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+PREFACE
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+The Financial Crisis Inquiry Commission was created to “examine the causes of the current financial and economic crisis in the United States.” In this report, the Commission presents to the President, the Congress, and the American people the results of its examination and its conclusions as to the causes of the crisis.
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+More than two years after the worst of the financial crisis, our economy, as well as communities and families across the country, continues to experience the after-shocks. Millions of Americans have lost their jobs and their homes, and the economy is still struggling to rebound. This report is intended to provide a historical accounting of what brought our financial system and economy to a precipice and to help policy makers and the public better understand how this calamity came to be.
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+The Commission was established as part of the Fraud Enforcement and Recovery Act (Public Law 111-21) passed by Congress and signed by the President in May
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+2009. This independent, 10-member panel was composed of private citizens with experience in areas such as housing, economics, finance, market regulation, banking, and consumer protection. Six members of the Commission were appointed by the Democratic leadership of Congress and four members by the Republican leadership.
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+The Commission’s statutory instructions set out specific topics for inquiry and called for the examination of the collapse of major financial institutions that failed or would have failed if not for exceptional assistance from the government. This report fulfills these mandates. In addition, the Commission was instructed to refer to the attorney general of the United States and any appropriate state attorney general any person that the Commission found may have violated the laws of the United States in relation to the crisis. Where the Commission found such potential violations, it referred those matters to the appropriate authorities. The Commission used the authority it was given to issue subpoenas to compel testimony and the production of documents, but in the vast majority of instances, companies and individuals voluntarily cooperated with this inquiry.
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+In the course of its research and investigation, the Commission reviewed millions of pages of documents, interviewed more than 700 witnesses, and held 19 days of public hearings in New York, Washington, D.C., and communities across the country xi
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+PREFACE
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+that were hard hit by the crisis. The Commission also drew from a large body of existing work about the crisis developed by congressional committees, government agencies, academics, journalists, legal investigators, and many others.
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+We have tried in this report to explain in clear, understandable terms how our complex financial system worked, how the pieces fit together, and how the crisis occurred. Doing so required research into broad and sometimes arcane subjects, such as mortgage lending and securitization, derivatives, corporate governance, and risk management. To bring these subjects out of the realm of the abstract, we conducted case study investigations of specific financial firms—and in many cases specific facets of these institutions—that played pivotal roles. Those institutions included American International Group (AIG), Bear Stearns, Citigroup, Countrywide Financial, Fannie Mae, Goldman Sachs, Lehman Brothers, Merrill Lynch, Moody’s, and Wachovia. We looked more generally at the roles and actions of scores of other companies.
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+We also studied relevant policies put in place by successive Congresses and administrations. And importantly, we examined the roles of policy makers and regulators, including at the Federal Deposit Insurance Corporation, the Federal Reserve Board, the Federal Reserve Bank of New York, the Department of Housing and Urban Development, the Office of the Comptroller of the Currency, the Office of Federal Housing Enterprise Oversight (and its successor, the Federal Housing Finance Agency), the Office of Thrift Supervision, the Securities and Exchange Commission, and the Treasury Department.
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+Of course, there is much work the Commission did not undertake. Congress did not ask the Commission to offer policy recommendations, but required it to delve into what caused the crisis. In that sense, the Commission has functioned somewhat like the National Transportation Safety Board, which investigates aviation and other transportation accidents so that knowledge of the probable causes can help avoid future accidents. Nor were we tasked with evaluating the federal law (the Troubled Asset Relief Program, known as TARP) that provided financial assistance to major financial institutions. That duty was assigned to the Congressional Oversight Panel and the Special Inspector General for TARP.
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+This report is not the sole repository of what the panel found. A website will host a wealth of information beyond what could be presented here.
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+It will contain a stockpile of materials—including documents and emails, video of the Commission’s public hearings, testimony, and supporting research—that can be studied for years to come. Much of what is footnoted in this report can be found on the website. In addition, more materials that cannot be released yet for various reasons will eventually be made public through the National Archives and Records Administration.
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+Our work reflects the extraordinary commitment and knowledge of the members of the Commission who were accorded the honor of this public service. We also benefited immensely from the perspectives shared with commissioners by thousands of concerned Americans through their letters and emails. And we are grateful to the hundreds of individuals and organizations that offered expertise, information, and personal accounts in extensive interviews, testimony, and discussions with the Commission.
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+PREFACE xiii We want to thank the Commission staff, and in particular, Wendy Edelberg, our executive director, for the professionalism, passion, and long hours they brought to this mission in service of their country. This report would not have been possible without their extraordinary dedication.
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+With this report and our website, the Commission’s work comes to a close. We present what we have found in the hope that readers can use this report to reach their own conclusions, even as the comprehensive historical record of this crisis continues to be written.
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+CONCLUSIONS OF THE
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+FINANCIAL CRISIS INQUIRY COMMISSION
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+The Financial Crisis Inquiry Commission has been called upon to examine the financial and economic crisis that has gripped our country and explain its causes to the American people. We are keenly aware of the significance of our charge, given the economic damage that America has suffered in the wake of the greatest financial crisis since the Great Depression.
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+Our task was first to determine what happened and how it happened so that we could understand why it happened. Here we present our conclusions. We encourage the American people to join us in making their own assessments based on the evidence gathered in our inquiry. If we do not learn from history, we are unlikely to fully recover from it. Some on Wall Street and in Washington with a stake in the status quo may be tempted to wipe from memory the events of this crisis, or to suggest that no one could have foreseen or prevented them. This report endeavors to expose the facts, identify responsibility, unravel myths, and help us understand how the crisis could have been avoided. It is an attempt to record history, not to rewrite it, nor allow it to be rewritten.
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+To help our fellow citizens better understand this crisis and its causes, we also present specific conclusions at the end of chapters in Parts III, IV, and V of this report.
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+The subject of this report is of no small consequence to this nation. The profound events of 2007 and 2008 were neither bumps in the road nor an accentuated dip in the financial and business cycles we have come to expect in a free market economic system. This was a fundamental disruption—a financial upheaval, if you will—that wreaked havoc in communities and neighborhoods across this country.
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+As this report goes to print, there are more than 26 million Americans who are out of work, cannot find full-time work, or have given up looking for work. About four million families have lost their homes to foreclosure and another four and a half million have slipped into the foreclosure process or are seriously behind on their mortgage payments. Nearly \f65311 trillion in household wealth has vanished, with retirement accounts and life savings swept away. Businesses, large and small, have felt xv
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+the sting of a deep recession. There is much anger about what has transpired, and justifiably so. Many people who abided by all the rules now find themselves out of work and uncertain about their future prospects. The collateral damage of this crisis has been real people and real communities. The impacts of this crisis are likely to be felt for a generation. And the nation faces no easy path to renewed economic strength.
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+Like so many Americans, we began our exploration with our own views and some preliminary knowledge about how the world’s strongest financial system came to the brink of collapse. Even at the time of our appointment to this independent panel, much had already been written and said about the crisis. Yet all of us have been deeply affected by what we have learned in the course of our inquiry. We have been at various times fascinated, surprised, and even shocked by what we saw, heard, and read. Ours has been a journey of revelation.
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+Much attention over the past two years has been focused on the decisions by the federal government to provide massive financial assistance to stabilize the financial system and rescue large financial institutions that were deemed too systemically important to fail. Those decisions—and the deep emotions surrounding them—will be debated long into the future. But our mission was to ask and answer this central question: how did it come to pass that in 2008 our nation was forced to choose between two stark and painful alternatives—either risk the total collapse of our financial system and economy or inject trillions of taxpayer dollars into the financial system and an array of companies, as millions of Americans still lost their jobs, their savings, and their homes1
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+In this report, we detail the events of the crisis. But a simple summary, as we see it, is useful at the outset. While the vulnerabilities that created the potential for crisis were years in the making, it was the collapse of the housing bubble—fueled by low interest rates, easy and available credit, scant regulation, and toxic mortgages—
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+that was the spark that ignited a string of events, which led to a full-blown crisis in the fall of 2008. Trillions of dollars in risky mortgages had become embedded throughout the financial system, as mortgage-related securities were packaged, repackaged, and sold to investors around the world. When the bubble burst, hundreds of billions of dollars in losses in mortgages and mortgage-related securities shook markets as well as financial institutions that had significant exposures to those mortgages and had borrowed heavily against them. This happened not just in the United States but around the world. The losses were magnified by derivatives such as synthetic securities.
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+The crisis reached seismic proportions in September 2008 with the failure of Lehman Brothers and the impending collapse of the insurance giant American International Group (AIG). Panic fanned by a lack of transparency of the balance sheets of major financial institutions, coupled with a tangle of interconnections among institutions perceived to be “too big to fail,” caused the credit markets to seize up. Trading ground to a halt. The stock market plummeted. The economy plunged into a deep recession.
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+The financial system we examined bears little resemblance to that of our parents’
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+generation. The changes in the past three decades alone have been remarkable. The CONCLUSIONS OF THE FINANCIAL CRISIS INQUIRY COMMISSION xvii financial markets have become increasingly globalized. Technology has transformed the efficiency, speed, and complexity of financial instruments and transactions. There is broader access to and lower costs of financing than ever before. And the financial sector itself has become a much more dominant force in our economy.
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+From 1978 to 2007, the amount of debt held by the financial sector soared from
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+\f653\f646 trillion to \f653\f6466 trillion, more than doubling as a share of gross domestic product.
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+The very nature of many Wall Street firms changed—from relatively staid private partnerships to publicly traded corporations taking greater and more diverse kinds of risks. By 2005, the 10 largest U.S. commercial banks held 55\f642 of the industry’s assets, more than double the level held in 1990. On the eve of the crisis in 2006, financial sector profits constituted 27\f642 of all corporate profits in the United States, up from
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+15\f642 in 1980. Understanding this transformation has been critical to the Commission’s analysis.
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+Now to our major findings and conclusions, which are based on the facts contained in this report: they are offered with the hope that lessons may be learned to help avoid future catastrophe.
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+• We conclude this financial crisis was avoidable. The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire. The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public. Theirs was a big miss, not a stumble.
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+While the business cycle cannot be repealed, a crisis of this magnitude need not have occurred. To paraphrase Shakespeare, the fault lies not in the stars, but in us.
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+Despite the expressed view of many on Wall Street and in Washington that the crisis could not have been foreseen or avoided, there were warning signs. The tragedy was that they were ignored or discounted. There was an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread reports of egregious and predatory lending practices, dramatic increases in household mortgage debt, and exponential growth in financial firms’ trading activities, unregulated derivatives, and short-term “repo” lending markets, among many other red flags. Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner.
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+The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards.
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+The Federal Reserve was the one entity empowered to do so and it did not. The record of our examination is replete with evidence of other failures: financial institutions made, bought, and sold mortgage securities they never examined, did not care to examine, or knew to be defective; firms depended on tens of billions of dollars of borrowing that had to be renewed each and every night, secured by subprime mortgage securities; and major firms and investors blindly relied on credit rating agencies as their arbiters of risk. What else could one expect on a highway where there were neither speed limits nor neatly painted lines1
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+• We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. The sentries were not at their posts, in no small part due to the widely accepted faith in the self-correcting nature of the markets and the ability of financial institutions to effectively police themselves. More than 30 years of deregulation and reliance on self-regulation by financial institutions, championed by former Federal Reserve chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry at every turn, had stripped away key safeguards, which could have helped avoid catastrophe. This approach had opened up gaps in oversight of critical areas with trillions of dollars at risk, such as the shadow banking system and over-the-counter derivatives markets. In addition, the government permitted financial firms to pick their preferred regulators in what became a race to the weakest supervisor.
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+Yet we do not accept the view that regulators lacked the power to protect the financial system. They had ample power in many arenas and they chose not to use it.
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+To give just three examples: the Securities and Exchange Commission could have required more capital and halted risky practices at the big investment banks. It did not.
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+The Federal Reserve Bank of New York and other regulators could have clamped down on Citigroup’s excesses in the run-up to the crisis. They did not. Policy makers and regulators could have stopped the runaway mortgage securitization train. They did not. In case after case after case, regulators continued to rate the institutions they oversaw as safe and sound even in the face of mounting troubles, often downgrading them just before their collapse. And where regulators lacked authority, they could have sought it. Too often, they lacked the political will—in a political and ideological environment that constrained it—as well as the fortitude to critically challenge the institutions and the entire system they were entrusted to oversee.
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+Changes in the regulatory system occurred in many instances as financial markets evolved. But as the report will show, the financial industry itself played a key role in weakening regulatory constraints on institutions, markets, and products. It did not surprise the Commission that an industry of such wealth and power would exert pressure on policy makers and regulators. From 1999 to 2008, the financial sector expended \f6532.7 billion in reported federal lobbying expenses; individuals and political action committees in the sector made more than \f6531 billion in campaign contributions. What troubled us was the extent to which the nation was deprived of the necessary strength and independence of the oversight necessary to safeguard financial stability.
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+• We conclude dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis. There was a view that instincts for self-preservation inside major financial firms would shield them from fatal risk-taking without the need for a steady regulatory hand, which, the firms argued, would stifle innovation. Too many of these institutions acted recklessly, taking on too much risk, with too little capital, and with too much dependence on short-term funding. In many respects, this reflected a funda-CONCLUSIONS OF THE FINANCIAL CRISIS INQUIRY COMMISSION xix mental change in these institutions, particularly the large investment banks and bank holding companies, which focused their activities increasingly on risky trading activities that produced hefty profits. They took on enormous exposures in acquiring and supporting subprime lenders and creating, packaging, repackaging, and selling trillions of dollars in mortgage-related securities, including synthetic financial products.
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+Like Icarus, they never feared flying ever closer to the sun.
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+Many of these institutions grew aggressively through poorly executed acquisition and integration strategies that made effective management more challenging. The CEO of Citigroup told the Commission that a \f65340 billion position in highly rated mortgage securities would “not in any way have excited my attention,” and the co-head of Citigroup’s investment bank said he spent “a small fraction of 1\f642” of his time on those securities. In this instance, too big to fail meant too big to manage.
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+Financial institutions and credit rating agencies embraced mathematical models as reliable predictors of risks, replacing judgment in too many instances. Too often, risk management became risk justification.
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+Compensation systems—designed in an environment of cheap money, intense competition, and light regulation—too often rewarded the quick deal, the short-term gain—without proper consideration of long-term consequences. Often, those systems encouraged the big bet—where the payoff on the upside could be huge and the downside limited. This was the case up and down the line—from the corporate boardroom to the mortgage broker on the street.
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+Our examination revealed stunning instances of governance breakdowns and irresponsibility. You will read, among other things, about AIG senior management’s ignorance of the terms and risks of the company’s \f65379 billion derivatives exposure to mortgage-related securities; Fannie Mae’s quest for bigger market share, profits, and bonuses, which led it to ramp up its exposure to risky loans and securities as the housing market was peaking; and the costly surprise when Merrill Lynch’s top management realized that the company held \f65355 billion in “super-senior” and supposedly
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+“super-safe” mortgage-related securities that resulted in billions of dollars in losses.
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+• We conclude a combination of excessive borrowing, risky investments, and lack of transparency put the financial system on a collision course with crisis. Clearly, this vulnerability was related to failures of corporate governance and regulation, but it is significant enough by itself to warrant our attention here.
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+In the years leading up to the crisis, too many financial institutions, as well as too many households, borrowed to the hilt, leaving them vulnerable to financial distress or ruin if the value of their investments declined even modestly. For example, as of
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+2007, the five major investment banks—Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley—were operating with extraordinarily thin capital. By one measure, their leverage ratios were as high as 40 to 1, meaning for every \f65340 in assets, there was only \f6531 in capital to cover losses. Less than a \f646\f642 drop in asset values could wipe out a firm. To make matters worse, much of their borrowing was short-term, in the overnight market—meaning the borrowing had to be renewed each and every day. For example, at the end of 2007, Bear Stearns had \f65311.8 billion in xx
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+equity and \f653\f6468\f646.6 billion in liabilities and was borrowing as much as \f65370 billion in the overnight market. It was the equivalent of a small business with \f65350,000 in equity borrowing \f6531.6 million, with \f653296,750 of that due each and every day. One can’t really ask “What were they thinking1” when it seems that too many of them were thinking alike.
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+And the leverage was often hidden—in derivatives positions, in off-balance-sheet entities, and through “window dressing” of financial reports available to the investing public.
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+The kings of leverage were Fannie Mae and Freddie Mac, the two behemoth government-sponsored enterprises (GSEs). For example, by the end of 2007, Fannie’s and Freddie’s combined leverage ratio, including loans they owned and guaranteed, stood at 75 to 1.
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+But financial firms were not alone in the borrowing spree: from 2001 to 2007, national mortgage debt almost doubled, and the amount of mortgage debt per household rose more than 6\f646\f642 from \f65391,500 to \f653149,500, even while wages were essentially stagnant. When the housing downturn hit, heavily indebted financial firms and families alike were walloped.
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+The heavy debt taken on by some financial institutions was exacerbated by the risky assets they were acquiring with that debt. As the mortgage and real estate markets churned out riskier and riskier loans and securities, many financial institutions loaded up on them. By the end of 2007, Lehman had amassed \f653111 billion in commercial and residential real estate holdings and securities, which was almost twice what it held just two years before, and more than four times its total equity. And again, the risk wasn’t being taken on just by the big financial firms, but by families, too. Nearly one in 10 mortgage borrowers in 2005 and 2006 took out “option ARM” loans, which meant they could choose to make payments so low that their mortgage balances rose every month.
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+Within the financial system, the dangers of this debt were magnified because transparency was not required or desired. Massive, short-term borrowing, combined with obligations unseen by others in the market, heightened the chances the system could rapidly unravel. In the early part of the 20th century, we erected a series of protections—the Federal Reserve as a lender of last resort, federal deposit insurance, ample regulations—to provide a bulwark against the panics that had regularly plagued America’s banking system in the 19th century. Yet, over the past \f6460-plus years, we permitted the growth of a shadow banking system—opaque and laden with short-term debt—that rivaled the size of the traditional banking system. Key components of the market—for example, the multitrillion-dollar repo lending market, off-balance-sheet entities, and the use of over-the-counter derivatives—were hidden from view, without the protections we had constructed to prevent financial meltdowns. We had a 21st-century financial system with 19th-century safeguards.
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+When the housing and mortgage markets cratered, the lack of transparency, the extraordinary debt loads, the short-term loans, and the risky assets all came home to roost. What resulted was panic. We had reaped what we had sown.
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+CONCLUSIONS OF THE FINANCIAL CRISIS INQUIRY COMMISSION xxi
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+• We conclude the government was ill prepared for the crisis, and its inconsistent response added to the uncertainty and panic in the financial markets. As part of our charge, it was appropriate to review government actions taken in response to the developing crisis, not just those policies or actions that preceded it, to determine if any of those responses contributed to or exacerbated the crisis.
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+As our report shows, key policy makers—the Treasury Department, the Federal Reserve Board, and the Federal Reserve Bank of New York—who were best positioned to watch over our markets were ill prepared for the events of 2007 and 2008.
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+Other agencies were also behind the curve. They were hampered because they did not have a clear grasp of the financial system they were charged with overseeing, particularly as it had evolved in the years leading up to the crisis. This was in no small measure due to the lack of transparency in key markets. They thought risk had been diversified when, in fact, it had been concentrated. Time and again, from the spring of 2007 on, policy makers and regulators were caught off guard as the contagion spread, responding on an ad hoc basis with specific programs to put fingers in the dike. There was no comprehensive and strategic plan for containment, because they lacked a full understanding of the risks and interconnections in the financial markets. Some regulators have conceded this error. We had allowed the system to race ahead of our ability to protect it.
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+While there was some awareness of, or at least a debate about, the housing bubble, the record reflects that senior public officials did not recognize that a bursting of the bubble could threaten the entire financial system. Throughout the summer of 2007, both Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson offered public assurances that the turmoil in the subprime mortgage markets would be contained. When Bear Stearns’s hedge funds, which were heavily invested in mortgage-related securities, imploded in June 2007, the Federal Reserve discussed the implications of the collapse. Despite the fact that so many other funds were exposed to the same risks as those hedge funds, the Bear Stearns funds were thought to be “relatively unique.” Days before the collapse of Bear Stearns in March 2008, SEC
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+Chairman Christopher Cox expressed “comfort about the capital cushions” at the big investment banks. It was not until August 2008, just weeks before the government takeover of Fannie Mae and Freddie Mac, that the Treasury Department understood the full measure of the dire financial conditions of those two institutions. And just a month before Lehman’s collapse, the Federal Reserve Bank of New York was still seeking information on the exposures created by Lehman’s more than 900,000 derivatives contracts.
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+In addition, the government’s inconsistent handling of major financial institutions during the crisis—the decision to rescue Bear Stearns and then to place Fannie Mae and Freddie Mac into conservatorship, followed by its decision not to save Lehman Brothers and then to save AIG—increased uncertainty and panic in the market.
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+In making these observations, we deeply respect and appreciate the efforts made by Secretary Paulson, Chairman Bernanke, and Timothy Geithner, formerly president of the Federal Reserve Bank of New York and now treasury secretary, and so xxii
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+many others who labored to stabilize our financial system and our economy in the most chaotic and challenging of circumstances.
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+• We conclude there was a systemic breakdown in accountability and ethics. The integrity of our financial markets and the public’s trust in those markets are essential to the economic well-being of our nation. The soundness and the sustained prosperity of the financial system and our economy rely on the notions of fair dealing, responsibility, and transparency. In our economy, we expect businesses and individuals to pursue profits, at the same time that they produce products and services of quality and conduct themselves well.
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+Unfortunately—as has been the case in past speculative booms and busts—we witnessed an erosion of standards of responsibility and ethics that exacerbated the financial crisis. This was not universal, but these breaches stretched from the ground level to the corporate suites. They resulted not only in significant financial consequences but also in damage to the trust of investors, businesses, and the public in the financial system.
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+For example, our examination found, according to one measure, that the percentage of borrowers who defaulted on their mortgages within just a matter of months after taking a loan nearly doubled from the summer of 2006 to late 2007. This data indicates they likely took out mortgages that they never had the capacity or intention to pay. You will read about mortgage brokers who were paid “yield spread premiums” by lenders to put borrowers into higher-cost loans so they would get bigger fees, often never disclosed to borrowers. The report catalogues the rising incidence of mortgage fraud, which flourished in an environment of collapsing lending standards and lax regulation. The number of suspicious activity reports—reports of possible financial crimes filed by depository banks and their affiliates—related to mortgage fraud grew 20-fold between 1996 and 2005 and then more than doubled again between
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+2005 and 2009. One study places the losses resulting from fraud on mortgage loans made between 2005 and 2007 at \f653112 billion.
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+Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities. As early as September 2004, Countrywide executives recognized that many of the loans they were originating could result in “catastrophic consequences.” Less than a year later, they noted that certain high-risk loans they were making could result not only in foreclosures but also in “financial and reputational catastrophe” for the firm. But they did not stop.
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+And the report documents that major financial institutions ineffectively sampled loans they were purchasing to package and sell to investors. They knew a significant percentage of the sampled loans did not meet their own underwriting standards or those of the originators. Nonetheless, they sold those securities to investors. The Commission’s review of many prospectuses provided to investors found that this critical information was not disclosed.
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+THESE CONCLUSIONS must be viewed in the context of human nature and individual and societal responsibility. First, to pin this crisis on mortal flaws like greed and CONCLUSIONS OF THE FINANCIAL CRISIS INQUIRY COMMISSION xxiii hubris would be simplistic. It was the failure to account for human weakness that is relevant to this crisis.
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+Second, we clearly believe the crisis was a result of human mistakes, misjudgments, and misdeeds that resulted in systemic failures for which our nation has paid dearly. As you read this report, you will see that specific firms and individuals acted irresponsibly. Yet a crisis of this magnitude cannot be the work of a few bad actors, and such was not the case here. At the same time, the breadth of this crisis does not mean that “everyone is at fault”; many firms and individuals did not participate in the excesses that spawned disaster.
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+We do place special responsibility with the public leaders charged with protecting our financial system, those entrusted to run our regulatory agencies, and the chief executives of companies whose failures drove us to crisis. These individuals sought and accepted positions of significant responsibility and obligation. Tone at the top does matter and, in this instance, we were let down. No one said “no.” But as a nation, we must also accept responsibility for what we permitted to occur.
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+Collectively, but certainly not unanimously, we acquiesced to or embraced a system, a set of policies and actions, that gave rise to our present predicament.
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+THIS REPORT DESCRIBES THE EVENTS and the system that propelled our nation toward crisis. The complex machinery of our financial markets has many essential gears—some of which played a critical role as the crisis developed and deepened. Here we render our conclusions about specific components of the system that we believe contributed significantly to the financial meltdown.
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+• We conclude collapsing mortgage-lending standards and the mortgage securitization pipeline lit and spread the flame of contagion and crisis. When housing prices fell and mortgage borrowers defaulted, the lights began to dim on Wall Street.
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+This report catalogues the corrosion of mortgage-lending standards and the securitization pipeline that transported toxic mortgages from neighborhoods across America to investors around the globe.
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+Many mortgage lenders set the bar so low that lenders simply took eager borrowers’ qualifications on faith, often with a willful disregard for a borrower’s ability to pay. Nearly one-quarter of all mortgages made in the first half of 2005 were interest-only loans. During the same year, 68\f642 of “option ARM” loans originated by Countrywide and Washington Mutual had low- or no-documentation requirements.
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+These trends were not secret. As irresponsible lending, including predatory and fraudulent practices, became more prevalent, the Federal Reserve and other regulators and authorities heard warnings from many quarters. Yet the Federal Reserve neglected its mission “to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers.” It failed to build the retaining wall before it was too late. And the Office of the Comptroller of the Currency and the Office of Thrift Supervision, caught up in turf wars, preempted state regulators from reining in abuses.
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+While many of these mortgages were kept on banks’ books, the bigger money came from global investors who clamored to put their cash into newly created mortgage-related securities. It appeared to financial institutions, investors, and regulators alike that risk had been conquered: the investors held highly rated securities they thought were sure to perform; the banks thought they had taken the riskiest loans off their books; and regulators saw firms making profits and borrowing costs reduced. But each step in the mortgage securitization pipeline depended on the next step to keep demand going. From the speculators who flipped houses to the mortgage brokers who scouted the loans, to the lenders who issued the mortgages, to the financial firms that created the mortgage-backed securities, collateralized debt obligations (CDOs), CDOs squared, and synthetic CDOs: no one in this pipeline of toxic mortgages had enough skin in the game. They all believed they could off-load their risks on a moment’s notice to the next person in line. They were wrong. When borrowers stopped making mortgage payments, the losses—amplified by derivatives—rushed through the pipeline. As it turned out, these losses were concentrated in a set of systemically important financial institutions.
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+In the end, the system that created millions of mortgages so efficiently has proven to be difficult to unwind. Its complexity has erected barriers to modifying mortgages so families can stay in their homes and has created further uncertainty about the health of the housing market and financial institutions.
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+• We conclude over-the-counter derivatives contributed significantly to this crisis. The enactment of legislation in 2000 to ban the regulation by both the federal and state governments of over-the-counter (OTC) derivatives was a key turning point in the march toward the financial crisis.
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+From financial firms to corporations, to farmers, and to investors, derivatives have been used to hedge against, or speculate on, changes in prices, rates, or indices or even on events such as the potential defaults on debts. Yet, without any oversight, OTC derivatives rapidly spiraled out of control and out of sight, growing to \f65367\f646 trillion in notional amount. This report explains the uncontrolled leverage; lack of transparency, capital, and collateral requirements; speculation; interconnections among firms; and concentrations of risk in this market.
+
+OTC derivatives contributed to the crisis in three significant ways. First, one type of derivative—credit default swaps (CDS)—fueled the mortgage securitization pipeline. CDS were sold to investors to protect against the default or decline in value of mortgage-related securities backed by risky loans. Companies sold protection—to the tune of \f65379 billion, in AIG’s case—to investors in these newfangled mortgage securities, helping to launch and expand the market and, in turn, to further fuel the housing bubble.
+
+Second, CDS were essential to the creation of synthetic CDOs. These synthetic CDOs were merely bets on the performance of real mortgage-related securities. They amplified the losses from the collapse of the housing bubble by allowing multiple bets on the same securities and helped spread them throughout the financial system.
+
+Goldman Sachs alone packaged and sold \f6537\f646 billion in synthetic CDOs from July 1, CONCLUSIONS OF THE FINANCIAL CRISIS INQUIRY COMMISSION xxv
+
+2004, to May \f6461, 2007. Synthetic CDOs created by Goldman referenced more than
+
+\f646,400 mortgage securities, and 610 of them were referenced at least twice. This is apart from how many times these securities may have been referenced in synthetic CDOs created by other firms.
+
+Finally, when the housing bubble popped and crisis followed, derivatives were in the center of the storm. AIG, which had not been required to put aside capital reserves as a cushion for the protection it was selling, was bailed out when it could not meet its obligations. The government ultimately committed more than \f653180 billion because of concerns that AIG’s collapse would trigger cascading losses throughout the global financial system. In addition, the existence of millions of derivatives contracts of all types between systemically important financial institutions—unseen and unknown in this unregulated market—added to uncertainty and escalated panic, helping to precipitate government assistance to those institutions.
+
+• We conclude the failures of credit rating agencies were essential cogs in the wheel of financial destruction. The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms.
+
+In our report, you will read about the breakdowns at Moody’s, examined by the Commission as a case study. From 2000 to 2007, Moody’s rated nearly 45,000
+
+mortgage-related securities as triple-A. This compares with six private-sector companies in the United States that carried this coveted rating in early 2010. In 2006
+
+alone, Moody’s put its triple-A stamp of approval on \f6460 mortgage-related securities every working day. The results were disastrous: 8\f646\f642 of the mortgage securities rated triple-A that year ultimately were downgraded.
+
+You will also read about the forces at work behind the breakdowns at Moody’s, including the flawed computer models, the pressure from financial firms that paid for the ratings, the relentless drive for market share, the lack of resources to do the job despite record profits, and the absence of meaningful public oversight. And you will see that without the active participation of the rating agencies, the market for mortgage-related securities could not have been what it became.
+
+
+
+* * *
+
+THERE ARE MANY COMPETING VIEWS as to the causes of this crisis. In this regard, the Commission has endeavored to address key questions posed to us. Here we discuss three: capital availability and excess liquidity, the role of Fannie Mae and Freddie Mac (the GSEs), and government housing policy. First, as to the matter of excess liquidity: in our report, we outline monetary policies and capital flows during the years leading up to the crisis. Low interest rates, widely available capital, and international investors seeking to put their money in real xxvi
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+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+estate assets in the United States were prerequisites for the creation of a credit bubble.
+
+Those conditions created increased risks, which should have been recognized by market participants, policy makers, and regulators. However, it is the Commission’s conclusion that excess liquidity did not need to cause a crisis. It was the failures outlined above—including the failure to effectively rein in excesses in the mortgage and financial markets—that were the principal causes of this crisis. Indeed, the availability of well-priced capital—both foreign and domestic—is an opportunity for economic expansion and growth if encouraged to flow in productive directions.
+
+Second, we examined the role of the GSEs, with Fannie Mae serving as the Commission’s case study in this area. These government-sponsored enterprises had a deeply flawed business model as publicly traded corporations with the implicit backing of and subsidies from the federal government and with a public mission. Their
+
+\f6535 trillion mortgage exposure and market position were significant. In 2005 and
+
+2006, they decided to ramp up their purchase and guarantee of risky mortgages, just as the housing market was peaking. They used their political power for decades to ward off effective regulation and oversight—spending \f653164 million on lobbying from
+
+1999 to 2008. They suffered from many of the same failures of corporate governance and risk management as the Commission discovered in other financial firms.
+
+Through the third quarter of 2010, the Treasury Department had provided \f653151 billion in financial support to keep them afloat.
+
+We conclude that these two entities contributed to the crisis, but were not a primary cause. Importantly, GSE mortgage securities essentially maintained their value throughout the crisis and did not contribute to the significant financial firm losses that were central to the financial crisis.
+
+The GSEs participated in the expansion of subprime and other risky mortgages, but they followed rather than led Wall Street and other lenders in the rush for fool’s gold. They purchased the highest rated non-GSE mortgage-backed securities and their participation in this market added helium to the housing balloon, but their purchases never represented a majority of the market. Those purchases represented 10.5\f642
+
+of non-GSE subprime mortgage-backed securities in 2001, with the share rising to
+
+40\f642 in 2004, and falling back to 28\f642 by 2008. They relaxed their underwriting standards to purchase or guarantee riskier loans and related securities in order to meet stock market analysts’ and investors’ expectations for growth, to regain market share, and to ensure generous compensation for their executives and employees—justifying their activities on the broad and sustained public policy support for homeownership.
+
+The Commission also probed the performance of the loans purchased or guaranteed by Fannie and Freddie. While they generated substantial losses, delinquency rates for GSE loans were substantially lower than loans securitized by other financial firms. For example, data compiled by the Commission for a subset of borrowers with similar credit scores—scores below 660—show that by the end of 2008, GSE mortgages were far less likely to be seriously delinquent than were non-GSE securitized mortgages: 6.2\f642 versus 28.\f646\f642.
+
+We also studied at length how the Department of Housing and Urban Development’s (HUD’s) affordable housing goals for the GSEs affected their investment in CONCLUSIONS OF THE FINANCIAL CRISIS INQUIRY COMMISSION xxvii risky mortgages. Based on the evidence and interviews with dozens of individuals involved in this subject area, we determined these goals only contributed marginally to Fannie’s and Freddie’s participation in those mortgages.
+
+Finally, as to the matter of whether government housing policies were a primary cause of the crisis: for decades, government policy has encouraged homeownership through a set of incentives, assistance programs, and mandates. These policies were put in place and promoted by several administrations and Congresses—indeed, both Presidents Bill Clinton and George W. Bush set aggressive goals to increase homeownership.
+
+In conducting our inquiry, we took a careful look at HUD’s affordable housing goals, as noted above, and the Community Reinvestment Act (CRA). The CRA was enacted in 1977 to combat “redlining” by banks—the practice of denying credit to individuals and businesses in certain neighborhoods without regard to their creditworthiness. The CRA requires banks and savings and loans to lend, invest, and provide services to the communities from which they take deposits, consistent with bank safety and soundness.
+
+The Commission concludes the CRA was not a significant factor in subprime lending or the crisis. Many subprime lenders were not subject to the CRA. Research indicates only 6\f642 of high-cost loans—a proxy for subprime loans—had any connection to the law. Loans made by CRA-regulated lenders in the neighborhoods in which they were required to lend were half as likely to default as similar loans made in the same neighborhoods by independent mortgage originators not subject to the law.
+
+Nonetheless, we make the following observation about government housing policies—they failed in this respect: As a nation, we set aggressive homeownership goals with the desire to extend credit to families previously denied access to the financial markets. Yet the government failed to ensure that the philosophy of opportunity was being matched by the practical realities on the ground. Witness again the failure of the Federal Reserve and other regulators to rein in irresponsible lending. Homeownership peaked in the spring of 2004 and then began to decline. From that point on, the talk of opportunity was tragically at odds with the reality of a financial disaster in the making.
+
+
+
+* * *
+
+WHEN THIS COMMISSION began its work 18 months ago, some imagined that the events of 2008 and their consequences would be well behind us by the time we issued this report. Yet more than two years after the federal government intervened in an unprecedented manner in our financial markets, our country finds itself still grappling with the aftereffects of the calamity. Our financial system is, in many respects, still unchanged from what existed on the eve of the crisis. Indeed, in the wake of the crisis, the U.S. financial sector is now more concentrated than ever in the hands of a few large, systemically significant institutions. While we have not been charged with making policy recommendations, the very purpose of our report has been to take stock of what happened so we can plot a new course. In our inquiry, we found dramatic breakdowns of corporate governance, xxviii
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+profound lapses in regulatory oversight, and near fatal flaws in our financial system.
+
+We also found that a series of choices and actions led us toward a catastrophe for which we were ill prepared. These are serious matters that must be addressed and resolved to restore faith in our financial markets, to avoid the next crisis, and to rebuild a system of capital that provides the foundation for a new era of broadly shared prosperity.
+
+The greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done. If we accept this notion, it will happen again.
+
+This report should not be viewed as the end of the nation’s examination of this crisis. There is still much to learn, much to investigate, and much to fix.
+
+This is our collective responsibility. It falls to us to make different choices if we want different results.
+
+
+
+
+
+PART I
+
+
+Crisis on the Horizon
+
+
+
+
+
+1
+
+BEFORE OUR VERY EYES
+
+In examining the worst financial meltdown since the Great Depression, the Financial Crisis Inquiry Commission reviewed millions of pages of documents and questioned hundreds of individuals—financial executives, business leaders, policy makers, regulators, 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 Inc., called the collapse in housing prices “wholly unanticipated.”1 Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway Inc., which until 2009
+
+was the largest single shareholder of Moody’s Corporation, told the Commission that “very, very few people could appreciate the bubble,” which he called a “mass delusion” shared by “\f64600 million Americans.”2 Lloyd Blankfein, the chairman and chief executive officer of Goldman Sachs Group, Inc., likened the financial crisis to a hurricane.\f646
+
+Regulators echoed a similar refrain. Ben Bernanke, the chairman of the Federal Reserve Board 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.”4 Alan Greenspan, the 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.”5
+
+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
+
+\f646
+
+
+
+4
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+were clanging inside financial institutions, regulatory offices, consumer service organizations, state law enforcement agencies, and corporations throughout America, as well as in neighborhoods across the country. Many knowledgeable executives saw trouble and managed to avoid the train wreck. While countless Americans joined in the financial euphoria that seized the nation, many others were shouting to government officials in Washington and within state legislatures, pointing to 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, the 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.”6
+
+Paul 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; they therefore 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 asserted, and they shared what they had learned when they got back home to the company’s Newport Beach, California, 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.7
+
+Veteran bankers, particularly those who remembered the savings and loan crisis, knew that age-old rules of prudent lending had been cast aside. Arnold Cattani, the chairman of Bakersfield, California–based Mission Bank, told the Commission that he grew uncomfortable with the “pure lunacy” he saw in the local home-building market, fueled by “voracious” Wall Street investment banks; he thus opted out of certain kinds of investments by 2005.8
+
+William Martin, the 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. “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 said.9
+
+Unlike so many other bubbles—tulip bulbs in Holland in the 1600s, South Sea stocks in the 1700s, Internet stocks in the late 1990s—this one involved not just another commodity but a building block of community and social life and a corner-stone of the economy: the family home. Homes are the foundation upon which many 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.
+
+
+
+BEFORE OUR VERY EYES 5
+
+When the Federal Reserve cut interest rates early in the new century and mortgage rates fell, home refinancing surged, climbing from \f653460 billion in 2000 to \f6532.8
+
+trillion in 200\f646,10 allowing people to withdraw equity built up over previous decades and to consume more, despite stagnant wages. Home sales volume started to increase, and average home prices nationwide climbed, rising 67\f642 in eight years by one measure and hitting a national high of \f653227,100 in early 2006.11 Home prices in many areas skyrocketed: prices increased nearly two and one-half times in Sacramento, for example, in just five years,12 and shot up by about the same percentage in Bakersfield, Miami, and Key West. Prices about doubled in more than 110 metropolitan areas, including Phoenix, Atlantic City, Baltimore, Ft. Lauderdale, Los Angeles, Poughkeepsie, San Diego, and West Palm Beach.1\f646 Housing starts nationwide climbed 5\f646\f642, from 1.4 million in 1995 to more than 2 million in 2005. Encouraged by government policies, homeownership reached a record 69.2\f642 in the spring of
+
+2004, 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
+
+\f6532.0 trillion in home equity between 2000 and 2007, including \f653\f646\f6464 billion in 2006
+
+alone, more than seven times the amount they took out in 1996.14 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. By the first half of 2005, more than one out of every ten home sales was to an investor, speculator, or someone buying a second home.15 Bigger was better, and even the structures themselves ballooned in size; the floor area of an average new home grew by 15\f642, to 2,277 square feet, in the decade from 1997 to 2007.
+
+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 share prices of the most aggressive financial service firms reached all-time highs.16 Homeowners pulled cash out of their homes to send their kids to college, pay medical bills, install designer kitchens with granite counters, take vacations, or launch new businesses. They also paid off credit cards, even as personal debt rose nationally. Survey evidence shows that about 5\f642 of homeowners pulled out cash to buy a vehicle and over 40\f642 spent the cash on a catch-all category including tax payments, clothing, gifts, and living expenses.17 Renters used new forms of loans to buy homes and to move to suburban subdivisions, erect-ing swing sets in their backyards and enrolling their children in local schools.
+
+In an interview with the Commission, Angelo Mozilo, the longtime 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 \f65350,000 . . . and talk at a cocktail party about it. . . . Housing suddenly went from being part of the American dream to house my family to settle
+
+
+
+6
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+down—it became a commodity. That was a change in the culture. . . . It was sudden, unexpected.”18
+
+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 in which ordinary household objects turn hostile, familiar market mechanisms were being transformed. The time-tested \f6460-year fixed-rate mortgage, with a 20\f642 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 multi-million-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, some 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 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 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, a managing director and financial services analyst at Calyon Securities (USA) Inc. “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.”19
+
+The securitization machine began to guzzle these once-rare mortgage products with their strange-sounding names: Alt-A, subprime, I-O (interest-only), low-doc, no-doc, or ninja (no income, no job, no assets) loans; 2–28s and \f646–27s; liar loans; piggyback second mortgages; payment-option or pick-a-pay adjustable rate mortgages. New variants on adjustable-rate mortgages, 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 a multitude of different kinds of mortgages available on the market, confounding consumers who didn’t examine the fine print, baffling BEFORE OUR VERY EYES 7
+
+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 mid-2005, nearly one-quarter of all borrowers nationwide were taking out interest-only loans that allowed them to defer the payment of principal.20 Some borrowers opted for nontraditional mortgages because that was the only way they could get a foothold in areas such as the sky-high California housing market.21 Some speculators saw the chance to snatch up investment properties and flip them for profit—and Florida and Georgia became a particular target for investors who used these loans to acquire real estate.22 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 in safe ones.2\f646 With these loans, buyers were able to bid up the prices of houses even if they didn’t have enough income to qualify for traditional loans.
+
+Some of these exotic loans had existed in the past, used by 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 stronger payment history before they refinanced. But the instruments began to deluge the larger market in 2004 and 2005. The changed occurred “almost overnight,” Faith Schwartz, then an executive at the subprime lender Option One and later the executive director of Hope Now, a lending-industry foreclosure relief group, told the Federal Reserve’s Consumer Advisory Council. “I would suggest most every lender in the country is in it, one way or another.”24
+
+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. But it soon became apparent that what had looked like newfound wealth was a mirage based on borrowed money. Overall mortgage indebtedness in the United States climbed from \f6535.\f646 trillion in 2001 to \f65310.5 trillion in 2007. The mortgage debt of American households rose almost as much in the six years 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 \f65391,500 in 2001 to \f653149,500 in 2007.25 With a simple flourish of a pen on 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 because of the growth of securitization, it wasn’t even clear anymore who the lender was. The mortgages would be packaged, sliced, repackaged, insured, and sold as incomprehensibly complicated debt securities to an assortment 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 companies that were expanding mortgage originations. He crisscrossed the nation, coaching about 10,000 loan originators a year in auditoriums and classrooms.
+
+
+
+8
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+His clients included many of the largest lenders—Countrywide, Ameriquest, and Ditech among them. Most of their new hires were young, with no mortgage experience, fresh out of school and with previous jobs “flipping burgers,” he told the FCIC.
+
+Given the right training, however, the best of them could “easily” earn millions.26
+
+“I was a sales and marketing trainer in terms of helping people to know how to sell these products to, in some cases, frankly 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 added, “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.”27
+
+On Wall Street, where many of these loans were packaged into securities and sold to investors around the globe, a new term was coined: IBGYBG, “I’ll be gone, you’ll be gone.”28 It referred to deals that brought in big fees up front while risking much larger losses in the future. And, for a long time, IBGYBG worked at every level.
+
+Most home loans entered the pipeline soon after borrowers signed the documents and picked up their keys. Loans were put into packages and sold off in bulk to securitization firms—including investment banks such as Merrill Lynch, Bear Stearns, and Lehman Brothers, and commercial banks and thrifts such as Citibank, Wells Fargo, and Washington Mutual. The firms would package the loans into residential mortgage–backed securities that would mostly be stamped with triple-A ratings by the credit rating agencies, and sold to investors. In many cases, the securities were repackaged again into collateralized debt obligations (CDOs)—often composed of the riskier portions of these securities—which would then be sold to other investors. Most 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 (CDS) to protect against the securities’ defaulting. For every buyer of a credit default swap, there was a seller: as these investors made opposing bets, the layers of entanglement in the securities market increased.
+
+The instruments grew more and more complex; CDOs were constructed out of CDOs, creating CDOs squared. When firms ran out of real product, they started generating cheaper-to-produce synthetic CDOs—composed not of real mortgage securities but just of 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—even well after the market had started to turn. So by the time the process was complete, a mortgage on a home in south Florida might become part of dozens of securities owned by hundreds of investors—or parts of bets being made by hundreds more. Treasury Secretary Timothy Geithner, the president of the New York Federal Reserve Bank during the crisis, described the resulting product as “cooked spaghetti” that became hard to “untangle.”29
+
+Ralph Cioffi spent several years creating CDOs for Bear Stearns and a couple of more years on the repurchase or “repo” desk, which was responsible for borrowing BEFORE OUR VERY EYES 9
+
+money every night to finance Bear Stearns’s broader securities portfolio. In September 200\f646, Cioffi created a hedge fund within Bear Stearns with a minimum investment of \f6531 million. As was common, he used borrowed money—up to \f6539 borrowed for every \f6531 from investors—to buy CDOs. Cioffi’s first fund was extremely successful; it earned 17\f642 for investors in 2004 and 10\f642 in 2005—after the annual management fee and the 20\f642 slice of the profit for Cioffi and his Bear Stearns team—and grew to almost \f6539 billion by the end of 2005. In the fall of 2006, he created another, more aggressive fund. This one would shoot for leverage of up to 12 to 1. By the end of 2006, the two hedge funds had \f65318 billion invested, half in securities issued by CDOs centered on housing. As a CDO manager, Cioffi also managed another \f65318 billion of mortgage-related CDOs for other investors.
+
+Cioffi’s investors and others like them wanted high-yielding mortgage securities.
+
+That, in turn, required high-yielding mortgages. An advertising barrage bombarded potential borrowers, urging them to buy or refinance homes. Direct-mail solicita-tions flooded people’s mailboxes.\f6460 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: One percent loan! (But only for the first year.) No money down! (Leaving no equity if home prices fell.) No income documentation needed! (Mortgages soon dubbed “liar loans” by the industry itself.) 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, efforts to boost homeownership had broad political support—from Presidents Bill Clinton and George W. Bush and successive Congresses—even though in reality the homeownership rate had peaked in the spring of 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 at a time when performance in other sectors of the economy was 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 mortgage market began its transformation in the late 1990s, consumer advocates and front-line local government officials were among the first to spot the changes: homeowners began streaming into their offices to seek help in dealing with mortgages they could not afford to pay. They began raising the issue with the Federal Reserve and other banking regulators.\f6461 Bob Gnaizda, the general counsel and policy director of the Greenlining Institute, a California-based nonprofit housing group, told the Commission that he began meeting with Greenspan at least once a year starting in 1999, each time highlighting to him the growth of predatory lending practices and discussing with him the social and economic problems they were creating.\f6462
+
+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\f642, climbing from a median of \f65375,200 to \f653125,100, while home prices nationally rose about
+
+49\f642 in those same years; at the same time, the city’s unemployment rate, ranging
+
+
+
+10
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+from 5.8\f642 in 1990 to 4.2\f642 in 1999, more or less tracked the broader U.S. pattern.
+
+James Rokakis, the longtime county 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 \f646,500 a year in 1995 to 7,000 a year in 2000.\f646\f646 Rokakis and other public officials watched as families who had lived for years in modest residences lost their homes. After they were gone, many homes were ultimately abandoned, vandalized, and then stripped bare, as scavengers ripped away their copper pipes and aluminum siding to sell for scrap.
+
+“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.”\f6464
+
+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 the 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 Edward 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.”\f6465
+
+Looking back, Rokakis remarked to 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.”\f6466
+
+In 2000, when Cleveland was looking for help from the federal government, other cities around the country were doing the same. John Taylor, the president of the National Community Reinvestment Coalition, with the support of community leaders from Nevada, Michigan, Maryland, Delaware, Chicago, Vermont, North Carolina, New Jersey, and Ohio, went to the Office of Thrift Supervision (OTS), which regulated 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.\f6467
+
+The California Reinvestment Coalition, a nonprofit housing group based in Northern California, also begged regulators to act, CRC officials told the Commission. The nonprofit group had reviewed the loans of 125 borrowers and discovered that many individuals were being placed into high-cost loans when they qualified for better mortgages and that many had been misled about the terms of their loans.\f6468
+
+
+
+BEFORE OUR VERY EYES 11
+
+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.\f6469 In December 2001, the Federal Reserve Board used the HOEPA law to amend some regulations; among the changes were new rules aimed at limiting high-interest lending and preventing multiple refinancings over a short period of time, if they were not in the borrower’s best interest.40 As it would turn out, those rules covered only 1\f642 of subprime loans. FDIC Chairman Sheila C. Bair, then an assistant treasury secretary in the administration of President George W. Bush, characterized the action to the FCIC as addressing only a “narrow range of predatory lending issues.”41 In 2002, Gramlich noted again the “increasing reports of abusive, unethical and in some cases, illegal, lending practices.”42
+
+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.4\f646 She said that she and Gramlich considered seeking rules to rein in the growth of these kinds of loans, but Gramlich told her that he thought the Fed, despite its broad powers in this area, would not support the effort. Instead, they sought voluntary rules for lenders, but that effort fell by the wayside as well.44
+
+In an environment of 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, the top 25
+
+nonprime lenders originated \f653105 billion in loans. Their volume rose to \f653188 billion in 2002, and then \f653\f64610 billion in 200\f646.45
+
+California, with its high housing costs, was a particular hotbed for this kind of lending. In 2001, nearly \f65352 billion, or 25\f642 of all nontraditional loans nationwide, were made in that state; California’s share rose to \f6465\f642 by 200\f646, with these kinds of loans growing to \f65395 billion or by 84\f642 in California in just two years.46 In those years, “subprime and option ARM loans saturated California communities,” Kevin Stein, the 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 \f653600 more per month on their mortgage payment as a result of having received the subprime loan.”47
+
+Gail Burks, president and CEO of Nevada Fair Housing, Inc., a Las Vegas–based housing clinic, told the Commission she and other groups took their 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 besides predatory lending practices such as flipping loans or misinforming seniors about reverse mortgages, she also witnessed examples of growing sloppiness in paperwork: not crediting payments appropriately or miscalculating accounts.48
+
+Lisa Madigan, the attorney general in Illinois, also spotted the emergence of a troubling trend. She joined state attorneys general from Minnesota, California, Washington, Arizona, Florida, New York, and Massachusetts in pursuing allegations
+
+
+
+12
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+about First Alliance Mortgage Company, a California-based mortgage lender. Consumers complained that they had been deceived into taking out 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, and borrowers received \f65350
+
+million. First Alliance went out of business. But other firms stepped into the void.49
+
+State officials from around the country joined together again in 200\f646 to investigate another fast-growing lender, California-based Ameriquest. It became the nation’s largest subprime lender, originating \f653\f6469 billion in subprime loans in
+
+200\f646—mostly refinances that let borrowers take cash out of their homes, but with hefty fees that ate away at their equity.50 Madigan testified to the FCIC, “Our multi-state 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.”51
+
+Ed Parker, the former head of Ameriquest’s Mortgage Fraud Investigations Department, told the Commission that he detected fraud at the company within one month of starting his job there in January 200\f646, but senior management did nothing with the reports he sent. He heard that other departments were complaining he
+
+“looked too much” into the loans. In November 2005, he was downgraded from
+
+“manager” to “supervisor,” and was laid off in May 2006.52
+
+In late 200\f646, Prentiss Cox, then a 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 “an-tiques dealers”—in his view, a blatant misrepresentation of employment. In another loan file, he recalled in an interview with the FCIC, a disabled borrower in his 80s who used a walker was described in the loan application as being employed in
+
+“light construction.”5\f646
+
+“It didn’t take Sherlock Holmes to figure out this was bogus,” Cox told the Commission. As he tried to figure out why Ameriquest would make such obviously fraudulent loans, a friend suggested that he “look upstream.” Cox suddenly realized that the lenders were simply generating product to ship to Wall Street to sell to investors.
+
+“I got that it had shifted,” Cox recalled. “The lending pattern had shifted.”54
+
+Ultimately, 49 states and the District of Columbia joined in the lawsuit against Ameriquest, on behalf of “more than 240,000 borrowers.” The result was a \f653\f64625 million settlement. But during the years when the investigation was under way, between
+
+2002 and 2005, Ameriquest originated another \f653217.9 billion in loans,55 which then flowed to Wall Street for securitization.
+
+Although the federal government played no role in the Ameriquest investigation, some federal officials said they had followed the case. At the Department of Housing and Urban Development, “we began to get rumors” that other firms were “running BEFORE OUR VERY EYES 1\f646
+
+wild, taking applications over the Internet, not verifying peoples’ income or their ability to have a job,” recalled Alphonso Jackson, the HUD 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 much of the blame on Congress.56
+
+Cox, the former Minnesota prosecutor, and Madigan, the Illinois attorney general, told the Commission that one of the single biggest obstacles to effective state regulation of unfair lending came from the federal government, particularly the Office of the Comptroller of the Currency (OCC), which regulated nationally chartered banks—including Bank of America, Citibank, and Wachovia—and the OTS, which regulated nationally chartered thrifts. The OCC and OTS issued rules preempting states from enforcing rules against national banks and thrifts.57 Cox recalled that in
+
+2001, Julie Williams, the chief counsel of the OCC, had delivered what he called a
+
+“lecture” to the states’ attorneys general, in a meeting in Washington, warning them that the OCC would “quash” them if they persisted in attempting to control the consumer practices of nationally regulated institutions.58
+
+Two former OCC comptrollers, John Hawke and John Dugan, told the Commission that they were defending the agency’s constitutional obligation to block state efforts to impinge on federally created entities. Because state-chartered lenders had more lending problems, they said, the states should have been focusing there rather than looking to involve themselves in federally chartered institutions, an arena where they had no jurisdiction.59 However, 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.”60
+
+Many states nevertheless pushed ahead in enforcing their own lending regulations, as did some cities. In 200\f646, Charlotte, North Carolina–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 5–\f646 in Wachovia’s favor on April 17, 2007, leaving the OCC its sole regulator for mortgage lending. Cox criticized the federal government: “Not only were they negligent, they were aggressive players attempting to stop any enforcement action[s]. . . . Those guys should have been on our side.”61
+
+Nonprime lending surged to \f6537\f6460 billion in 2004 and then \f6531.0 trillion in 2005, and its impact began to be felt in more and more places.62 Many of those loans were funneled into the pipeline by mortgage brokers—the link between borrowers and the lenders who financed the mortgages—who prepared the paperwork for loans and earned fees from lenders for doing it. More than 200,000 new mortgage brokers
+
+
+
+14
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+began their jobs during the boom, and some were less than honorable in their dealings with borrowers.6\f646 According to an investigative news report published in 2008, between 2000 and 2007, at least 10,500 people with criminal records entered the field in Florida, for example, including 4,065 who had previously been convicted of such crimes as fraud, bank robbery, racketeering, and extortion.64 J. Thomas Cardwell, the commissioner of the Florida Office of Financial Regulation, told the Commission that “lax lending standards” and a “lack of accountability . . . created a condition in which fraud flourished.”65 Marc S. Savitt, a 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, about 50,000 of the newcomers to the field nationwide were willing to do whatever it took to maximize the number of loans they made. He added that some loan origination firms, such as Ameriquest, were “absolutely” corrupt.66
+
+In Bakersfield, California, where home starts doubled and home values grew even faster between 2001 and 2006, the 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 oil industry center in the San Joaquin Valley, was drawing national attention for the pace of its development.
+
+Wide-open farm fields were plowed under and divided into thousands of building lots. Home prices jumped 11\f642 in Bakersfield in 2002, 17\f642 in 200\f646, \f6462\f642 in 2004, and 29\f642 more in 2005.
+
+Crabtree, an appraiser for 48 years, started in 200\f646 and 2004 to think 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, when he passed some of these same houses, he saw that they were vacant. “For sale” signs appeared on the front lawns. And when he passed again, 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 began studying the market. In 2006, he ended up identifying what he believed were 214 fraudulent transactions in Bakersfield; some, for instance, were allowing insiders to siphon cash from each property transfer. The transactions involved many of the nation’s largest lenders. One house, for example, was listed for sale for \f653565,000, and was recorded as selling for \f653605,000 with 100\f642 financing, though the real estate agent told Crabtree that it actually sold for \f6535\f6465,000. Crabtree realized that the gap between the sales price and loan amount allowed these insiders to pocket \f65370,000. The terms of the loan required the buyer to occupy the house, but it was never occupied. The house went into foreclosure and was sold in a distress sale for \f653\f64622,000.67
+
+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 BEFORE OUR VERY EYES 15
+
+Investment & Loan, the nation’s eighth-largest subprime lender. “Don’t put your nose where it doesn’t belong,” he was told.68
+
+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. He grew infuriated at the slow pace of enforcement and at prosecutors’ lack of response to a problem that was wreaking economic havoc in Bakersfield.69
+
+At the Washington, D.C., 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.”70
+
+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 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.”71
+
+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 (FinCEN), a bureau within the Treasury Department. In November 2006, the network published an analysis that found a 20-fold increase in mortgage fraud reports between 1996 and 2005. According to FinCEN, 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.72 In addition, many lenders who were required to submit reports did not in fact do so.7\f646
+
+“The claim that no one could have foreseen the crisis is false,” said William K.
+
+Black, an expert on white-collar crime and a former staff director of the National Commission on Financial Institution Reform, Recovery and Enforcement, created by Congress in 1990 as the savings and loan crisis was unfolding.74
+
+Former attorney general Alberto Gonzales, who served from February 2005 to
+
+2007, told the FCIC he could not remember the press conferences or news reports about mortgage fraud. Both Gonzales and his successor Michael Mukasey, who served as attorney general in 2007 and 2008, told the FCIC that mortgage fraud had never been communicated to them as a top priority. “National security . . . was an overriding” concern, Mukasey said.75
+
+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—she specified Bear Stearns and Lehman Brothers—were producing such bad loans that the very survival of the firms was put in question. “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
+
+
+
+16
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+quality of the firms’ due diligence; otherwise, she said, serious questions could arise about whether they could be forced to buy back bad loans that they had made or securitized.76
+
+Maker told the board that she feared an “enormous economic impact” could result from a confluence of financial events: flat or declining incomes, a housing bubble, and fraudulent loans with overstated values.77
+
+In an interview with the FCIC, Maker said that Fed officials seemed impervious to what the consumer advocates were saying. The Fed governors politely listened and said little, she recalled. “They had their economic models, and their economic models did not see this coming,” she said. “We kept getting back, ‘This is all anecdotal.’”78
+
+Soon nontraditional mortgages were crowding other kinds of products out of the market in many parts of the country. More mortgage borrowers nationwide took out interest-only loans, and the trend was far more pronounced on the West and East Coasts.79 Because of their easy credit terms, nontraditional loans enabled 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 appeared soon after.
+
+As home prices shot up in much of the country, many observers began to wonder if the country was witnessing a housing bubble. On June 18, 2005, the Economist magazine’s cover story posited that the day of reckoning was at hand, with the headline “House Prices: After the Fall.” The illustration depicted a brick plummeting out of the sky. “It is not going to be pretty,” the article declared. “How the current housing boom ends could decide the course of the entire world economy over the next few years.”80
+
+That same month, 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.”81 For years, he had warned that Fannie Mae and Freddie Mac, bolstered by investors’ belief that these institutions had the backing of the U.S. government, were growing so large, with so little oversight, that they were creating systemic risks for the financial system. 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 testified in June.
+
+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 likely BEFORE OUR VERY EYES 17
+
+that financial intermediation would be impaired than was the case in prior episodes of regional house price corrections.82
+
+Indeed, Greenspan would not be the only one confident that a housing downturn would leave the broader financial system largely unscathed. As late as March 2007, after housing prices had been declining for a year, Bernanke testified to Congress that
+
+“the problems in the subprime market were likely to be contained”—that is, he expected little spillover to the broader economy.8\f646
+
+Some were less sanguine. For example, the consumer lawyer Sheila Canavan, of Moab, Utah, informed the Fed’s Consumer Advisory Council in October 2005 that
+
+61\f642 of recently originated loans in California were interest-only, a proportion that was 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.”84
+
+On another front, some academics offered pointed analyses as they raised alarms.
+
+For example, in August 2005, the Yale professor Robert Shiller, who along with Karl Case developed the Case-Shiller Index, charted home prices to illustrate how precipitously they had climbed and how distorted the market appeared in historical terms.
+
+Shiller warned that the housing bubble would likely burst.85
+
+In that same month, a conclave of economists gathered at Jackson Lake Lodge in Wyoming, in a conference center nestled in Grand Teton National Park. It was a
+
+“who’s who of central bankers,” recalled Raghuram Rajan, who was then on leave from the University of Chicago’s business school while serving as the chief economist of the International Monetary Fund. Greenspan was there, and so was Bernanke.
+
+Jean-Claude Trichet, the president of the European Central Bank, and Mervyn King, the governor of the Bank of England, were among the other dignitaries.86
+
+Rajan presented a paper with a provocative title: “Has Financial Development Made the World Riskier1” He posited that executives were being overcompensated for short-term gains but let off the hook for any eventual losses—the IBGYBG syn-drome. Rajan added that investment strategies such as credit default swaps could have disastrous consequences if the system became unstable, and that regulatory institutions might be unable to deal with the fallout.87
+
+He recalled to the FCIC that he was treated with scorn. Lawrence Summers, a former U.S. treasury secretary who was then president of Harvard University, called Rajan a “Luddite,” implying that he was simply opposed to technological change.88 “I felt like an early Christian who had wandered into a convention of half-starved lions,” Rajan wrote later.89
+
+Susan M. Wachter, a professor of real estate and finance at the University of Pennsylvania’s Wharton School, prepared a research paper in 200\f646 suggesting that the United States could have a real estate crisis similar to that suffered in Asia in the
+
+1990s. When she discussed her work at another Jackson Hole gathering two years later, it received a chilly reception, she told the Commission. “It was universally panned,” she said, and an economist from the Mortgage Bankers Association called it
+
+“absurd.”90
+
+
+
+18
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+In 2005, news reports were beginning to highlight indications that the real estate market was weakening. Home sales began to drop, and Fitch Ratings reported signs that mortgage delinquencies were rising. That year, the hedge fund manager Mark Klipsch 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 added. He said he was unnerved because people were saying, “It’s different this time”—a rationale commonly heard before previous collapses.91
+
+Some real estate appraisers had also been expressing concerns for years. From
+
+2000 to 2007, a coalition of appraisal organizations circulated and ultimately delivered to Washington officials a public petition; signed by 11,000 appraisers and including the name and address of each, it charged that lenders were pressuring appraisers to place artificially high prices on properties. According to the petition, lenders were “blacklisting honest appraisers” and instead assigning business only to appraisers who would hit the desired price targets. “The powers that be cannot claim ignorance,” the appraiser Dennis J. Black of Port Charlotte, Florida, testified to the Commission.92
+
+The 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. The steep hike in home prices and the un-merited and inflated appraisals she was seeing in Northern California convinced her that the housing industry was headed for a cataclysmic downturn. In 2005, she laid off some of her staff in order to cut her overhead expenses, in anticipation of the coming storm; two years later, she shut down her office and began working out of her home.9\f646
+
+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, a combination that spelled trouble for mortgage-backed securities. But from the third quarter of 2006 on, banks created and sold some \f6531.\f646
+
+trillion in mortgage-backed securities and more than \f653\f64650 billion in mortgage-related CDOs.94
+
+Not everyone on Wall Street kept applauding, however. Some executives were urging caution, as corporate governance and risk management were breaking down.
+
+Reflecting on the causes of the crisis, Jamie Dimon, CEO of JP Morgan testified to the FCIC, “I blame the management teams 100\f642 and . . . no one else.”95
+
+At too many financial firms, management brushed aside the growing risks to their firms. At Lehman Brothers, for example, Michael Gelband, the head of fixed income, and his colleague Madelyn Antoncic warned against taking on too much risk in the face of growing pressure to compete aggressively against other investment banks. Antoncic, who was the firm’s chief risk officer 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 with gov-BEFORE OUR VERY EYES 19
+
+ernment 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, received a promotion in early 2006 when he was named business chief under writer. He would go on to oversee loan quality for over \f65390 billion a year of mortgages underwritten and purchased by CitiFinancial. These mortgages were sold to Fannie Mae, Freddie Mac, and others. In June 2006, Bowen discovered that as much as 60\f642 of the loans that Citi was buying were defective. They did not meet Citi -
+
+group’s loan guidelines and thus endangered the company—if the borrowers were to default on their loans, the investors could force Citi to buy them back. Bowen told the Commission that he tried to alert top managers at the firm by “email, weekly reports, committee presentations, and discussions”; but though they expressed concern, it
+
+“never translated into any action.” Instead, he said, “there was a considerable push to build volumes, to increase market share.” Indeed, Bowen recalled, Citi began to loosen its own standards during these years up to 2005: specifically, it started to purchase stated-income loans. “So we joined the other lemmings headed for the cliff,” he said in an interview with the FCIC.98
+
+He finally took his warnings to the highest level he could reach—Robert Rubin, the chairman of the Executive Committee of the Board of Directors and a former U.S. treasury secretary in the Clinton administration, and three other bank officials.
+
+He sent Rubin and the others a memo with the words “URGENT—READ IMMEDIATELY” in the subject line. Sharing his concerns, he stressed to top managers that Citi faced billions of dollars in losses if investors were to demand that Citi repurchase the defective loans.99
+
+Rubin told the Commission in a public hearing in April 2010 that Citibank handled the Bowen matter promptly and effectively. “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.”100 According to Citigroup, the bank undertook an investigation in response to Bowen’s claims and the system of underwriting reviews was revised.101
+
+Bowen told the Commission that after he alerted management by sending emails, he went from supervising0 people to supervising only 2, his bonus was reduced, and he was downgraded in his performance review.102
+
+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 that he believed the housing securitization market to be 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 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.”10\f646
+
+
+
+20
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+Even those who had profited from the growth of nontraditional lending practices said they became disturbed by what was happening. Herb Sandler, the co-founder of the mortgage lender Golden West Financial Corporation, which was heavily loaded with option ARM loans, wrote a letter 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.”104
+
+Similarly, Lewis Ranieri, a mortgage finance veteran who helped engineer 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.”105 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” was the word famously used by Countrywide’s Mozilo to describe one of the loan products his firm was originating.106 “In all my years in the business I have never seen a more toxic [product],” he wrote in an internal email.107 Others at the bank argued in response that they were offering products “pervasively offered in the marketplace by virtually every relevant competitor of ours.”108 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.”109
+
+In late 2005, regulators decided to take a look at the changing mortgage market.
+
+Sabeth Siddique, the assistant director for credit risk in the Division of Banking Supervision and Regulation at the Federal Reserve Board, was charged with investigating how broadly loan patterns were changing. He took the questions directly to large banks in 2005 and asked them how many of which kinds of loans they were making.
+
+Siddique found the information he received “very alarming,” he told the Commission.110 In fact, nontraditional loans made up 59\f642 percent of originations at Countrywide, 58\f642 percent at Wells Fargo, 51\f642 at National City, \f6461\f642 at Washington Mutual, 26.5\f642 at CitiFinancial, and 18.\f646\f642 at Bank of America. Moreover, the banks expected that their originations of nontraditional loans would rise by 17\f642 in 2005, to
+
+\f653608.5 billion. The review also noted the “slowly deteriorating quality of loans due to loosening underwriting standards.” In addition, it found that two-thirds of the nontraditional loans made by the banks in 200\f646 had been of the stated-income, minimal documentation variety known as liar loans, which had a particularly great likelihood of going sour.111
+
+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.112
+
+
+
+BEFORE OUR VERY EYES 21
+
+The OCC was also pondering the situation. Former comptroller of the currency John C. 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.11\f646
+
+The agency began to consider issuing “guidance,” a kind of nonbinding official warning to banks, that nontraditional loans could jeopardize safety and soundness and would invite scrutiny by bank examiners. Siddique said the OCC led the effort, which became a multiagency initiative.114
+
+Bies said that deliberations over the potential guidance also stirred debate within the Fed, because some critics feared it both would stifle the financial innovation that was bringing record profits to Wall Street and the banks and would make homes less affordable. Moreover, all the agencies—the Fed, the OCC, the OTS, the FDIC, and the National Credit Union Administration—would need to work together on it, or it would unfairly block one group of lenders from issuing types of loans that were available from other lenders. 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.”115
+
+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,” the trade association wrote to regulators in 2006. “The most recent market trends show alarming signs of undue risk-taking that puts both lenders and consumers at risk.”116
+
+In congressional testimony about a month later, William A. Simpson, the group’s vice president, pointedly referred to past real estate downturns. “We take a conservative position on risk because of our first loss position,” Simpson informed 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.”117
+
+Within the Fed, the debate grew heated and emotional, Siddique recalled. “It got very personal,” he told the Commission. The ideological turf war lasted more than a year, while the number of nontraditional loans kept growing and growing.118
+
+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 nontraditional loans posed to the economy. Stella Adams, the executive director of the North Carolina Fair Housing Center, raised concerns that nontraditional 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.”119
+
+At the next meeting of the Fed’s Consumer Advisory Council, held in June 2006
+
+and attended by Bernanke, Bies, Olson, and Warsh, several consumer advocates described to the Fed governors alarming incidents that were now occurring all over the
+
+
+
+22
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+country. Edward Sivak, the director of policy and evaluation at the Enterprise Corp.
+
+of the Delta, in Jackson, Mississippi, spoke of being told by mortgage brokers that property values were being inflated to maximize profit for real estate appraisers and loan originators. Alan White, the supervising attorney at Community Legal Services in Philadelphia, reported a “huge surge in foreclosures,” noting that up to half of the 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, the president and chief executive officer of Atlanta Neighborhood Development, said she worried that houses were being flipped back and forth so much that the result would be neighborhood “decay.” Carolyn Carter of the National Consumer Law Center in Massachusetts urged the Fed to use its regulatory authority to “prohibit abuses in the mortgage market.”120
+
+The balance was tipping. According to Siddique, before Greenspan left his post as Fed chairman in January 2006, he had indicated his willingness to accept the guidance. Ferguson worked with the Fed board and the regional Fed presidents to get it done. Bies supported it, and Bernanke did as well.121
+
+More than a year after the OCC had began discussing the guidance, and after the housing market had peaked, it was issued in September 2006 as an interagency warning that affected banks, thrifts, and credit unions nationwide. Dozens of states followed, directing their versions of the guidance to tens of thousands of state-chartered lenders and mortgage brokers.
+
+Then, in July 2008, long after the risky, nontraditional mortgage market had disappeared 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 that time, however, the damage had been done. The total value of mortgage-backed securities issued between 2001 and 2006 reached \f6531\f646.4 trillion.122 There was a mountain of problematic securities, debt, and derivatives resting on real estate assets that were far less secure than they were thought to have been.
+
+Just as Bernanke thought the spillovers from a housing market crash would be contained, so too policymakers, regulators, and financial executives did not understand how dangerously exposed major firms and markets had become to the potential contagion from these risky financial instruments. As the housing market began to turn, they scrambled to understand the rapid deterioration in the financial system and respond as losses in one part of that system would ricochet to others.
+
+By the end of 2007, most of the 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. It soon became clear that 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 lending, was bought by JP Morgan with government assistance in the spring.
+
+
+
+BEFORE OUR VERY EYES 2\f646
+
+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, which had their own exposures to declining mortgage assets and their own exposures to short-term credit markets, teetered. IndyMac had already failed over the summer; in September, Washington Mutual became the largest bank failure in U.S. history. In October, Wachovia struck a deal to be acquired by Wells Fargo. Citigroup and Bank of America fought to stay afloat. Before it was over, taxpayers had committed trillions of dollars through 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 testimony to the Commission, former Fed chairman Greenspan defended his record and said most of his judgments had been correct. “I was right 70\f642 of the time but I was wrong \f6460\f642 of the time,” he told the Commission.12\f646 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 devasta-tion is continuing. The officially reported unemployment rate hovered at almost 10\f642
+
+in November 2010, but the underemployment rate, which includes those who have given up looking for work and part-time workers who would prefer to be working full-time, was above 17\f642. And the share of unemployed workers who have been out of work for more than six months was just above 40\f642. Of large metropolitan areas, Las Vegas, Nevada, and Riverside–San Bernardino, California, had the highest unemployment—their rates were above 14\f642.
+
+The loans were as lethal as many had predicted, and it has been estimated that ultimately as many as 1\f646 million households in the United States may lose their homes to foreclosure. As of 2010, foreclosure rates were highest in Florida and Nevada; in Florida, nearly 14\f642 of loans were in foreclosure, and Nevada was not very far behind.124 Nearly one-quarter of American mortgage borrowers owed more on their mortgages than their home was worth. In Nevada, the percentage was nearly 70\f642.125
+
+Households have lost \f65311 trillion in wealth since 2006.
+
+As Mark Zandi, the 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 19\f6460s. . . . The longer-term fallout from the economic crisis is also very substantial. . . . It will take years for employment to regain its pre-crisis level.”126
+
+Looking back on the years before the crisis, the economist Dean Baker said: “So much of this was absolute public knowledge in the sense that we knew the number of loans that were being issued with zero down. Now, do we suddenly think we have that many more people—who are capable of taking on a loan with zero down who we
+
+
+
+24
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+think are going to be able to pay that off—than was true 10, 15, 20 years ago1 I mean, what’s changed in the world1 There were a lot of things that didn’t require any investigation at all; these were totally available in the data.”127
+
+Warren Peterson, a home builder in Bakersfield, felt that he could pinpoint when the world changed to the day. Peterson built homes in an upscale neighborhood, and each Monday morning, he would arrive at the office to find a bevy of real estate agents, sales contracts in hand, vying to be the ones chosen to purchase the new homes he was building. The stream of traffic was constant. On one Saturday in November 2005, he was at the sales office and noticed that not a single purchaser had entered the building.
+
+He called a friend, also in the home-building business, who said he had noticed the same thing, and asked him what he thought about it.
+
+“It’s over,” his friend told Peterson.128
+
+
+
+
+
+PART II
+
+
+Setting the Stage
+
+
+
+
+
+2
+
+SHADOW BANKING
+
+CONTENTS
+
+Commercial paper and repos: “Unfettered markets”............................................29
+
+The savings and loan crisis: “They put a lot of
+
+pressure on their regulators” ............................................................................\f6464
+
+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, government officials, and others had missed or dismissed. When subprime and other risky mortgages—issued during a housing bubble that many experts failed to identify, and whose consequences were not understood—
+
+began to default at unexpected rates, a once-obscure market for complex investment securities backed by those mortgages abruptly failed. When the contagion spread, investors panicked—and the danger inherent in the whole system became 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 now acknowledges that he missed the systemic risks. “Prospective subprime losses were clearly not large enough on their own to account for the magnitude of the crisis,” Bernanke told the Commission.
+
+“Rather, 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.”1
+
+This part of our report explores the origins of risks as they developed in the financial system over recent 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 that helped shape the events that shook our financial markets and economy. Detailed books could be written about each of them; we stick to the essentials for understanding our specific concern, which is the recent crisis.
+
+First, we describe the phenomenal growth of the shadow banking system—the investment banks, most prominently, but also other financial institutions—that freely operated in capital markets 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.
+
+27
+
+
+
+28
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+This new system threatened the once-dominant traditional commercial banks, and they took their grievances to their regulators and to Congress, which slowly but steadily removed long-standing restrictions and helped banks break out of their traditional mold and join the feverish growth. As a result, two parallel financial systems of enormous scale emerged. 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, regulators looked to financial institutions to police themselves—“deregulation” was the label. Former Fed chairman Alan Greenspan put it this way: “The market-stabilizing private regulatory forces should gradually displace many cumbersome, increasingly ineffective government structures.”2 In 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 the loosening of their restraints—could provide vital support. And if problems outstripped the market’s ability to right itself, the Federal Reserve would take on the responsibility to restore financial stability. 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.
+
+Third, we follow the profound changes in the mortgage industry, from the sleepy days when local lenders took full responsibility for making and servicing \f6460-year loans to a new era in which the idea was to sell the loans off as soon as possible, so that they could be packaged and sold to investors around the world. New mortgage products proliferated, and so did new borrowers. Inevitably, this became a market in which the participants—mortgage brokers, lenders, and Wall Street firms—had a greater stake in the quantity of mortgages signed up and sold than in their quality.
+
+We also trace the history of Fannie Mae and Freddie Mac, publicly traded corporations established by Congress that became dominant forces in providing financing to support the mortgage market while also seeking to maximize returns for investors.
+
+Fourth, we introduce some of the most arcane subjects in our report: securitization, structured finance, and derivatives—words that entered the national vocabu-lary as the financial markets unraveled through 2007 and 2008. Put simply and most pertinently, structured finance was the mechanism by which subprime and other mortgages were turned into complex investments often accorded triple-A ratings by credit rating agencies whose own motives were conflicted. 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 20 years earlier, were the first dominoes to fall in the financial sector.
+
+
+
+SHADOW BANKING 29
+
+A basic understanding of these four developments will bring the reader up to speed in grasping where matters stood for the financial system in the year 2000, at the dawn of a decade of promise and peril.
+
+COMMERCIAL PAPER AND REPOS:
+
+“UNFETTERED MARKETS”
+
+For most of the 20th century, banks and thrifts accepted deposits and loaned that money to home buyers or businesses. Before the Depression, these institutions were vulnerable to runs, when reports or merely rumors that a bank was in trouble spurred depositors to demand their cash. If the run was widespread, the bank might not have enough cash on hand to meet depositors’ demands: runs were common before the Civil War and then occurred in 187\f646, 1884, 1890, 189\f646, 1896, and 1907.\f646 To stabilize financial markets, Congress created the Federal Reserve System in 191\f646, which acted as the lender of last resort to banks.
+
+But the creation of the Fed was not enough to avert bank runs and sharp contrac-tions in the financial markets in the 1920s and 19\f6460s. So in 19\f646\f646 Congress passed the Glass-Steagall Act, which, among other changes, established the Federal Deposit Insurance Corporation. The FDIC insured bank deposits up to \f6532,500—an amount that covered the vast majority of deposits at the time; that limit would climb to \f653100,000 by
+
+1980, where it stayed until it was raised to \f653250,000 during the crisis in October 2008.
+
+Depositors no longer needed to worry about being first in line at a troubled bank’s door. And if banks were short of cash, they could now borrow from the Federal Reserve, even when they could borrow nowhere else. The Fed, acting as lender of last resort, would ensure that banks would not fail simply from a lack of liquidity.
+
+With these backstops in place, Congress restricted banks’ activities to discourage them from taking excessive risks, another move intended to help prevent bank failures, with taxpayer dollars now at risk. Furthermore, Congress let the Federal Reserve cap interest rates that banks and thrifts—also known as savings and loans, or S&Ls—
+
+could pay depositors. This rule, known as Regulation Q, was also intended to keep institutions safe by ensuring that competition for deposits did not get out of hand.4
+
+The system was stable as long as interest rates remained relatively steady, which they did during the first two decades after World War II. Beginning in the late-1960s, however, inflation started to increase, pushing up interest rates. For example, the rates that banks paid other banks for overnight loans had rarely exceeded 6\f642 in the decades before 1980, when it reached 20\f642. However, thanks to Regulation Q, banks and thrifts were stuck offering roughly less than 6\f642 on most deposits. 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 whom1 In the 1970s, Merrill Lynch, Fidelity, Vanguard, and others persuaded consumers and businesses to abandon banks and thrifts for higher returns.
+
+These firms—eager to find new businesses, particularly after the Securities and Exchange Commission (SEC) abolished fixed commissions on stock trades in 1975—
+
+created money market mutual funds that invested these depositors’ money in
+
+
+
+\f6460
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+short-term, safe securities such as Treasury bonds and highly rated corporate debt, and the funds paid higher interest rates than banks and thrifts were allowed to pay.
+
+The funds functioned like bank accounts, although with a different mechanism: customers bought shares redeemable daily at a stable value. In 1977, Merrill Lynch introduced something even more like a bank account: “cash management accounts” allowed customers to write checks. Other money market mutual funds quickly followed.5
+
+These funds differed from bank and thrift deposits in one important respect: they were not protected by FDIC deposit insurance. Nevertheless, consumers liked the higher interest rates, and the stature of the funds’ sponsors reassured them. The fund sponsors implicitly promised to maintain the full \f6531 net asset value of a share. The funds would not “break the buck,” in Wall Street terms. Even without FDIC insurance, then, depositors considered these funds almost as safe as deposits in a bank or thrift. Business boomed, and so was born a key player in the shadow banking industry, the less-regulated market for capital that was growing up beside the traditional banking system. Assets in money market mutual funds jumped from \f653\f646 billion in
+
+1977 to more than \f653740 billion in 1995 and \f6531.8 trillion by 2000.6
+
+To maintain their edge over the insured banks and thrifts, the money market funds needed safe, high-quality assets to invest in, and they quickly developed an appetite for two booming markets: the “commercial paper” and “repo” markets.
+
+Through these instruments, Merrill Lynch, Morgan Stanley, and other Wall Street investment banks could broker and provide (for a fee) short-term financing to large corporations. Commercial paper was unsecured corporate debt—meaning that it was backed not by a pledge of collateral but only by the corporation’s promise to pay.
+
+These loans were cheaper because they were short-term—for less than nine months, sometimes as short as two weeks and, eventually, as short as one day; the borrowers usually “rolled them over” when the loan came due, and then again and again. Because only financially stable corporations were able to issue commercial paper, it was considered a very safe investment; companies such as General Electric and IBM, investors believed, would always be good for the money. Corporations had been issuing commercial paper to raise money since the beginning of the century, but the practice grew much more popular in the 1960s.
+
+This market, though, underwent a crisis that demonstrated that capital markets, too, were vulnerable to runs. Yet that crisis actually strengthened the market. In 1970, the Penn Central Transportation Company, the sixth-largest nonfinancial corporation in the U.S., filed for bankruptcy with \f653200 million in commercial paper outstanding. The railroad’s default caused investors to worry about the broader commercial paper market; holders of that paper—the lenders—refused to roll over their loans to other corporate borrowers. The commercial paper market virtually shut down. In response, the Federal Reserve supported the commercial banks with almost \f653600 million in emergency loans and with interest rate cuts.7 The Fed’s actions enabled the banks, in turn, to lend to corporations so that they could pay off their commercial paper. After the Penn Central crisis, the issuers of commercial paper—the borrowers—typically set up standby lines of credit with major banks to en-SHADOW BANKING \f6461
+
+able them to pay off their debts should there be another shock. These moves reassured investors that commercial paper was a safe investment.
+
+In the 1960s, the commercial paper market jumped more than sevenfold. Then in the 1970s, it grew almost fourfold. Among the largest buyers of commercial paper were the money market mutual funds. It seemed a win-win-win deal: the mutual funds could earn a solid return, stable companies could borrow more cheaply, and Wall Street firms could earn fees for putting the deals together. By 2000, commercial paper had risen to \f6531.6 trillion from less than \f653125 billion in 1980.8
+
+The second major shadow banking market that grew significantly was the market for repos, or repurchase agreements. Like commercial paper, repos have a long history, but they proliferated quickly in the 1970s. Wall Street securities dealers often sold Treasury bonds with their relatively low returns to banks and other conservative investors, while then investing the cash proceeds of these sales in securities that paid higher interest rates. The dealers agreed to repurchase the Treasuries—often within a day—at a slightly higher price than that for which they sold them. This repo transaction—in essence a loan—made it inexpensive and convenient for Wall Street firms to borrow. Because these deals were essentially collateralized loans, the securities dealers borrowed nearly the full value of the collateral, minus a small “haircut.” Like commercial paper, repos were renewed, or “rolled over,” frequently. For that reason, both forms of borrowing could be considered “hot money”—because lenders could quickly move in and out of these investments in search of the highest returns, they could be a risky source of funding.
+
+The repo market, too, had vulnerabilities, but it, too, had emerged from an early crisis stronger than ever. In 1982, two major borrowers, the securities firms Drysdale and Lombard-Wall, defaulted on their repo obligations, creating large losses for lenders. In the ensuing fallout, the Federal Reserve acted as lender of last resort to support a shadow banking market. The Fed loosened the terms on which it lent Treasuries to securities firms, leading to a 10-fold increase in its securities lending.
+
+Following this episode, most repo participants switched to a tri-party arrangement in which a large clearing bank acted as intermediary between borrower and lender, essentially protecting the collateral and the funds by putting them in escrow.9 This mechanism would have severe consequences in 2007 and 2008. In the 1980s, however, these new procedures stabilized the repo market.
+
+The new parallel banking system—with commercial paper and repo providing cheaper financing, and money market funds providing better returns for consumers and institutional investors—had a crucial catch: its popularity came at the expense of the banks and thrifts. Some regulators viewed this development with growing alarm.
+
+According to Alan Blinder, the vice chairman of the 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 a 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.”10
+
+
+
+\f6462
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+Traditional and Shadow Banking Systems
+
+The funding available through the shadow banking system grew sharply in the 2000s, exceeding the traditional banking system in the years before the crisis.
+
+IN TRILLIONS OF DOLLARS
+
+$15
+
+$13.0
+
+Traditional
+
+12
+
+Banking
+
+9
+
+$8.5
+
+Shadow
+
+6
+
+Banking
+
+3
+
+0
+
+1980
+
+1985
+
+1990
+
+1995
+
+2000
+
+2005
+
+2010
+
+NOTE: Shadow banking funding includes commercial paper and other short-term borrowing (bankers acceptances), repo, net securities loaned, liabilities of asset-backed securities issuers, and money market mutual fund assets.
+
+SOURCE: Federal Reserve Flow of Funds Report
+
+Figure 2.1
+
+Figure 2.1 shows that during the 1990s the shadow banking system steadily gained ground on the traditional banking sector—and actually surpassed the banking sector for a brief time after 2000.
+
+Banks argued that their problems stemmed from the Glass-Steagall Act. Glass-Steagall strictly limited commercial banks’ participation in the securities markets, in part to end the practices of the 1920s, when banks sold highly speculative securities to depositors. In 1956, Congress also imposed new regulatory requirements on banks owned by holding companies, in order to prevent a holding company from endangering any of its deposit-taking banks.
+
+Bank supervisors monitored banks’ leverage—their assets relative to equity—
+
+because excessive leverage endangered a bank. Leverage, used by nearly every financial institution, amplifies returns. For example, if an investor uses \f653100 of his own money to purchase a security that increases in value by 10\f642, he earns \f65310. However, if he borrows another \f653900 and invests 10 times as much (\f6531,000), the same 10\f642 increase in value yields a profit of \f653100, double his out-of-pocket investment. If the investment sours, though, leverage magnifies the loss just as much. A decline of 10\f642
+
+costs the unleveraged investor \f65310, leaving him with \f65390, but wipes out the leveraged investor’s \f653100. An investor buying assets worth 10 times his capital has a leverage SHADOW BANKING \f646\f646
+
+ratio of 10:1, with the numbers representing the total money invested compared to the money the investor has committed to the deal.
+
+In 1981, bank supervisors established the first formal minimum capital standards, which mandated that capital—the amount by which assets exceed debt and other liabilities—should be at least 5\f642 of assets for most banks. Capital, in general, reflects the value of shareholders’ investment in the bank, which bears the first risk of any potential losses.
+
+By comparison, Wall Street investment banks could employ far greater leverage, unhindered by oversight of their safety and soundness or by capital requirements outside of their broker-dealer subsidiaries, which were subject to a net capital rule.
+
+The main shadow banking participants—the money market funds and the investment banks that sponsored many of them—were not subject to the same supervision as banks and thrifts. The money in the shadow banking markets came not from federally insured depositors but principally from investors (in the case of money market funds) or commercial paper and repo markets (in the case of investment banks).
+
+Both money market funds and securities firms were regulated by the Securities and Exchange Commission. But the SEC, created in 19\f6464, was supposed to supervise the securities markets to protect investors. It was charged with ensuring that issuers of securities disclosed sufficient information for investors, and it required firms that bought, sold, and brokered transactions in securities to comply with procedural restrictions such as keeping customers’ funds in separate accounts. Historically, the SEC did not focus on the safety and soundness of securities firms, although it did impose capital requirements on broker-dealers designed to protect their clients.
+
+Meanwhile, since deposit insurance did not cover such instruments as money market mutual funds, the government was not on the hook. There was little concern about a run. In theory, the investors had knowingly risked their money. If an investment lost value, it lost value. If a firm failed, it failed. As a result, money market funds had no capital or leverage standards. “There was no regulation,” former Fed chairman Paul Volcker told the Financial Crisis Inquiry Commission. “It was kind of a free ride.”11 The funds had to follow only regulations restricting the type of securities in which they could invest, the duration of those securities, and the diversification of their portfolios. These requirements were supposed to ensure that investors’ shares would not diminish in value and would be available anytime—important reassurances, but not the same as FDIC insurance. The only protection against losses was the implicit guarantee of sponsors like Merrill Lynch with reputations to protect.
+
+Increasingly, the traditional world of banks and thrifts was ill-equipped to keep up with the parallel world of the Wall Street firms. The new shadow banks had few constraints on raising and investing money. Commercial banks were at a disadvantage and in danger of losing their dominant position. Their bind was labeled “disintermediation,” and many critics of the financial regulatory system concluded that policy makers, all the way back to the Depression, had trapped depository institutions in this unprofitable straitjacket not only by capping the interest rates they could pay depositors and imposing capital requirements but also by preventing the institutions from competing against the investment banks (and their money market mutual
+
+
+
+\f6464
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+funds). Moreover, critics argued, the regulatory constraints on industries across the entire economy discouraged competition and restricted innovation, and the financial sector was a prime example of such a hampered industry.
+
+Years later, Fed Chairman Greenspan described the argument for deregulation:
+
+“Those of us who support market capitalism in its more competitive forms might argue that unfettered markets create a degree of wealth that fosters a more civilized existence. I have always found that insight compelling.”12
+
+THE SAVINGS AND LOAN CRISIS:
+
+“THEY PUT A LOT OF PRESSURE ON THEIR REGULATORS”
+
+Traditional financial institutions continued to chafe against the regulations still in place. The playing field wasn’t level, which “put a lot of pressure on institutions to get higher-rate performing assets,” former SEC Chairman Richard Breeden told the FCIC. “And they put a lot of pressure on their regulators to allow this to happen.”1\f646
+
+The banks and the S&Ls went to Congress for help. In 1980, the Depository Institutions Deregulation and Monetary Control Act repealed the limits on the interest rates that depository institutions could offer on their deposits. Although this law removed a significant regulatory constraint on banks and thrifts, it could not restore their competitive advantage. Depositors wanted a higher rate of return, which banks and thrifts were now free to pay. But the interest banks and thrifts could earn off of mortgages and other long-term loans was largely fixed and could not match their new costs. While their deposit base increased, they now faced an interest rate squeeze. In 1979, the difference in interest earned on the banks’ and thrifts’ safest investments (one-year Treasury notes) over interest paid on deposits was almost 5.5
+
+percentage points; by 1994, it was only 2.6 percentage points. The institutions lost almost \f646 percentage points of the advantage they had enjoyed when the rates were capped.14 The 1980 legislation had not done enough to reduce 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 broader scope in the mortgage market. Traditionally, they had relied on \f6460-year, fixed-rate mortgages. But the interest on fixed-rate mortgages on their books fell short as inflation surged in the mid-1970s and early 1980s and banks and thrifts found it increasingly difficult to cover the rising costs of their short-term deposits. In the Garn-St. Germain Act, Congress sought to relieve this interest rate mismatch by permitting banks and thrifts to issue interest-only, balloon-payment, and adjustable-rate mortgages (ARMs), even in states where state laws forbade these loans. For consumers, interest-only and balloon mortgages made homeownership more affordable, but only in the short term. Borrowers with ARMs enjoyed lower mortgage rates when interest rates decreased, but their rates would rise when interest rates rose. For banks and thrifts, ARMs offered an interest rate that floated in relationship to the rates they were paying to attract money from depositors. The floating mortgage rate protected banks and S&Ls from the interest rate SHADOW BANKING \f6465
+
+squeeze caused by inflation, but it effectively transferred the risk of rising interest rates to borrowers.
+
+Then, beginning in 1987, the Federal Reserve accommodated a series of requests from the banks to undertake activities forbidden under Glass-Steagall and its modifications. The new rules permitted nonbank subsidiaries of bank holding companies to engage in “bank-ineligible” activities, including selling or holding certain kinds of securities that were not permissible for national banks to invest in or underwrite. At first, the Fed strictly limited these bank-ineligible securities activities to no more than 5\f642 of the assets or revenue of any subsidiary. Over time, however, the Fed relaxed these restrictions. By 1997, bank-ineligible securities could represent up to 25\f642
+
+of assets or revenues of a securities subsidiary, and the Fed also weakened or eliminated other firewalls between traditional banking subsidiaries and the new securities subsidiaries of bank holding companies.15
+
+Meanwhile, the OCC, the regulator of banks with national charters, was expanding the permissible activities of national banks to include those that were “functionally equivalent to, or a logical outgrowth of, a recognized bank power.”16 Among these new activities were underwriting as well as trading bets and hedges, known as derivatives, on the prices of certain assets. Between 198\f646 and 1994, the OCC broadened the derivatives in which banks might deal to include those related to debt securities (198\f646), interest and currency exchange rates (1988), stock indices (1988), precious metals such as gold and silver (1991), and equity stocks (1994).
+
+Fed Chairman Greenspan and many other regulators and legislators supported and encouraged this shift toward deregulated financial markets. They argued that financial institutions had strong incentives to protect their shareholders and would therefore regulate themselves through improved risk management. Likewise, financial markets would exert strong and effective discipline through analysts, credit rating agencies, and investors. Greenspan argued that the urgent question about government regulation was whether it strengthened or weakened private regulation.
+
+Testifying before Congress in 1997, he framed the issue this way: financial “modern-ization” 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.”17
+
+During the 1980s and early 1990s, banks and thrifts expanded into higher-risk loans with higher interest payments. They made loans to oil and gas producers, financed leveraged buyouts of corporations, and funded developers of residential and commercial real estate. The largest commercial banks advanced money to companies and governments in “emerging markets,” such as countries in Asia and Latin America. Those markets offered potentially higher profits, but were much riskier than the banks’ traditional lending. The consequences appeared almost immediately—especially in the real estate markets, with a bubble and massive overbuilding in residential and commercial sectors in certain regions. For example, house prices rose 7\f642 per year in Texas from 1980 to 1985.18 In California, prices rose 1\f646\f642 annually from 1985
+
+
+
+\f6466
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+to 1990.19 The bubble burst first in Texas in 1985 and 1986, but the trouble rapidly spread across the Southeast to the mid-Atlantic states and New England, then swept back across the country to California and Arizona. Before the crisis ended, house prices had declined nationally by 2.5\f642 from July 1990 to February 199220—the first such fall since the Depression—driven by steep drops in regional markets.21 In the
+
+1980s, with the mortgages in their portfolios paying considerably less than current interest rates, spiraling defaults on the thrifts’ residential and commercial real estate loans, and losses on energy-related, leveraged-buyout, and overseas loans, the industry was shattered.22
+
+Almost \f646,000 commercial banks and thrifts failed in what became known as the S&L crisis of the 1980s and early 1990s. By comparison, only 24\f646 banks had failed between 19\f6464 and 1980. By 1994, one-sixth of federally insured depository institutions had either closed or required financial assistance, affecting 20\f642 of the banking system’s assets.2\f646 More than 1,000 bank and S&L executives were convicted of felonies.24 By the time the government cleanup was complete, the ultimate cost of the crisis was \f653160 billion.25
+
+Despite new laws passed by Congress in 1989 and 1991 in response to the S&L
+
+crisis that toughened supervision of thrifts, the impulse toward deregulation continued. The deregulatory movement focused in part on continuing to dismantle regulations that limited depository institutions’ activities in the capital markets. In 1991, the Treasury Department issued an extensive study calling for the elimination of the old regulatory framework for banks, including removal of all geographic restrictions on banking and repeal of the Glass-Steagall Act. The study urged Congress to abolish these restrictions in 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 report contended that its proposals would let banks embrace innovation and produce a “stronger, more diversified financial system that will provide important benefits to the consumer and important protections to the taxpayer.”26
+
+The biggest banks pushed Congress to adopt Treasury’s recommendations. Opposed were insurance agents, real estate brokers, and smaller banks, who felt threatened by the possibility that the largest banks and their huge pools of deposits would be unleashed to compete without restraint. The House of Representatives rejected Treasury’s proposal in 1991, but similar proposals were adopted by Congress later in the 1990s.
+
+In dealing with the banking and thrift crisis of the 1980s and early 1990s, Congress was greatly concerned by a spate of high-profile bank bailouts. In 1984, federal regulators rescued Continental Illinois, the nation’s 7th-largest bank; in 1988, First Republic, number 14; in 1989, MCorp, number \f6466; in 1991, Bank of New England, number \f646\f646. These banks had relied heavily on uninsured short-term financing to aggressively expand into high-risk lending, leaving them vulnerable to abrupt withdrawals once confidence in their solvency evaporated. Deposits covered by the FDIC
+
+were protected from loss, but regulators felt obliged to protect the uninsured depositors—those whose balances exceeded the statutorily protected limits—to prevent po-SHADOW BANKING \f6467
+
+tential runs on even larger banks that reportedly may have lacked sufficient assets to satisfy their obligations, such as First Chicago, Bank of America, and Manufacturers Hanover.27
+
+During a hearing on the rescue of Continental Illinois, Comptroller of the Currency C. Todd Conover stated that federal regulators would not allow the 11 largest
+
+“money center banks” to fail.28 This was a new regulatory principle, and within mo-ments it had a catchy name. 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.”29
+
+In 1990, during this era of federal rescues of large commercial banks, Drexel Burnham Lambert—once the country’s fifth-largest investment bank—failed. Crippled by legal troubles and losses in its junk bond portfolio, the firm was forced into the largest bankruptcy in the securities industry to date when lenders shunned it in the commercial paper 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 financial firms, only commercial banks were deemed too big to fail.
+
+In 1991, Congress tried to limit this “too big to fail” principle, passing the Federal Deposit Insurance Corporation Improvement Act (FDICIA), which sought to curb the use of taxpayer funds to rescue failing depository institutions. FDICIA mandated that federal regulators must intervene early when a bank or thrift got into trouble. In addition, if an institution did fail, the FDIC had to resolve the failed institution in a manner that produced the least cost to the FDIC’s deposit insurance fund. However, the legislation contained two important loopholes. One exempted the FDIC from the least-cost constraints if it, the Treasury, and the Federal Reserve determined that the failure of an institution posed a “systemic risk” to markets. The other loophole addressed a concern raised by some Wall Street investment banks, Goldman Sachs in particular: the reluctance of commercial banks to help securities firms during previous market disruptions, such as Drexel’s failure. Wall Street firms successfully lobbied for an amendment to FDICIA to authorize the Fed to act as lender of last resort to investment banks by extending loans collateralized by the investment banks’
+
+securities.\f6460
+
+In the end, the 1991 legislation sent financial institutions a mixed message: you are not too big to fail—until and unless you are too big to fail. So the possibility of bailouts for the biggest, most centrally placed institutions—in the commercial and shadow banking industries—remained an open question until the next crisis, 16
+
+years later.
+
+
+
+3
+
+SECURITIZATION AND DERIVATIVES
+
+CONTENTS
+
+Fannie Mae and Freddie Mac: “The whole army of lobbyists”.............................\f6468
+
+Structured finance: “It wasn’t reducing the risk”...................................................42
+
+The growth of derivatives: “By far the most significant event in finance during the past decade” ...................................................................45
+
+FANNIE MAE AND FREDDIE MAC:
+
+“THE WHOLE ARMY OF LOBBYISTS”
+
+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 support the mortgage market.
+
+Fannie Mae (officially, the Federal National Mortgage Association) was chartered by the Reconstruction Finance Corporation during the Great Depression in 19\f6468 to buy mortgages insured by the Federal Housing Administration (FHA). The new government agency was authorized to purchase mortgages that adhered to the FHA’s underwriting standards, thereby virtually guaranteeing the supply of mortgage credit that banks and thrifts could extend to homebuyers. Fannie Mae either held the mortgages in its portfolio or, less often, resold them to thrifts, insurance companies, or other investors. After World War II, Fannie Mae got authority to buy home loans guaranteed by the Veterans Administration (VA) as well.
+
+This system worked well, but it had a weakness: Fannie Mae bought mortgages by borrowing. By 1968, Fannie’s mortgage portfolio had grown to \f6537.2 billion and its debt weighed on the federal government.1 To get Fannie’s debt off of the government’s balance sheet, the Johnson administration and Congress reorganized it as a publicly traded corporation and created a new government entity, Ginnie Mae (officially, the Government National Mortgage Association) to take over Fannie’s subsidized mortgage programs and loan portfolio. Ginnie also began guaranteeing pools of FHA and VA mortgages. The new Fannie still purchased federally insured mortgages, but it was now a hybrid, a “government-sponsored enterprise.” Two years later, in 1970, the thrifts persuaded Congress to charter a second GSE, Freddie Mac (officially, the Federal Home Loan Mortgage Corporation), to help the
+
+\f6468
+
+
+
+SECURITIZATION AND DERIVATIVES \f6469
+
+thrifts sell their mortgages. The legislation also authorized Fannie and Freddie to buy
+
+“conventional” fixed-rate mortgages, which were not backed by the FHA or the VA.
+
+Conventional mortgages were stiff competition to FHA mortgages because borrowers could get them more quickly and with lower fees. Still, the conventional mortgages did have to conform to the GSEs’ loan size limits and underwriting guidelines, such as debt-to-income and loan-to-value ratios. The GSEs purchased only these
+
+“conforming” mortgages.
+
+Before 1968, Fannie Mae generally held the mortgages it purchased, profiting from the difference—or spread—between its cost of funds and the interest paid on these mortgages. The 1968 and 1970 laws gave Ginnie, Fannie, and Freddie another option: securitization. Ginnie was the first to securitize mortgages, in 1970. A lender would assemble a pool of mortgages and issue securities backed by the mortgage pool. Those securities would be sold to investors, with Ginnie guaranteeing timely payment of principal and interest. Ginnie charged a fee to issuers for this guarantee.
+
+In 1971, Freddie got into the business of buying mortgages, pooling them, and then selling mortgage-backed securities. Freddie collected fees from lenders for guaranteeing timely payment of principal and interest. In 1981, after a spike in interest rates caused large losses on Fannie’s portfolio of mortgages, Fannie followed. During the
+
+1980s and 1990s, the conventional mortgage market expanded, the GSEs grew in importance, and the market share of the FHA and VA declined.
+
+Fannie and Freddie had dual missions, both public and private: support the mortgage market and maximize 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 and a \f6532.25 billion line of credit each from the Treasury. The Federal Reserve provided services such as electronically clearing payments for GSE debt and securities as if they were Treasury bonds. So Fannie and Freddie could borrow at rates almost as low as the Treasury paid. Federal laws allowed banks, thrifts, and investment funds to invest in GSE securities with relatively favorable capital requirements and without limits. By contrast, laws and regulations strictly limited the amount of loans banks could make to a single borrower and restricted their investments in the debt obligations of other firms. In addition, unlike banks and thrifts, the GSEs were required to hold very little capital to protect against losses: only 0.45\f642 to back their guarantees of mortgage-backed securities and 2.5\f642 to back the mortgages in their portfolios. This compared to bank and thrift capital requirements of at least 4\f642 of mortgages assets under capital standards. Such privileges led investors and creditors to believe that the government implicitly guaranteed the GSEs’ mortgage-backed securities and debt and that GSE securities were therefore almost as safe as Treasury bills. As a result, investors accepted very low returns on GSE-guaranteed mortgage-backed securities and GSE debt obligations.
+
+Mortgages are long-term assets often funded by short-term borrowings. For example, thrifts generally used customer deposits to fund their mortgages. Fannie
+
+
+
+40
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+bought its mortgage portfolio by borrowing short- and medium-term. In 1979, when the Fed increased short-term interest rates to quell inflation, Fannie, like the thrifts, found that its cost of funding rose while income from mortgages did not. By the 1980s, the Department of Housing and Urban Development (HUD) estimated Fannie had a negative net worth of \f65310 billion.2 Freddie emerged unscathed because unlike Fannie then, its primary business was guaranteeing mortgage-backed securities, not holding mortgages in its portfolio. In guaranteeing mortgage-backed securities, Freddie Mac avoided taking the interest rate risk that hit Fannie’s portfolio.
+
+In 1982, Congress provided tax relief and HUD relaxed Fannie’s capital requirements to help the company avert failure. These efforts were consistent with lawmakers’ repeated proclamations that a vibrant market for home mortgages served the best interests of the country, but the moves also reinforced the impression that the government would never abandon Fannie and Freddie. Fannie and Freddie would soon buy and either hold or securitize mortgages worth hundreds of billions, then trillions, of dollars. Among the investors were U.S. banks, thrifts, investment funds, and pension funds, as well as central banks and investment funds around the world.
+
+Fannie and Freddie had become too big to fail.
+
+While the government continued to favor Fannie and Freddie, they toughened regulation of the thrifts following the savings and loan crisis. Thrifts had previously dominated the mortgage business as large holders of mortgages. In the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), Congress imposed tougher, bank-style capital requirements and regulations on thrifts. By contrast, in the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, Congress created a supervisor for the GSEs, the Office of Federal Housing Enterprise Oversight (OFHEO), without legal powers comparable to those of bank and thrift supervisors in enforcement, capital requirements, funding, and receivership. Crack-ing down on thrifts while not on the GSEs was no accident. The GSEs had shown their immense political power during the drafting of the 1992 law.\f646 “OFHEO was structurally weak and almost designed to fail,” said Armando Falcon Jr., a former director of the agency, to the FCIC.4
+
+All this added up to a generous federal subsidy. One 2005 study put the value of that subsidy at \f653122 billion or more and estimated that more than half of these benefits accrued to shareholders, not to homebuyers.5
+
+Given these circumstances, regulatory arbitrage worked as it always does: the markets shifted to the lowest-cost, least-regulated havens. After Congress imposed stricter capital requirements on thrifts, it became increasingly profitable for them to securitize with or sell loans to Fannie and Freddie rather than hold on to the loans.
+
+The stampede was on. Fannie’s and Freddie’s debt obligations and outstanding mortgage-backed securities grew from \f653759 billion in 1990 to \f6531.4 trillion in 1995 and
+
+\f6532.4 trillion in 2000.6
+
+The legislation that transformed Fannie in 1968 also authorized HUD to prescribe affordable housing goals for Fannie: to “require that a reasonable portion of the corporation’s mortgage purchases be related to the national goal of providing adequate SECURITIZATION AND DERIVATIVES 41
+
+housing for low and moderate income families, but with reasonable economic return to the corporation.”7 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 regulation encouraging affordable housing.8 In the 1992 Federal Housing Enterprises Financial Safety and Soundness Act, Congress extended HUD’s authority to set affordable housing goals for Fannie and Freddie. Congress also changed the language to say that in the pursuit of affordable housing, “a reasonable economic return . . . may be less than the return earned on other activities.” The law required HUD to consider
+
+“the need to maintain the sound financial condition of the enterprises.” The act now ordered HUD to set goals for Fannie and Freddie to buy loans for low- and moderate-income housing, special affordable housing, and housing in central cities, rural areas, and other underserved areas. Congress instructed HUD to periodically set a goal for each category as a percentage of the GSEs’ mortgage purchases.
+
+In 1995, President Bill Clinton announced an initiative to boost homeownership from 65.1\f642 to 67.5\f642 of families by 2000, and one component raised the affordable housing goals at the GSEs. Between 199\f646 and 1995, almost 2.8 million households entered the ranks of 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.”9 The push to expand homeownership continued under President George W. Bush, who, for example, introduced a “Zero Down Payment Initiative” that under certain circumstances could remove the \f646\f642 down payment rule for first-time home buyers with FHA-insured mortgages.10
+
+In describing the GSEs’ affordable housing loans, Andrew Cuomo, secretary of Housing and Urban Development from 1997 to 2001 and now governor of New York, told the FCIC, “Affordability means many things. There were moderate income loans. These were teachers, these were firefighters, these were municipal employees, these were people with jobs who paid mortgages. These were not subprime, predatory loans at all.”11
+
+Fannie and Freddie were now crucial to the housing market, but their dual missions—promoting mortgage lending while maximizing returns to shareholders—
+
+were problematic. Former Fannie CEO Daniel Mudd told the FCIC that “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.”12 Former Freddie CEO Richard Syron concurred: “I don’t think it’s a good business model.”1\f646
+
+Fannie and Freddie accumulated political clout because they depended on federal subsidies and an implicit government guarantee, and because they had to deal with regulators, affordable housing goals, and capital standards imposed by Congress and HUD. From 1999 to 2008, the two reported spending more than \f653164 million on lobbying, and their employees and political action committees contributed \f65315 million
+
+
+
+42
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+to federal election campaigns.14 The “Fannie and Freddie political machine resisted any meaningful regulation using highly improper tactics,” Falcon, who regulated them from 1999 to 2005, testified. “OFHEO was constantly subjected to malicious political attacks and efforts of intimidation.”15 James Lockhart, the director of OFHEO and its successor, the Federal Housing Finance Agency, from 2006 through
+
+2009, testified that he argued for reform from the moment he became director and that the companies were “allowed to be . . . so politically strong that for many years they resisted the very legislation that might have saved them.”16 Former HUD secretary Mel Martinez described to the FCIC “the whole army of lobbyists that continually paraded in a bipartisan fashion through my offices. . . . It’s pretty amazing the number of people that were in their employ.”17
+
+In 1995, that army helped secure new regulations allowing the GSEs to count toward their affordable housing goals not just their whole loans but mortgage-related securities issued by other companies, which the GSEs wanted to purchase as investments. Still, Congressional Budget Office Director June O’Neill declared in 1998 that
+
+“the goals are not difficult to achieve, and it is not clear how much they have affected the enterprises’ actions. In fact . . . 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 enterprises.”18
+
+Something else was clear: Fannie and Freddie, with their low borrowing costs and lax capital requirements, were immensely profitable throughout the 1990s. In 2000, Fannie had a return on equity of 26\f642; Freddie, \f6469\f642. That year, Fannie and Freddie held or guaranteed more than \f6532 trillion of mortgages, backed by only \f653\f6465.7 billion of shareholder equity.19
+
+STRUCTURED FINANCE:
+
+“IT WASN’ T REDUCING THE RISK”
+
+While Fannie and Freddie enjoyed a near-monopoly on securitizing fixed-rate mortgages that were within their permitted loan limits, in the 1980s the markets began to securitize many other types of loans, including adjustable-rate mortgages (ARMs) and other mortgages the GSEs were not eligible or willing to buy. The mechanism worked the same: an investment bank, such as Lehman Brothers or Morgan Stanley (or a securities affiliate of a bank), bundled loans from a bank or other lender into securities and sold them to investors, who received investment returns funded by the principal and interest payments from the loans. Investors held or traded these securities, which were often more complicated than the GSEs’ basic mortgage-backed securities; the assets were not just mortgages but equipment leases, credit card debt, auto loans, and manufactured housing loans. Over time, banks and securities firms used securitization to mimic banking activities outside the regulatory framework for banks. For example, where banks traditionally took money from deposits to make loans and held them until maturity, banks now used money from the capital markets—often from money market mutual funds—to make loans, packaging them into securities to sell to investors.
+
+
+
+SECURITIZATION AND DERIVATIVES 4\f646
+
+For commercial banks, the benefits were large. By moving loans off their books, the banks reduced the amount of capital they were required to hold as protection against losses, thereby improving their earnings. Securitization also let banks rely less on deposits for funding, because selling securities generated cash that could be used to make loans. Banks could also keep parts of the securities on their books as collateral for borrowing, and fees from securitization became an important source of revenues.
+
+Lawrence Lindsey, a former Federal Reserve governor and the director of the National Economic Council under President George W. Bush, told the FCIC that previous housing downturns made regulators worry about banks’ holding whole loans on their books. “If you had a regional . . . real estate downturn it took down the banks in that region along with it, which exacerbated the downturn,” Lindsey said. “So we said to ourselves, ‘How on earth do we get around this problem1’ And the answer was,
+
+‘Let’s have a national securities market so we don’t have regional concentration.’ . . . It was intentional.”20
+
+Private securitizations, or structured finance securities, had two key benefits to investors: pooling and tranching. If many loans were pooled into one security, a few defaults would have minimal impact. Structured finance securities could also be sliced up and sold in portions—known as tranches—which let buyers customize their payments. Risk-averse investors would buy tranches that paid off first in the event of default, but had lower yields. Return-oriented investors bought riskier tranches with higher yields. Bankers often compared it to a waterfall; the holders of the senior tranches—at the top of the waterfall—were paid before the more junior tranches.
+
+And if payments came in below expectations, those at the bottom would be the first to be left high and dry.
+
+Securitization was designed to benefit lenders, investment bankers, and investors.
+
+Lenders earned fees for originating and selling loans. Investment banks earned fees for issuing mortgage-backed securities. These securities fetched a higher price than if the underlying loans were sold individually, because the securities were customized to investors’ needs, were more diversified, and could be easily traded. Purchasers of the safer tranches got a higher rate of return than ultra-safe Treasury notes without 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 likely returns, investors had to calculate the statistical probabilities that certain kinds of mortgages might default, and to estimate the revenues that would be lost because of those defaults. Then investors had to determine the effect of the losses on the payments to different tranches.
+
+This complexity transformed the three leading credit rating agencies—Moody’s, Standard & Poor’s (S&P), and Fitch—into key players in the process, positioned between the issuers and the investors of securities. Before securitization became common, the credit rating agencies had mainly helped investors evaluate the safety of municipal and corporate bonds and commercial paper. Although evaluating probabilities was their stock-in-trade, they found that rating these securities required a new type of analysis.
+
+
+
+44
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+Participants in the securitization industry realized that they needed to secure favorable credit ratings in order to sell structured products to investors. Investment banks therefore paid handsome fees to the rating agencies to obtain the desired ratings. “The rating agencies were important tools to do that because you know the people that we were selling these bonds to had never really had any history in the mortgage business. . . . They were looking for an independent party to develop an opinion,” Jim Callahan told the FCIC; Callahan is CEO of PentAlpha, which services the securitization industry, and years ago he worked on some of the earliest securitizations.21
+
+With these pieces in place—banks that wanted to shed assets and transfer risk, investors ready to put their money to work, securities firms poised to earn fees, rating agencies ready to expand, and information technology capable of handling the job—
+
+the securitization market exploded. By 1999, when the market was 16 years old, about \f653900 billion worth of securitizations, beyond those done by Fannie, Freddie, and Ginnie, were outstanding (see figure \f646.1). That included \f653114 billion of automobile loans and over \f653250 billion of credit card debt; nearly \f653150 billion worth of securities were mortgages ineligible for securitization by Fannie and Freddie. Many were subprime.22
+
+Securitization was not just a boon for commercial banks; it was also a lucrative new line of business for the Wall Street investment banks, with which the commercial banks worked to create the new securities. Wall Street firms such as Salomon Brothers and Morgan Stanley became major players in these complex markets and relied increasingly on quantitative analysts, called “quants.” As early as the 1970s, Wall Street executives had hired quants—analysts adept in advanced mathematical theory and computers—to develop models to predict how markets or securities might change. Securitization increased the importance of this expertise. Scott Patterson, author of The Quants, told the FCIC that using models dramatically changed finance.
+
+“Wall Street is essentially floating on a sea of mathematics and computer power,” Patterson said.2\f646
+
+The increasing dependence on mathematics let the quants create more complex products and let their managers say, and maybe even believe, that they could better manage those products’ risk. JP Morgan developed the first “Value at Risk” model (VaR), and the industry soon adopted different versions. These models purported to predict with at least 95\f642 certainty how much a firm could lose if market prices changed.24 But models relied on assumptions based on limited historical data; for mortgage-backed securities, the models would turn out to be woefully inadequate.
+
+And modeling human behavior was different from the problems the quants had addressed in graduate school. “It’s not 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 the way the rocket behaves.”25
+
+Paul Volcker, Fed chairman from 1979 to 1987, told the Commission that regulators were concerned as early as the late 1980s that once banks began selling instead of holding the loans they were making, they would care less about loan quality. Yet as SECURITIZATION AND DERIVATIVES 45
+
+Asset-Backed Securities Outstanding
+
+In the 1990s, many kinds of loans were packaged into asset-backed securities.
+
+IN BILLIONS OF DOLLARS
+
+$1,000
+
+Other
+
+800
+
+Student
+
+loans
+
+600
+
+Manufactured
+
+housing
+
+400
+
+Home equity
+
+Equipment
+
+and other
+
+residential
+
+200
+
+Credit card
+
+Automobile
+
+0
+
+’85
+
+’86
+
+’87
+
+’88
+
+’89
+
+’90
+
+’91
+
+’92
+
+’93
+
+’94
+
+’95
+
+’96
+
+’97
+
+’98
+
+’99
+
+NOTE: Residential loans do not include loans securitized by government-sponsored enterprises.
+
+SOURCE: Securities Industry and Financial Markets Association Figure \f646.1
+
+these instruments became increasingly complex, regulators increasingly relied on the banks to police their own risks. “It was all tied up in the hubris of financial engineers, but the greater hubris let markets take care of themselves,” Volcker said.26 Vincent Reinhart, a former director of the Fed’s Division of Monetary Affairs, told the Commission that he and other regulators failed to appreciate the complexity of the new financial instruments and the difficulties that complexity posed in assessing risk.27
+
+Securitization “was diversifying the risk,” said Lindsey, the former Fed governor.
+
+“But it wasn’t reducing the risk. . . . 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.”28
+
+THE GROWTH OF DERIVATIVES: “BY FAR THE MOST
+
+SIGNIFICANT EVENT IN FINANCE DURING THE PAST DECADE” During the financial crisis, leverage and complexity became closely identified with one element of the story: derivatives. Derivatives are financial contracts whose prices are determined by, or “derived” from, the value of some underlying asset, rate, index,
+
+
+
+46
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+or event. They are not used for capital formation or investment, as are securities; rather, they are instruments for hedging business risk or for speculating on changes in prices, interest rates, and the like. Derivatives come in many forms; the most common are over-the-counter-swaps and exchange-traded futures and options.29 They may be based on commodities (including agricultural products, metals, and energy products), interest rates, currency rates, stocks and indexes, and credit risk. They can even be tied to events such as hurricanes or announcements of government figures.
+
+Many financial and commercial firms use such derivatives. A firm may hedge its price risk by entering into a derivatives contract that offsets the effect of price movements. Losses suffered because of price movements can be recouped through gains on the derivatives contract. Institutional investors that are risk-averse sometimes use interest rate swaps to reduce the risk to their investment portfolios of inflation and rising interest rates by trading fixed interest payments for floating payments with risk-taking entities, such as hedge funds. Hedge funds may use these swaps for the purpose of speculating, in hopes of profiting on the rise or fall of a price or interest rate.
+
+The derivatives markets are organized as exchanges or as over-the-counter (OTC) markets, although some recent electronic trading facilities blur the 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—that is, in revealing the market’s view on prices of commodities or rates underlying futures and options. OTC derivatives are traded by large financial institutions—traditionally, bank holding companies and investment banks—which act as derivatives dealers, buying and selling contracts with customers. Unlike the futures and options exchanges, the OTC market is neither centralized nor regulated. Nor is it transparent, and thus price discovery is limited. No matter the measurement—trading volume, dollar volume, risk exposure—derivatives represent a very significant sector of the U.S. financial system.
+
+The principal legislation governing these markets is the Commodity Exchange Act of 19\f6466, which originally applied only to derivatives on domestic agricultural products. In 1974, Congress amended the act to require that futures and options contracts on virtually all commodities, including financial instruments, be traded on a regulated exchange, and created a new federal independent agency, the Commodity Futures Trading Commission (CFTC), to regulate and supervise the market.\f6460
+
+Outside of this regulated market, an over-the-counter market began to develop and grow rapidly in the 1980s. The large financial institutions acting as OTC derivatives dealers worried that the Commodity Exchange Act’s requirement that trading occur on a regulated exchange might be applied to the products they were buying and selling. In 199\f646, the CFTC sought to address these concerns by exempting certain nonstandardized OTC derivatives from that requirement and from certain other provisions of the Commodity Exchange Act, except for prohibitions against fraud and manipulation.\f6461
+
+As the OTC market grew following the CFTC’s exemption, a wave of significant losses and scandals hit the market. Among many examples, in 1994 Procter & Gamble, SECURITIZATION AND DERIVATIVES 47
+
+a leading consumer products company, reported a pretax loss of \f653157 million, the largest derivatives loss by a nonfinancial firm, stemming from OTC interest and foreign exchange rate derivatives sold to it by Bankers Trust. Procter & Gamble sued Bankers Trust for fraud—a suit settled when Bankers Trust forgave most of the money that Procter & Gamble owed it. That year, the CFTC and the Securities and Exchange Commission (SEC) fined Bankers Trust \f65310 million for misleading Gibson Greeting Cards on interest rate swaps resulting in a mark-to-market loss of \f6532\f646 million, larger than Gibson’s prior-year profits. In late 1994, Orange County, California, announced it had lost \f6531.5 billion speculating in OTC derivatives. The county filed for bankruptcy—the largest by a municipality in U.S. history. Its derivatives dealer, Merrill Lynch, paid \f653400
+
+million to settle claims.\f6462 In response, the U.S. General Accounting Office issued a report on financial derivatives that found dangers in the concentration of OTC derivatives activity among 15 major dealers, concluding that “the sudden failure or abrupt withdrawal from trading of any one of these large dealers could cause liquidity problems in the markets and could also pose risks to the others, including federally insured banks and the financial system as a whole.”\f646\f646 While Congress then held hearings on the OTC derivatives market, the adoption of regulatory legislation failed amid intense lobbying by the OTC derivatives dealers and opposition by Fed Chairman Greenspan.
+
+In 1996, Japan’s Sumitomo Corporation lost \f6532.6 billion on copper derivatives traded on a London exchange. The CFTC charged the company with using derivatives to manipulate copper prices, including using OTC derivatives contracts to disguise the speculation and to finance the scheme. Sumitomo settled for \f653150 million in penalties and restitution. 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 \f65315 million.\f6464
+
+Debate intensified in 1998. In May, the CFTC under Chairperson Brooksley Born said the agency would reexamine the way it regulated the OTC derivatives market, given the market’s rapid evolution and the string of major losses since 199\f646. The CFTC requested comments. It got them.
+
+Some came from other regulators, who took the unusual step of publicly criticizing the CFTC. On the day that the CFTC issued a concept release, Treasury Secretary Robert Rubin, Greenspan, and SEC Chairman Arthur Levitt issued a joint statement denouncing the CFTC’s move: “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 legal uncertainty concerning certain types of OTC derivatives.”\f6465 They proposed a moratorium on the CFTC’s ability to regulate OTC
+
+derivatives.
+
+For months, Rubin, Greenspan, Levitt, and Deputy Treasury Secretary Lawrence Summers opposed the CFTC’s efforts in testimony to Congress and in other public pronouncements. As Alan Greenspan said: “Aside from safety and soundness regulation of derivatives dealers under the banking and securities laws, regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.”\f6466
+
+In September, the Federal Reserve Bank of New York orchestrated a \f653\f646.6 billion recapitalization of Long-Term Capital Management (LTCM) by 14 major OTC
+
+
+
+48
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+derivatives dealers. An enormous hedge fund, LTCM had amassed more than \f6531
+
+trillion in notional amount of OTC derivatives and \f653125 billion of securities on \f6534.8
+
+billion of capital without the knowledge of its major derivatives counterparties or federal regulators.\f6467 Greenspan testified to Congress that in the New York Fed’s judgment, LTCM’s failure would potentially have had systemic effects: a default by 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.”\f6468
+
+Nonetheless, just weeks later, in October 1998, Congress passed the requested moratorium.
+
+Greenspan continued to champion derivatives and advocate deregulation of the OTC market and the exchange-traded market. “By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives,” Greenspan said at a Futures Industry Association conference in March 1999. “The fact that the OTC markets function quite effectively without the benefits of [CFTC regulation] provides a strong argument for development of a less burdensome regime for exchange-traded financial derivatives.”\f6469
+
+The following year—after Born’s resignation—the President’s Working Group on Financial Markets, a committee of the heads of the Treasury, Federal Reserve, SEC, and Commodity Futures Trading Commission charged with tracking the financial system and chaired by then Treasury Secretary Larry Summers, essentially adopted Greenspan’s view. The group issued a report urging Congress to deregulate OTC derivatives broadly and to reduce CFTC regulation of exchange-traded derivatives as well.40
+
+In December 2000, in response, Congress passed and President Clinton signed the Commodity Futures Modernization Act of 2000 (CFMA), which in essence deregulated the OTC derivatives market and eliminated oversight by both the CFTC
+
+and the SEC. The law also preempted application of state laws on gaming and on bucket shops (illegal brokerage operations) that otherwise could have made OTC derivatives transactions illegal. The SEC did retain antifraud authority over securities-based OTC derivatives such as stock options. In addition, the regulatory powers of the CFTC relating to exchange-traded derivatives were weakened but not eliminated.
+
+The CFMA effectively shielded OTC derivatives from virtually all regulation or oversight. Subsequently, other laws enabled the expansion of the market. For example, under a 2005 amendment to the bankruptcy laws, derivatives counterparties were given the advantage over other creditors of being able to immediately terminate their contracts and seize collateral at the time of bankruptcy.
+
+The OTC derivatives market boomed. At year-end 2000, when the CFMA was passed, the notional amount of OTC derivatives outstanding globally was \f65395.2 trillion, and the gross market value was \f653\f646.2 trillion.41 In the seven and a half years from then until June 2008, when the market peaked, outstanding OTC derivatives increased more than sevenfold to a notional amount of \f653672.6 trillion; their gross market value was \f65320.\f646 trillion.42
+
+Greenspan testified to the FCIC that credit default swaps—a small part of the SECURITIZATION AND DERIVATIVES 49
+
+market when Congress discussed regulating derivatives in the 1990s—“did create problems” during the financial crisis.4\f646 Rubin testified that when the CFMA passed he was “not opposed to the regulation of derivatives” and had personally agreed with Born’s views, but that “very strongly held views in the financial services industry in opposition to regulation” were insurmountable.44 Summers told the FCIC that while risks could not necessarily have been foreseen years ago, “by 2008 our regulatory framework with respect to derivatives was manifestly inadequate,” and that “the derivatives that proved to be by far the most serious, those associated with credit default swaps, increased 100 fold between 2000 and 2008.”45
+
+One reason for the rapid growth of the derivatives market was the capital requirements advantage that many financial institutions could obtain through hedging with derivatives. As discussed above, financial firms may use derivatives to hedge their risks. Such use of derivatives can lower a firm’s Value at Risk as determined by computer models. In addition to gaining this advantage in risk management, such hedges can lower the amount of capital that 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 principles for banks’ capital standards, and U.S. banking regulators made adjustments to implement them. Among the most important was the requirement that banks hold more capital against riskier assets. Fatefully, the Basel rules made capital requirements for mortgages and mortgage-backed securities looser than for all other assets related to corporate and consumer loans.46 Indeed, capital requirements for banks’ holdings of Fannie’s and Freddie’s securities were less than for all other assets except those explicitly backed by the U.S. government.47
+
+These international capital standards accommodated the shift to increased leverage. In 1996, large banks sought more favorable capital treatment for their trading, and the Basel Committee on Banking Supervision adopted the Market Risk Amendment to Basel I. This provided that if banks hedged their credit or market risks using derivatives, they could hold less capital against their exposures from trading and other activities.48
+
+OTC derivatives let derivatives traders—including the large banks and investment banks—increase their leverage. For example, entering into an equity swap that mimicked the returns of someone who owned the actual stock may have had some upfront costs, but the amount of collateral posted was much smaller than the upfront cost of purchasing the stock directly. Often no collateral was required at all. Traders could use derivatives to receive the same gains—or losses—as if they had bought the actual security, and with only a fraction of a buyer’s initial financial outlay.49 Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway Inc., testified to the FCIC about the unique characteristics of the derivatives market, saying, “they accentuated enormously, in my view, the leverage in the system.” He went on to call derivatives “very dangerous stuff,” difficult for market participants, regulators, auditors, and investors to understand—indeed, he concluded, “I don’t think I could manage” a complex derivatives book.50
+
+
+
+50
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+A key OTC derivative in the financial crisis was the credit default swap (CDS), which offered the seller a little potential upside at the relatively small risk of a potentially large downside. The purchaser of a CDS transferred to the seller the default risk of an underlying debt. The debt security could be any bond or loan obligation. The CDS buyer made periodic payments to the seller during the life of the swap. In return, the seller offered protection against default or specified “credit events” such as a partial default. If a credit event such as a default occurred, the CDS seller would typically pay the buyer the face value of the debt.
+
+Credit default swaps were often compared to insurance: the seller was described as insuring against a default in the underlying asset. However, while similar to insurance, CDS escaped regulation by state insurance supervisors because they were treated as deregulated OTC derivatives. This made CDS very different from insurance in at least two important respects. First, only a person with an insurable interest can obtain an insurance policy. A car owner can insure only the car she owns—not her neighbor’s.
+
+But a CDS purchaser can use it to speculate on the default of a loan the purchaser does not own. These are often called “naked credit default swaps” and can inflate potential losses and corresponding gains on the default of a loan or institution.
+
+Before the CFMA was passed, there was uncertainty about whether or not state insurance regulators had authority over credit default swaps. In June 2000, in response to a letter from the law firm of Skadden, Arps, Slate, Meagher & Flom, LLP, the New York State Insurance Department determined that “naked” credit default swaps did not count as insurance and were therefore not subject to regulation.51
+
+In addition, when an insurance company sells a policy, insurance regulators require that it put aside reserves in case of a loss. In the housing boom, CDS were sold by firms that failed to put up any reserves or initial collateral or to hedge their exposure. In the run-up to the crisis, AIG, the largest U.S. insurance company, would accumulate a one-half trillion dollar position in credit risk through the OTC market without being required to post one dollar’s worth of initial collateral or making any other provision for loss.52 AIG was not alone. The value of the underlying assets for CDS outstanding worldwide grew from \f6536.4 trillion at the end of 2004 to a peak of
+
+\f65358.2 trillion at the end of 2007.5\f646 A significant portion was apparently speculative or naked credit default swaps.54
+
+Much of the risk of CDS and other derivatives was concentrated in a few of the very largest banks, investment banks, and others—such as AIG Financial Products, a unit of AIG55—that dominated dealing in OTC derivatives. Among U.S. bank holding companies, 97\f642 of the notional amount of OTC derivatives, millions of contracts, were traded by just five large institutions (in 2008, JPMorgan Chase, Citigroup, Bank of America, Wachovia, and HSBC)—many of the same firms that would find themselves in trouble during the financial crisis.56 The country’s five largest investment banks were also among the world’s largest OTC derivatives dealers.
+
+While financial institutions surveyed by the FCIC said they do not track revenues and profits generated by their derivatives operations, some firms did provide estimates. For example, Goldman Sachs estimated that between 25\f642 and \f6465\f642 of its revenues from 2006 through 2009 were generated by derivatives, including 70\f642 to SECURITIZATION AND DERIVATIVES 51
+
+75\f642 of the firm’s commodities business, and half or more of its interest rate and currencies business. From May 2007 through November 2008, \f6531\f646\f646 billion, or 86\f642, of the \f653155 billion of trades made by Goldman’s mortgage department were derivative transactions.57
+
+When the nation’s biggest financial institutions were teetering on the edge of failure in 2008, everyone watched the derivatives markets. What were the institutions’
+
+holdings1 Who were the counterparties1 How would they fare1 Market participants and regulators would find themselves straining to understand an unknown battlefield shaped by unseen exposures and interconnections as they fought to keep the financial system from collapsing.
+
+
+
+4
+
+DEREGULATION REDUX
+
+CONTENTS
+
+Expansion of banking activities: “Shatterer of Glass-Steagall” .............................52
+
+Long-Term Capital Management:
+
+“That’s what history had proved to them” .....................................................56
+
+Dot-com crash: “Lay on more risk”......................................................................59
+
+The wages of finance: “Well, this one’s doing it, so how can I not do it1” ..............61
+
+Financial sector growth:
+
+“I think we overdid finance versus the real economy”....................................64
+
+EXPANSION OF BANKING ACTIVITIES:
+
+“SHATTERER OF GLASS\f6baSTEAGALL”
+
+By the mid-1990s, the parallel banking system was booming, some of the largest commercial banks appeared increasingly like the large investment banks, and all of them were becoming larger, more complex, and more active in securitization. Some academics and industry analysts argued that advances in data processing, telecommunications, and information services created economies of scale and scope in finance and thereby justified ever-larger financial institutions. Bigger would be safer, the argument went, and more diversified, innovative, efficient, and better able to serve the needs of an expanding economy. Others contended that the largest banks were not necessarily more efficient but grew because of their commanding market positions and creditors’ perception they were too big to fail. As they grew, the large banks pressed regulators, state legislatures, and Congress to remove almost all remaining barriers to growth and competition. They had much success. In 1994 Congress authorized nationwide banking with the Riegle-Neal Interstate Banking and Branching Efficiency Act. This let bank holding companies acquire banks in every state, and removed most restrictions on opening branches in more than one state. It preempted any state law that restricted the ability of out-of-state banks to compete within the state’s borders.1
+
+Removing barriers helped consolidate the banking industry. Between 1990 and
+
+2005, 74 “megamergers” occurred involving banks with assets of more than \f65310 billion each. Meanwhile the 10 largest jumped from owning 25\f642 of the industry’s assets
+
+52
+
+
+
+DEREGULATION REDUX 5\f646
+
+to 55\f642. From 1998 to 2007, the combined assets of the five largest U.S. banks—Bank of America, Citigroup, JP Morgan, Wachovia, and Wells Fargo—more than tripled, from \f6532.2 trillion to \f6536.8 trillion.2 And investment banks were growing bigger, too.
+
+Smith Barney acquired Shearson in 199\f646 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 of the five largest investment banks—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns—quadrupled, from \f6531 trillion in 1998 to \f6534 trillion in 2007.\f646
+
+In 1996, the Economic Growth and Regulatory Paperwork Reduction Act required federal regulators to review their rules every decade and solicit comments on
+
+“outdated, unnecessary, or unduly burdensome” rules.4 Some agencies responded with gusto. In 200\f646, the Federal Deposit Insurance Corporation’s annual report included a photograph of the vice chairman, John Reich; the director of the Office of Thrift Supervision (OTS), James Gilleran; and three banking industry representatives using a chainsaw and pruning shears to cut the “red tape” binding a large stack of documents representing regulations.
+
+Less enthusiastic agencies felt heat. Former Securities and Exchange Commission chairman Arthur Levitt told the FCIC that once word of a proposed regulation got out, industry lobbyists would rush to complain to members of the congressional committee with jurisdiction over the financial activity at issue. According to Levitt, these members would then “harass” the SEC with frequent letters demanding answers to complex questions and appearances of officials before Congress. These requests consumed much of the agency’s time and discouraged it from making regulations. Levitt described it as “kind of a blood sport to make the particular agency look stupid or inept or venal.”5
+
+However, others said interference—at least from the executive branch—was modest. John Hawke, a former comptroller of the currency, told the FCIC he found the Treasury Department “exceedingly sensitive” to his agency’s independence. His successor, John Dugan, said “statutory firewalls” prevented interference from the executive branch.6
+
+Deregulation went beyond dismantling regulations; its supporters were also disin-clined to adopt new regulations or challenge industry on the risks of innovations.
+
+Federal Reserve officials argued that financial institutions, with strong incentives to protect shareholders, would regulate themselves by carefully managing their own risks. In a 200\f646 speech, Fed Vice Chairman Roger Ferguson praised “the truly impressive improvement in methods of risk measurement and management and the growing adoption of these technologies by mostly large banks and other financial intermediaries.”7 Likewise, Fed and other officials believed that markets would self-regulate through the activities of analysts and investors. “It is critically important to recognize that no market is ever truly unregulated,” said Fed Chairman Alan Greenspan in 1997. “The self-interest of market participants generates private market regulation. Thus, the real question is not whether a market should be regulated.
+
+
+
+54
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+Rather, the real question is whether government intervention strengthens or weakens private regulation.”8
+
+Richard Spillenkothen, the Fed’s director of Banking Supervision and Regulation from 1991 to 2006, discussed banking supervision in a memorandum submitted to the FCIC: “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-handed, ii) an undesirable constraint on credit availability, or iii) inconsistent with the Fed’s public posture.”9
+
+To create checks and balances and keep any agency from becoming arbitrary or inflexible, senior policy makers pushed to keep multiple regulators.10 In 1994, 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.”11 Further, some regulators, including the OTS and Office of the Comptroller of the Currency (OCC), were funded largely by assessments from the institutions they regulated. As a result, the larger the number of institutions that chose these regulators, the greater their budget.
+
+Emboldened by success and the tenor of the times, the largest banks and their regulators continued to oppose limits on banks’ activities or growth. The barriers separating commercial banks and investment banks had been crumbling, little by little, and now seemed the time to remove the last remnants of the restrictions that separated banks, securities firms, and insurance companies.
+
+In the spring of 1996, after years of opposing repeal of Glass-Steagall, the Securities Industry Association—the trade organization of Wall Street firms such as Goldman Sachs and Merrill Lynch—changed course. Because restrictions on banks had been slowly removed during the previous decade, banks already had beachheads in securities and insurance. Despite numerous lawsuits against the Fed and the OCC, securities firms and insurance companies could not stop this piecemeal process of deregulation through agency rulings.12 Edward Yingling, the CEO of the American Bankers Association (a lobbying organization), said, “Because we had knocked so many holes in the walls separating commercial and investment banking and 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.”1\f646
+
+In 1998, Citicorp forced the issue by seeking a merger with the insurance giant Travelers to form Citigroup. The Fed approved it, citing a technical exemption to the Bank Holding Company Act,14 but Citigroup would have to divest itself of many Travelers assets within five years unless the laws were changed. Congress had to make a decision: Was it prepared to break up the nation’s largest financial firm1 Was it time to repeal the Glass-Steagall Act, once and for all1
+
+
+
+DEREGULATION REDUX 55
+
+As Congress began fashioning legislation, the banks were close at hand. In 1999, the financial sector spent \f653187 million lobbying at the federal level, and individuals and political action committees (PACs) in the sector donated \f653202 million to federal election campaigns in the 2000 election cycle. From 1999 through 2008, federal lobbying by the financial sector reached \f6532.7 billion; campaign donations from individuals and PACs topped \f6531 billion.15
+
+In November 1999, Congress passed and President Clinton signed the Gramm-Leach-Bliley Act (GLBA), which lifted most of the remaining Glass-Steagall-era restrictions. The new law embodied many of the measures Treasury had previously advocated.16 The New York Times 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.’”17
+
+Now, as long as bank holding companies satisfied certain safety and soundness conditions, they could underwrite and sell banking, securities, and insurance products and services. Their securities affiliates were no longer bound by the Fed’s 25\f642
+
+limit—their primary regulator, the SEC, set their only boundaries. Supporters of the legislation argued that the new holding companies would be more profitable (due to economies of scale and scope), safer (through a broader diversification of risks), more useful to consumers (thanks 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. The legislation’s opponents warned that allowing banks to combine with securities firms would promote excessive speculation and could trigger a crisis like the crash of 1929. John Reed, former co-CEO of Citigroup, acknowledged to the FCIC that, in hindsight, “the compartmentalization that was created by Glass-Steagall would be a positive factor,” making less likely a “catastrophic failure” of the financial system.18
+
+To win the securities industry’s support, the new law left in place two exceptions that let securities firms own thrifts and industrial loan companies, a type of depository institution with stricter limits on its activities. Through them, securities firms could access FDIC-insured deposits without supervision by the Fed. Some securities firms immediately expanded their industrial loan company and thrift subsidiaries.
+
+Merrill’s industrial loan company grew from less than \f6531 billion in assets in 1998 to
+
+\f6534 billion in 1999, and to \f65378 billion in 2007. Lehman’s thrift grew from \f65388 million in 1998 to \f653\f646 billion in 1999, and its assets rose as high as \f65324 billion in 2005.19
+
+For institutions regulated by the Fed, the new law also established a hybrid regulatory structure known colloquially as “Fed-Lite.” The Fed supervised financial holding companies as a whole, looking only for risks that cut across the various subsidiaries owned by the holding company. To avoid duplicating other regulators’ work, the Fed was required to rely “to the fullest extent possible” on examinations and reports of those agencies regarding subsidiaries of the holding company, including banks, securities firms, and insurance companies. The expressed intent of Fed-Lite was to eliminate excessive or duplicative regulation.20 However, Fed Chairman Ben Bernanke told the FCIC that Fed-Lite “made it difficult for any single regulator to reliably see the whole picture of activities and risks of large, complex banking institutions.”21
+
+
+
+56
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+Indeed, the regulators, including the Fed, would fail to identify excessive risks and unsound practices building up in nonbank subsidiaries of financial holding companies such as Citigroup and Wachovia.22
+
+The convergence of banks and securities firms also undermined the supportive relationship between banking and securities markets that Fed Chairman Greenspan had considered a source of stability. He compared it to a “spare tire”: if large commercial banks ran into trouble, their large customers could borrow from investment banks and others in the capital markets; if those markets froze, banks could lend using their deposits. After 1990, securitized mortgage lending provided another source of credit to home buyers and other borrowers that softened a steep decline in lending by thrifts and banks. The system’s resilience following the crisis in Asian financial markets in the late 1990s further proved his point, Greenspan said.2\f646
+
+The new regime encouraged growth and consolidation within and across banking, securities, and insurance. The bank-centered financial holding companies such as Citigroup, JP Morgan, and Bank of America could compete directly with the “big five” investment banks—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns—in securitization, stock and bond underwriting, loan syndication, and trading in over-the-counter (OTC) derivatives. The biggest bank holding companies became major players in investment banking. The strategies of the largest commercial banks and their holding companies came to more closely resemble the strategies of investment banks. Each had advantages: commercial banks enjoyed greater access to insured deposits, and the investment banks enjoyed less regulation. Both prospered from the late 1990s until the outbreak of the financial crisis in 2007. However, Greenspan’s “spare tire” that had helped make the system less vulnerable would be gone when the financial crisis emerged—all the wheels of the system would be spinning on the same axle.
+
+LONG\f6baTERM CAPITAL MANAGEMENT:
+
+“THAT’S WHAT HISTORY HAD PROVED TO THEM”
+
+In August 1998, Russia defaulted on part of its national debt, panicking markets. Russia announced it would restructure its debt and postpone some payments. In the aftermath, investors dumped higher-risk securities, including those having nothing to do with Russia, and fled to the safety of U.S. Treasury bills and FDIC-insured deposits. In response, the Federal Reserve cut short-term interest rates three times in seven weeks.24 With the commercial paper market in turmoil, it was up to the commercial banks to take up the slack by lending to corporations that could not roll over their short-term paper. Banks loaned \f653\f6460 billion in September and October of
+
+1998—about 2.5 times the usual amount25—and helped prevent a serious disruption from becoming much worse. The economy avoided a slump.
+
+Not so for Long-Term Capital Management, a large U.S. hedge fund. LTCM had devastating losses on its \f653125 billion portfolio of high-risk debt securities, including the junk bonds and emerging market debt that investors were dumping.26 To buy these securities, the firm had borrowed \f65324 for every \f6531 of investors’ equity;27 lenders DEREGULATION REDUX 57
+
+included Merrill Lynch, JP Morgan, Morgan Stanley, Lehman Brothers, Goldman Sachs, and Chase Manhattan. The previous four years, LTCM’s leveraging strategy had produced magnificent returns: 19.9\f642, 42.8\f642, 40.8\f642, and 17.1\f642, while the S&P
+
+500 yielded an average 21\f642.28
+
+But leverage works both ways, and in just one month after Russia’s partial default, the fund lost more than \f6534 billion—or more than 80\f642 of its nearly \f6535 billion in capital. Its debt was about \f653120 billion. The firm faced insolvency.29
+
+If it were only a matter of less than \f6535 billion, LTCM’s failure might have been manageable. But the firm had further leveraged itself by entering into derivatives contracts with more than \f6531 trillion in notional amount—mostly interest rate and equity derivatives.\f6460 With very little capital in reserve, it threatened to default on its obligations to its derivatives counterparties—including many of the largest commercial and investment banks. Because LTCM had negotiated its derivatives transactions in the opaque over-the-counter market, the markets did not know the size of its positions or the fact that it had posted very little collateral against those positions. As the Fed noted then, if all the fund’s counterparties had tried to liquidate their positions simultaneously, asset prices across the market might have plummeted, which would have created “exaggerated” losses. This was a classic setup for a run: losses were likely, but nobody knew who would get burned. The Fed worried that with financial markets already fragile, these losses would spill over to investors with no relationship to LTCM, and credit and derivatives markets might “cease to function for a period of one or more days and maybe longer.”\f6461
+
+To avert such a disaster, the Fed called an emergency meeting of major banks and securities firms with large exposures to LTCM.\f6462 On September 2\f646, after considerable urging, 14 institutions agreed to organize a consortium to inject \f653\f646.6 billion into LTCM in return for 90\f642 of its stock.\f646\f646 The firms contributed between \f653100 million and \f653\f64600 million each, although Bear Stearns declined to participate.\f6464 An orderly liquidation of LTCM’s securities and derivatives followed.
+
+William McDonough, then president of the New York Fed, insisted “no Federal Reserve official pressured anyone, and no promises were made.”\f6465 The rescue involved no government funds. Nevertheless, the Fed’s orchestration raised a question: how far would it go to forestall what it saw as a systemic crisis1
+
+The Fed’s aggressive response had precedents in the previous two decades. In
+
+1970, the Fed had supported the commercial paper market; in 1980, dealers in silver futures; in 1982, the repo market; in 1987, the stock market after the Dow Jones Industrial Average fell by 26\f642 percent in three days. All provided a template for future interventions. Each time, the Fed cut short-term interest rates and encouraged financial firms in the parallel banking and traditional banking sectors to help ailing markets. And sometimes it organized a consortium of financial institutions to rescue firms.\f6466
+
+During the same period, federal regulators also rescued several large banks that they viewed as “too big to fail” and protected creditors of those banks, including uninsured depositors. Their rationale was that major banks were crucial to the financial markets and the economy, and regulators could not allow the collapse of one
+
+
+
+58
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+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+large bank to trigger a panic among uninsured depositors that might lead to more bank failures.
+
+But it was a completely different proposition to argue that a hedge fund could be considered too big to fail because its collapse might destabilize capital markets. Did LTCM’s rescue indicate that the Fed was prepared to protect creditors of any type of firm if its collapse might threaten the capital markets1 Harvey Miller, the bankruptcy counsel for Lehman Brothers when it failed in 2008, told the FCIC that “they [hedge funds] expected the Fed to save Lehman, based on the Fed’s involvement in LTCM’s rescue. That’s what history had proved to them.”\f6467
+
+For Stanley O’Neal, Merrill’s CFO during the LTCM rescue, the experience was
+
+“indelible.” He told the FCIC, “The lesson I took away from it though was that had the market seizure and panic and lack of liquidity lasted longer, there would have been a lot of firms across the Street that were irreparably harmed, and Merrill would have been one of those.”\f6468
+
+Greenspan argued that the events of 1998 had confirmed the spare tire theory. He said in a 1999 speech that 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.”\f6469 The President’s Working Group on Financial Markets came to a less definite conclusion. In a 1999 report, the group noted 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.”40 Many financial firms would make essentially the same mistake a decade later. For the Working Group, this miscalculation raised an important issue: “As 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.”41
+
+The need for risk management grew in the following decade. The Working Group was already concerned that neither the markets nor their regulators were prepared for tail risk—an unanticipated event causing catastrophic damage to financial institutions and the economy. Nevertheless, it cautioned that overreacting to threats such as LTCM would diminish the dynamism of the financial sector and the real economy:
+
+“Policy 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.”42
+
+Following the Working Group’s findings, the SEC five years later would issue a rule expanding the number of hedge fund advisors—to include most advisors—that needed to register with the SEC. The rule would be struck down in 2006 by the United States Court of Appeals for the District of Columbia after the SEC was sued by an investment advisor and hedge fund.4\f646
+
+Markets were relatively calm after 1998, Glass-Steagall would be deemed unnecessary, OTC derivatives would be deregulated, and the stock market and the economy would continue to prosper for some time. Like all the others (with the exception DEREGULATION REDUX 59
+
+of the Great Depression), this crisis soon faded into memory. But not before, in February 1999, Time magazine featured Robert Rubin, Larry Summers, and Alan Greenspan on its cover as “The Committee to Save the World.” Federal Reserve Chairman Greenspan became a cult hero—the “Maestro”—who had handled every emergency since the 1987 stock market crash.44
+
+DOT\f6baCOM CRASH: “LAY ON MORE RISK”
+
+The late 1990s was a good time for investment banking. Annual public underwrit-ings and private placements of corporate securities in U.S. markets almost quadrupled, from \f653600 billion in 1994 to \f6532.2 trillion in 2001. Annual initial public offerings of stocks (IPOs) soared from \f65328 billion in 1994 to \f65376 billion in 2000 as banks and securities firms sponsored IPOs for new Internet and telecommunications companies—the dot-coms and telecoms.45 A stock market boom ensued comparable to the great bull market of the 1920s. The value of publicly traded stocks rose from \f6535.8 trillion in December 1994 to \f65317.8 trillion in March 2000.46 The boom was particularly striking in recent dot-com and telecom issues on the NASDAQ exchange. Over this period, the NASDAQ skyrocketed from 752 to 5,048.
+
+In the spring of 2000, the tech bubble burst. The “new economy” dot-coms and telecoms had failed to match the lofty expectations of investors, who had relied on bullish—and, as it turned out, sometimes deceptive—research reports issued by the same banks and securities firms that had underwritten the tech companies’ initial public offerings. Between March 2000 and March 2001, the NASDAQ fell by almost two-thirds. This slump accelerated after the terrorist attacks on September 11 as the nation slipped into recession. Investors were further shaken by revelations of accounting frauds and other scandals at prominent firms such as Enron and World-com. Some leading commercial and investment banks settled with regulators over improper practices in the allocation of IPO shares during the bubble—for spinning (doling out shares in “hot” IPOs in return for reciprocal business) and laddering (doling out shares to investors who agreed to buy more later at higher prices).47 The regulators also found that public research reports prepared by investment banks’ analysts were tainted by conflicts of interest. The SEC, New York’s attorney general, the National Association of Securities Dealers (now FINRA), and state regulators settled enforcement actions against 10 firms for \f653875 million, forbade certain practices, and instituted reforms.48
+
+The sudden collapses of Enron and WorldCom were shocking; with assets of \f6536\f646
+
+billion and \f653104 billion, respectively, they were the largest corporate bankruptcies before the default of Lehman Brothers in 2008.
+
+Following legal proceedings and investigations, Citigroup, JP Morgan, Merrill Lynch, and other Wall Street banks paid billions of dollars—although admitted no wrongdoing—for helping Enron hide its debt until just before its collapse. Enron and its bankers had created entities to do complex transactions generating fictitious earnings, disguised debt as sales and derivative transactions, and understated the firm’s leverage. Executives at the banks had pressured their analysts to write glowing
+
+
+
+60
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+evaluations of Enron. The scandal cost Citigroup, JP Morgan, CIBC, Merrill Lynch, and other financial institutions more than \f653400 million in settlements with the SEC; Citigroup, JP Morgan, CIBC, Lehman Brothers, and Bank of America paid another
+
+\f6536.9 billion to investors to settle class action lawsuits.49 In response, the Sarbanes-Oxley Act of 2002 required the personal certification of financial reports by CEOs and CFOs; independent audit committees; longer jail sentences and larger fines for executives who misstate financial results; and protections for whistleblowers.
+
+Some firms that lent to companies that failed during the stock market bust were successfully hedged, having earlier purchased credit default swaps on these firms.
+
+Regulators seemed to draw comfort from the fact that major banks had succeeded in transferring losses from those relationships to investors through these and other hedging transactions. In November 2002, Fed Chairman Greenspan said credit derivatives “appear to have effectively spread losses” from defaults by Enron and other large corporations. Although he conceded the market was “still too new to have been tested” thoroughly, he observed that “to date, it appears to have functioned well.”50
+
+The following year, Fed Vice Chairman Roger Ferguson noted that “the most remarkable fact regarding the banking industry during this period is its resilience and retention of fundamental strength.”51
+
+This resilience led many executives and regulators to presume the financial system had achieved unprecedented stability and strong risk management. The Wall Street banks’ pivotal role in the Enron debacle did not seem to trouble senior Fed officials. In a memorandum to the FCIC, Richard Spillenkothen described a presentation to the Board of Governors in which some Fed governors received details of the banks’ complicity “coolly” and were “clearly unimpressed” by analysts’ findings. “The message to some supervisory staff was neither ambiguous nor subtle,” Spillenkothen wrote. Earlier in the decade, he remembered, senior economists at the Fed had called Enron an example of a derivatives market participant successfully regulated by market discipline without government oversight.52
+
+The Fed cut interest rates aggressively in order to contain damage from the dot-com and telecom bust, the terrorist attacks, and the financial market scandals. In January 2001, the federal funds rate, the overnight bank-to-bank lending rate, was 6.5\f642.
+
+By mid-200\f646, the Fed had cut that rate to just 1\f642, the lowest in half a century, where it stayed for another year. In addition, to offset the market disruptions following the
+
+9/11 attacks, the Fed flooded the financial markets with money by purchasing more than \f653150 billion in government securities and lending \f65345 billion to banks. It also suspended restrictions on bank holding companies so the banks could make large loans to their securities affiliates. With these actions the Fed prevented a protracted liquidity crunch in the financial markets during the fall of 2001, just as it had done during the 1987 stock market crash and the 1998 Russian crisis.
+
+Why wouldn’t the markets assume the central bank would act again—and again save the day1 Two weeks before the Fed cut short-term rates in January 2001, the Economist anticipated it: “the ‘Greenspan put’ is once again the talk of Wall Street. . . .
+
+The idea is that the Federal Reserve can be relied upon in times of crisis to come to DEREGULATION REDUX 61
+
+the rescue, cutting interest rates and pumping in liquidity, thus providing a floor for equity prices.”5\f646 The “Greenspan put” was analysts’ shorthand for investors’ faith that the Fed would keep the capital markets functioning no matter what. The Fed’s policy was clear: to restrain growth of an asset bubble, it would take only small steps, such as warning investors some asset prices might fall; but after a bubble burst, it would use all the tools available to stabilize the markets. Greenspan argued that intentionally bursting a bubble would heavily damage the economy. “Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences,” he said in 2004, when housing prices were ballooning, “we chose . . . to focus on policies ‘to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.’”54
+
+This asymmetric policy—allowing unrestrained growth, then working hard to cushion the impact of a bust—raised the question of “moral hazard”: did the policy encourage investors and financial institutions to gamble because their upside was unlimited while the full power and influence of the Fed protected their downside (at least against catastrophic losses)1 Greenspan himself warned about this in a 2005
+
+speech, noting that higher asset prices were “in part the indirect result of investors accepting lower compensation for risk” and cautioning that “newly abundant liquidity can readily disappear.”55 Yet the only real action would be an upward march of the federal funds rate that had begun in the summer of 2004, although, as he pointed out in the same 2005 speech, this had little effect.
+
+And the markets were undeterred. “We had convinced ourselves that we were in a less risky world,” former Federal Reserve governor and National Economic Council director under President George W. Bush Lawrence Lindsey told the Commission.
+
+“And how should any rational investor respond to a less risky world1 They should lay on more risk.”56
+
+THE WAGES OF FINANCE:
+
+“WELL, THIS ONE’S DOING IT, SO HOW CAN I NOT DO IT1 ” As figure 4.1 demonstrates, for almost half a century after the Great Depression, pay inside the financial industry and out was roughly equal. Beginning in 1980, they diverged. By 2007, financial sector compensation was more than 80\f642 greater than in other businesses—a considerably larger gap than before the Great Depression.
+
+Until 1970, the New York Stock Exchange, a private self-regulatory organization, required members to operate as partnerships.57 Peter J. Solomon, a former Lehman Brothers partner, testified before the FCIC that this profoundly affected the investment bank’s culture. Before the change, he and the other partners had sat in a single room at headquarters, not to socialize but to “overhear, interact, and monitor” each other. They were all on the hook together. “Since they were personally liable as partners, they took risk very seriously,” Solomon said.58 Brian Leach, formerly an executive at Morgan Stanley, described to FCIC staff Morgan Stanley’s compensation practices before it issued stock and became a public corporation: “When I first
+
+
+
+62
+
+FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+
+
+
+
+
+Compensation in the financial sector outstripped pay elsewhere, a pattern not seen since the years before the Great Depression.
+
+ANNUAL AVERAGE, IN 2009 DOLLARS
+
+$120,000
+
+$102,069
+
+100,000
+
+Financial
+
+80,000
+
+$58,666
+
+60,000
+
+40,000
+
+20,000
+
+0
+
+1929
+
+1940
+
+1950
+
+1960
+
+1970
+
+1980
+
+1990
+
+2000
+
+2009
+
+NOTE: Average compensation includes wages, salaries, commissions, tips, bonuses, and payments for SOURCES: Bureau of Economic Analysis, Bureau of Labor Statistics, CPI-Urban, FCIC calculations Figure 4.1
+
+started at Morgan Stanley, it was a private company. When you’re a private company, you don’t get paid until you retire. I mean, you get a
projects / crisishaiku.git / commitdiff
