print.html See doc on FCIC website.
1329

Transcript of 7/30/2007 phone call with Jonathan Liebergall and Andrew Forster, AIG-SEC 1361815 (Tab 9 of
AIG/Goldman Sachs collateral call timeline – available on FCIC website).

540

damage to the relationship and GS said that this has gone to the ‘highest levels’ at GS and they
feel that… this is a ‘test case’…”1330
Actually, Goldman did budge. It almost immediately reduced its July 27 of $1.8 billion by $600
million – a move that underscored the difficulty of finding reliable market prices in the summer
of 2007. The new demand, $1.2 billion, was still too high, in AIG’s view, which was
corroborated by third party marks. Forster characterized their marks as “ridiculous.” Goldman’s
marks valued the CDOs between 80 and 97 cents on the dollar, while Merrill Lynch—for
example—was valuing the same securities between 95 and 100 cents on the dollar.1331
On August 7, Joe Cassano, CEO of AIG Financial Products, told his independent auditors, PwC,
that there was “little or no price transparency” on the proper marks and it was “difficult to
determine whether [collateral calls] were indicative of true market levels moving.” AIG
managers did call other dealers holding similar bonds to check their marks to help its case with
Goldman, but those marks were not “actionable”-- that is, the dealers would not actually execute
transactions at the quoted prices. “The above estimated values … do not represent actual bids or
offers by Merrill Lynch” was the disclaimer in listing of estimated market values provided by
Merrill to AIG.1332 Goldman Sachs disputed the reliability of such estimates.
“Without being flippant”
Prior to that August, investors had no way of knowing AIG had a $78 billion mortgage-related
credit default swap portfolio. On August 9, during the company’s second-quarter earnings call

1332

11/9/07 email and enclosed marks from Merrill Lynch; Tab 20 the collateral call timeline.

541

with analysts, AIG executives disclosed the protection on

Full text of Financial Crisis Inquiry Commission : Documents Relating to the Financial Crisis of 2007-2009 : Financial Crisis Inquiry Report [Draft]

FRASER