PREFACE
-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.
+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.
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.
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.
-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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-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.
+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 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.
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.
-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.
+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.
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.
-CONCLUSIONS OF THE
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+CONCLUSIONS OF THE FINANCIAL CRISIS INQUIRY COMMISSION
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.
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.
-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.
+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 $11 trillion in household wealth has vanished, with retirement accounts and life savings swept away. Businesses, large and small, have felt 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.
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.
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.
-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’
+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.
-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.
+The financial system we examined bears little resemblance to that of our parents’ 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.
From 1978 to 2007, the amount of debt held by the financial sector soared from
-\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
+$3 trillion to $36 trillion, more than doubling as a share of gross domestic product.
-15\f642 in 1980. Understanding this transformation has been critical to the Commission’s analysis.
+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% 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% of all corporate profits in the United States, up from 15% in 1980. Understanding this transformation has been critical to the Commission’s analysis.
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.
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.
-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.
+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.
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.
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.
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.
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.
-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.
+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 $2.7 billion in reported federal lobbying expenses; individuals and political action committees in the sector made more than $1 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.
• 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.
Like Icarus, they never feared flying ever closer to the sun.
-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.
+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 $40 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%" of his time on those securities. In this instance, too big to fail meant too big to manage.
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.
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.
-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
+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 $79 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 $55 billion in "super-senior" and supposedly
-“super-safe” mortgage-related securities that resulted in billions of dollars in losses.
+"super-safe" mortgage-related securities that resulted in billions of dollars in losses.
• 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.
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
-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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+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 $40 in assets, there was only $1 in capital to cover losses. Less than a 3% 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 $11.8 billion in equity and $383.6 billion in liabilities and was borrowing as much as $70 billion in the overnight market. It was the equivalent of a small business with $50,000 in equity borrowing $1.6 million, with $296,750 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.
-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.
+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.
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.
-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.
+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 63% from $91,500 to $149,500, even while wages were essentially stagnant. When the housing downturn hit, heavily indebted financial firms and families alike were walloped.
-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.
+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 $111 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.
-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.
+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 30-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.
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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• 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.
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.
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.
-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
+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
-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.
+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.
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.
-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.
+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 many others who labored to stabilize our financial system and our economy in the most chaotic and challenging of circumstances.
• 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.
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.
-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
+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
-2005 and 2009. One study places the losses resulting from fraud on mortgage loans made between 2005 and 2007 at \f653112 billion.
+2005 and 2009. One study places the losses resulting from fraud on mortgage loans made between 2005 and 2007 at $112 billion.
-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.
+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.
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.
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.
-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.
+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.
-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.
+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.
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.
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.
-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.
-
-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.
-
+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% 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.
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.
• 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.
-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.
+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 $673 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.
+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 $79 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
+Goldman Sachs alone packaged and sold $73 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
+2004, to May 31, 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.
+3,400 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.
+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 $180 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.
+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 30 mortgage-related securities every working day. The results were disastrous: 83% 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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-estate assets in the United States were prerequisites for the creation of a credit bubble.
+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 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
+$5 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
+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 $164 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.
+Through the third quarter of 2010, the Treasury Department had provided $151 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
+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% 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.
+40% in 2004, and falling back to 28% 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.
+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% versus 28.3%.
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.
+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.
+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% 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
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-
-profound lapses in regulatory oversight, and near fatal flaws in our financial system.
+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, 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.
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
+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 "300 million Americans."2 Lloyd Blankfein, the chairman and chief executive officer of Goldman Sachs Group, Inc., likened the financial crisis to a hurricane.3
-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]
+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
+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
+In fact, there were warning signs. In the decade preceding the collapse, there were many signs that house prices were inflated, that lending practices had spun out of control, that too many homeowners were taking on mortgages and debt they could ill afford, and that risks to the financial system were growing unchecked. Alarm bells were clanging inside financial institutions, regulatory offices, consumer service organizations, state law enforcement agencies, and 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.
-\f646
+"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
-4
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-
-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
-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
+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
+When the Federal Reserve cut interest rates early in the new century and mortgage rates fell, home refinancing surged, climbing from $460 billion in 2000 to $2.8 trillion in 2003,10 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% in eight years by one measure and hitting a national high of $227,100 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.13 Housing starts nationwide climbed 53%, from 1.4 million in 1995 to more than 2 million in 2005. Encouraged by government policies, homeownership reached a record 69.2% 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.
+$2.0 trillion in home equity between 2000 and 2007, including $334 billion in 2006 alone, more than seven times the amount they took out in 1996.14 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%, 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.
+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% of homeowners pulled out cash to buy a vehicle and over 40% 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
+"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.
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-down—it became a commodity. That was a change in the culture. . . . It was sudden, unexpected.”18
+They buy a house, make $50,000 . . . and talk at a cocktail party about it. . . . Housing suddenly went from being part of the American dream to house my family to settle 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.
+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 30-year fixed-rate mortgage, with a 20% 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
+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
+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 3–27s; 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 conscientious borrowers who tried to puzzle out their implications, and opening the door for those who wanted in on the action.
-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.23 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.
-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
-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.
+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 $5.3 trillion in 2001 to $10.5 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 $91,500 in 2001 to $149,500 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.
+is 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
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-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
-“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.
+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
+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
-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.
+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 money every night to finance Bear Stearns’s broader securities portfolio. In September 2003, Cioffi created a hedge fund within Bear Stearns with a minimum investment of $1 million. As was common, he used borrowed money—up to $9 borrowed for every $1 from investors—to buy CDOs. Cioffi’s first fund was extremely successful; it earned 17% for investors in 2004 and 10% in 2005—after the annual management fee and the 20% slice of the profit for Cioffi and his Bear Stearns team—and grew to almost $9 billion by the end of 2005. In the fall of 2006, he created another, more aggressive fund. This one would shoot for leverage of up to 12 to 1. By the end of 2006, the two hedge funds had $18 billion invested, half in securities issued by CDOs centered on housing. As a CDO manager, Cioffi also managed another $18 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.
+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.30 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
+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.31 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.32
-49\f642 in those same years; at the same time, the city’s unemployment rate, ranging
+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%, climbing from a median of $75,200 to $125,100, while home prices nationally rose about
+49% in those same years; at the same time, the city’s unemployment rate, ranging rom 5.8% in 1990 to 4.2% 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.
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-from 5.8\f642 in 1990 to 4.2\f642 in 1999, more or less tracked the broader U.S. pattern.
+City officials began to hear reports that these activities were being propelled by new kinds of nontraditional loans that enabled investors to buy properties with little or no money down and gave homeowners the ability to refinance their houses, regardless of whether they could afford to repay the loans. Foreclosures shot up in Cuyahoga County from 3,500 a year in 1995 to 7,000 a year in 2000.33 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.
-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.
+"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.
-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.
+But then people realized they could scam it."34
-“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.
+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
-But then people realized they could scam it.”\f6464
+"combated with legal enforcement measures."35
-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
+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."36
-“combated with legal enforcement measures.”\f6465
+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.37
-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
+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.38
-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
+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.39 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% 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
-
-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
+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.43 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
+The volume of subprime and nontraditional lending rose sharply. In 2000, the top 25 nonprime lenders originated $105 billion in loans. Their volume rose to $188 billion in 2002, and then $310 billion in 2003.45
-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
+California, with its high housing costs, was a particular hotbed for this kind of lending. In 2001, nearly $52 billion, or 25% of all nontraditional loans nationwide, were made in that state; California’s share rose to 35% by 2003, with these kinds of loans growing to $95 billion or by 84% 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 $600 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
+"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
+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 bout 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 $50 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 2003 to investigate another fast-growing lender, California-based Ameriquest. It became the nation’s largest subprime lender, originating $39 billion in subprime loans in
-12
+2003—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
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+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 2003, but senior management did nothing with the reports he sent. He heard that other departments were complaining he
-about First Alliance Mortgage Company, a California-based mortgage lender. Consumers complained that they had been deceived into taking out loans with hefty fees.
+"looked too much" into the loans. In November 2005, he was downgraded from
-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
+"manager" to "supervisor," and was laid off in May 2006.52
-million. First Alliance went out of business. But other firms stepped into the void.49
+In late 2003, 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
-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
+"light construction."53
-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
+"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.
-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
+"I got that it had shifted," Cox recalled. "The lending pattern had shifted."54
-“looked too much” into the loans. In November 2005, he was downgraded from
+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 $325 million settlement. But during the years when the investigation was under way, between
-“manager” to “supervisor,” and was laid off in May 2006.52
+2002 and 2005, Ameriquest originated another $217.9 billion in loans,55 which then flowed to Wall Street for securitization.
-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
+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 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
-“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
+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
+"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 2003, 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 5–3 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
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-
-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
+Nonprime lending surged to $730 billion in 2004 and then $1.0 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 egan their jobs during the boom, and some were less than honorable in their dealings with borrowers.63 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.
+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.
+Wide-open farm fields were plowed under and divided into thousands of building lots. Home prices jumped 11% in Bakersfield in 2002, 17% in 2003, 32% in 2004, and 29% 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.
+Crabtree, an appraiser for 48 years, started in 2003 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 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 $565,000, and was recorded as selling for $605,000 with 100% financing, though the real estate agent told Crabtree that it actually sold for $535,000. Crabtree realized that the gap between the sales price and loan amount allowed these insiders to pocket $70,000. 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 $322,000.67
-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
+Crabtree began calling lenders to tell them what he had found; but to his shock, they did not seem to care. He finally reached one quality assurance officer at Fremont Investment & Loan, the nation’s eighth-largest subprime lender. "Don’t put your nose where it doesn’t belong," he was told.68
-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
-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
-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
+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
+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.73
-“The claim that no one could have foreseen the crisis is false,” said William K.
+"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
+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 uality 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
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-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
+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
+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.
+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.
+"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
+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 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
+"the problems in the subprime market were likely to be contained"—that is, he expected little spillover to the broader economy.83
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
+61% 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.
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.
+"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
+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
+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
+Susan M. Wachter, a professor of real estate and finance at the University of Pennsylvania’s Wharton School, prepared a research paper in 2003 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
+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
+"absurd."90
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-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
+n 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
+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
+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.93
-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
+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 $1.3 trillion in mortgage-backed securities and more than $350 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
+Reflecting on the causes of the crisis, Jamie Dimon, CEO of JP Morgan testified to the FCIC, "I blame the management teams 100% and . . . no one else."95
-ernment regulators.96 Gelband left; Lehman officials blamed Gelband’s departure on
+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 government regulators.96 Gelband left; Lehman officials blamed Gelband’s departure on
-“philosophical differences.”97
+"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 -
+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 $90 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% 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
+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
+"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
+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
+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
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+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."103
-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
+ven 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.
+"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.
+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
+"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
+Siddique found the information he received "very alarming," he told the Commission.110 In fact, nontraditional loans made up 59% percent of originations at Countrywide, 58% percent at Wells Fargo, 51% at National City, 31% at Washington Mutual, 26.5% at CitiFinancial, and 18.3% at Bank of America. Moreover, the banks expected that their originations of nontraditional loans would rise by 17% in 2005, to
-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
+$608.5 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 2003 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
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-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 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.113
-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
+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 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
+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
+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
+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
+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
+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 ountry. Edward Sivak, the director of policy and evaluation at the Enterprise Corp.
-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
+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.
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-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
+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
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.
+By that time, however, the damage had been done. The total value of mortgage-backed securities issued between 2001 and 2006 reached $13.4 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.
-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 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% of the time but I was wrong 30% of the time," he told the Commission.123 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
+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% 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%. And the share of unemployed workers who have been out of work for more than six months was just above 40%. Of large metropolitan areas, Las Vegas, Nevada, and Riverside–San Bernardino, California, had the highest unemployment—their rates were above 14%.
-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 13 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% 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%.125
-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 $11 trillion in wealth since 2006.
-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.
-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 1930s. . . . The longer-term fallout from the economic crisis is also very substantial. . . . It will take years for employment to regain its pre-crisis level."126
-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
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-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
+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 hink 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
+"It’s over," his friend told Peterson.128
CONTENTS
-Commercial paper and repos: “Unfettered markets”............................................29
+Commercial paper and repos: "Unfettered markets"............................................29
-The savings and loan crisis: “They put a lot of
+The savings and loan crisis: "They put a lot of
-pressure on their regulators” ............................................................................\f6464
+pressure on their regulators" ............................................................................34
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.
+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
+"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.
+ 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.
-27
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+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.
-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.
+Third, we follow the profound changes in the mortgage industry, from the sleepy days when local lenders took full responsibility for making and servicing 30-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.
-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”
+"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.
+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 1873, 1884, 1890, 1893, 1896, and 1907.3 To stabilize financial markets, Congress created the Federal Reserve System in 1913, 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
+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 1930s. So in 1933 Congress passed the Glass-Steagall Act, which, among other changes, established the Federal Deposit Insurance Corporation. The FDIC insured bank deposits up to $2,500—an amount that covered the vast majority of deposits at the time; that limit would climb to $100,000 by
-1980, where it stayed until it was raised to \f653250,000 during the crisis in October 2008.
+1980, where it stayed until it was raised to $250,000 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.
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.
+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% in the decades before 1980, when it reached 20%. However, thanks to Regulation Q, banks and thrifts were stuck offering roughly less than 6% 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
+created money market mutual funds that invested these depositors’ money in hort-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.
-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+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
-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.
+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 $1 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 $3 billion in
-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
+1977 to more than $740 billion in 1995 and $1.8 trillion by 2000.6
-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.
+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
+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.
-able them to pay off their debts should there be another shock. These moves reassured investors that commercial paper was a safe investment.
+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 $200 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 $600 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 enable 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
+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 $1.6 trillion from less than $125 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 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.
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
-
-
+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
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-
-Traditional and Shadow Banking Systems
+raditional 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
+because excessive leverage endangered a bank. Leverage, used by nearly every financial institution, amplifies returns. For example, if an investor uses $100 of his own money to purchase a security that increases in value by 10%, he earns $10. However, if he borrows another $900 and invests 10 times as much ($1,000), the same 10% increase in value yields a profit of $100, double his out-of-pocket investment. If the investment sours, though, leverage magnifies the loss just as much. A decline of 10% costs the unleveraged investor $10, leaving him with $90, but wipes out the leveraged investor’s $100. An investor buying assets worth 10 times his capital has a leverage ratio of 10:1, with the numbers representing the total money invested compared to the money the investor has committed to the deal.
-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.
+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% 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
-
+Both money market funds and securities firms were regulated by the Securities and Exchange Commission. But the SEC, created in 1934, 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.
-\f6464
-
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-
-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.
+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 unds). 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
+"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.
+"THEY PUT A LOT OF PRESSURE ON THEIR REGULATORS"
-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
+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."13
-squeeze caused by inflation, but it effectively transferred the risk of rising interest rates to borrowers.
+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 3 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.
-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
+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 30-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 squeeze caused by inflation, but it effectively transferred the risk of rising interest rates to borrowers.
-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
+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% 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% 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).
+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 1983 and 1994, the OCC broadened the derivatives in which banks might deal to include those related to debt securities (1983), 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
+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
-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
+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% per year in Texas from 1980 to 1985.18 In California, prices rose 13% annually from 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% 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
+Almost 3,000 commercial banks and thrifts failed in what became known as the S&L crisis of the 1980s and early 1990s. By comparison, only 243 banks had failed between 1934 and 1980. By 1994, one-sixth of federally insured depository institutions had either closed or required financial assistance, affecting 20% of the banking system’s assets.23 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 $160 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
+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
+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 36; in 1991, Bank of New England, number 33. 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
+were protected from loss, but regulators felt obliged to protect the uninsured depositors—those whose balances exceeded the statutorily protected limits—to prevent potential 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
+"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 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’
-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
+securities.30
-years later.
+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.
CONTENTS
-Fannie Mae and Freddie Mac: “The whole army of lobbyists”.............................\f6468
+Fannie Mae and Freddie Mac: "The whole army of lobbyists".............................38
-Structured finance: “It wasn’t reducing the risk”...................................................42
+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
+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 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
+Fannie Mae (officially, the Federal National Mortgage Association) was chartered by the Reconstruction Finance Corporation during the Great Depression in 1938 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.
-\f6468
+This system worked well, but it had a weakness: Fannie Mae bought mortgages by borrowing. By 1968, Fannie’s mortgage portfolio had grown to $7.2 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
+38
-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" 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.
+"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.
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.
+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 $2.25 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% to back their guarantees of mortgage-backed securities and 2.5% to back the mortgages in their portfolios. This compared to bank and thrift capital requirements of at least 4% 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
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-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.
+Mortgages are long-term assets often funded by short-term borrowings. For example, thrifts generally used customer deposits to fund their mortgages. Fannie ought 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 $10 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
+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.3 "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
+All this added up to a generous federal subsidy. One 2005 study put the value of that subsidy at $122 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
+The stampede was on. Fannie’s and Freddie’s debt obligations and outstanding mortgage-backed securities grew from $759 billion in 1990 to $1.4 trillion in 1995 and
-\f6532.4 trillion in 2000.6
+$2.4 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
+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 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
-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.
-“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% to 67.5% of families by 2000, and one component raised the affordable housing goals at the GSEs. Between 1993 and 1995, almost 2.8 million households entered the ranks of homeowners, nearly twice as many as in the previous two years.
-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 3% down payment rule for first-time home buyers with FHA-insured mortgages.10
-“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
+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
+were problematic. Former Fannie CEO Daniel Mudd told the FCIC that "the GSE
-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
+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."13
+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 $164 million on lobbying, and their employees and political action committees contributed $15 million o 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
-
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-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
+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
+"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
+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%; Freddie, 39%. That year, Fannie and Freddie held or guaranteed more than $2 trillion of mortgages, backed by only $35.7 billion of shareholder equity.19
STRUCTURED FINANCE:
-“IT WASN’ T REDUCING THE RISK”
+"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,
+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
+‘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.
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.
-
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-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
+articipants 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
+the securitization market exploded. By 1999, when the market was 16 years old, about $900 billion worth of securitizations, beyond those done by Fannie, Freddie, and Ginnie, were outstanding (see figure 3.1). That included $114 billion of automobile loans and over $250 billion of credit card debt; nearly $150 billion worth of securities were mortgages ineligible for securitization by Fannie and Freddie. Many were subprime.22
-’99
+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.
-NOTE: Residential loans do not include loans securitized by government-sponsored enterprises.
+"Wall Street is essentially floating on a sea of mathematics and computer power," Patterson said.23
-SOURCE: Securities Industry and Financial Markets Association Figure \f646.1
+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% 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.
-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
+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
-Securitization “was diversifying the risk,” said Lindsey, the former Fed governor.
+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 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
-“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
+Securitization "was diversifying the risk," said Lindsey, the former Fed governor.
-THE GROWTH OF DERIVATIVES: “BY FAR THE MOST
+"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
-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,
+THE GROWTH OF DERIVATIVES: "BY FAR THE MOST
-
-
-46
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-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.
+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, r 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
+The principal legislation governing these markets is the Commodity Exchange Act of 1936, 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.30
-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
+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 1993, 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.31
-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.
+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, a leading consumer products company, reported a pretax loss of $157 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 $10 million for misleading Gibson Greeting Cards on interest rate swaps resulting in a mark-to-market loss of $23 million, larger than Gibson’s prior-year profits. In late 1994, Orange County, California, announced it had lost $1.5 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 $400 million to settle claims.32 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."33 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
+In 1996, Japan’s Sumitomo Corporation lost $2.6 billion on copper derivatives traded on a London exchange. The CFTC charged the company with using derivatives to manipulate copper prices, including using OTC derivatives contracts to disguise the speculation and to finance the scheme. Sumitomo settled for $150 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 $15 million.34
-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.
+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 1993. 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
+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."35 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
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+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."36
-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
+In September, the Federal Reserve Bank of New York orchestrated a $3.6 billion recapitalization of Long-Term Capital Management (LTCM) by 14 major OTC erivatives dealers. An enormous hedge fund, LTCM had amassed more than $1 trillion in notional amount of OTC derivatives and $125 billion of securities on $4.8 billion of capital without the knowledge of its major derivatives counterparties or federal regulators.37 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."38
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
+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."39
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
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
+The OTC derivatives market boomed. At year-end 2000, when the CFMA was passed, the notional amount of OTC derivatives outstanding globally was $95.2 trillion, and the gross market value was $3.2 trillion.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 $672.6 trillion; their gross market value was $20.3 trillion.42
-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
+Greenspan testified to the FCIC that credit default swaps—a small part of the market when Congress discussed regulating derivatives in the 1990s—"did create problems" during the financial crisis.43 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.”
+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
-
+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
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-
-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.
+ 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
+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.
-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
+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
-\f65358.2 trillion at the end of 2007.5\f646 A significant portion was apparently speculative or naked credit default swaps.54
+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 $6.4 trillion at the end of 2004 to a peak of
-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.
+$58.2 trillion at the end of 2007.53 A significant portion was apparently speculative or naked credit default swaps.54
-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
+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% 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.
-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
+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% and 35% of its revenues from 2006 through 2009 were generated by derivatives, including 70% to 75% of the firm’s commodities business, and half or more of its interest rate and currencies business. From May 2007 through November 2008, $133 billion, or 86%, of the $155 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’
CONTENTS
-Expansion of banking activities: “Shatterer of Glass-Steagall” .............................52
+Expansion of banking activities: "Shatterer of Glass-Steagall" .............................52
Long-Term Capital Management:
-“That’s what history had proved to them” .....................................................56
+"That’s what history had proved to them" .....................................................56
-Dot-com crash: “Lay on more risk”......................................................................59
+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
+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
+"I think we overdid finance versus the real economy"....................................64
EXPANSION OF BANKING ACTIVITIES:
-“SHATTERER OF GLASS\f6baSTEAGALL”
+"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
+Removing barriers helped consolidate the banking industry. Between 1990 and 2005, 74 "megamergers" occurred involving banks with assets of more than $10 billion each. Meanwhile the 10 largest jumped from owning 25% of the industry’s assets to 55%. 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 $2.2 trillion to $6.8 trillion.2 And investment banks were growing bigger, too.
-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
-
-
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-DEREGULATION REDUX 5\f646
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-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
+Smith Barney acquired Shearson in 1993 and Salomon Brothers in 1997, while Paine Webber purchased Kidder, Peabody in 1995. Two years later, Morgan Stanley merged with Dean Witter, and Bankers Trust purchased Alex. Brown & Sons. The assets of the five largest investment banks—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns—quadrupled, from $1 trillion in 1998 to $4 trillion in 2007.3
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.
+"outdated, unnecessary, or unduly burdensome" rules.4 Some agencies responded with gusto. In 2003, 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
+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
+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.
+Federal Reserve officials argued that financial institutions, with strong incentives to protect shareholders, would regulate themselves by carefully managing their own risks. In a 2003 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.
+ather, 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
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-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.
+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 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."13
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
+As Congress began fashioning legislation, the banks were close at hand. In 1999, the financial sector spent $187 million lobbying at the federal level, and individuals and political action committees (PACs) in the sector donated $202 million to federal election campaigns in the 2000 election cycle. From 1999 through 2008, federal lobbying by the financial sector reached $2.7 billion; campaign donations from individuals and PACs topped $1 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
+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
+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% 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
-
-
+Merrill’s industrial loan company grew from less than $1 billion in assets in 1998 to
-56
+$4 billion in 1999, and to $78 billion in 2007. Lehman’s thrift grew from $88 million in 1998 to $3 billion in 1999, and its assets rose as high as $24 billion in 2005.19
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+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
-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
+ndeed, 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 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.23
-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.
+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”
+"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
+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 $30 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
+Not so for Long-Term Capital Management, a large U.S. hedge fund. LTCM had devastating losses on its $125 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 $24 for every $1 of investors’ equity;27 lenders 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%, 42.8%, 40.8%, and 17.1%, while the S&P
-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%.28
-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 $4 billion—or more than 80% of its nearly $5 billion in capital. Its debt was about $120 billion. The firm faced insolvency.29
-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 $5 billion, LTCM’s failure might have been manageable. But the firm had further leveraged itself by entering into derivatives contracts with more than $1 trillion in notional amount—mostly interest rate and equity derivatives.30 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."31
-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.32 On September 23, after considerable urging, 14 institutions agreed to organize a consortium to inject $3.6 billion into LTCM in return for 90% of its stock.33 The firms contributed between $100 million and $300 million each, although Bear Stearns declined to participate.34 An orderly liquidation of LTCM’s securities and derivatives followed.
-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
+William McDonough, then president of the New York Fed, insisted "no Federal Reserve official pressured anyone, and no promises were made."35 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
+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% 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.36
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+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 arge bank to trigger a panic among uninsured depositors that might lead to more bank failures.
-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
+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."37
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
+"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."38
-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
+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."39 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.
+"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
-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
+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.43
-The sudden collapses of Enron and WorldCom were shocking; with assets of \f6536\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 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
-billion and \f653104 billion, respectively, they were the largest corporate bankruptcies before the default of Lehman Brothers in 2008.
+DOT\f6baCOM CRASH: "LAY ON MORE RISK"
-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
+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 $600 billion in 1994 to $2.2 trillion in 2001. Annual initial public offerings of stocks (IPOs) soared from $28 billion in 1994 to $76 billion in 2000 as banks and securities firms 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 $5.8 trillion in December 1994 to $17.8 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 $875 million, forbade certain practices, and instituted reforms.48
+The sudden collapses of Enron and WorldCom were shocking; with assets of $63 billion and $104 billion, respectively, they were the largest corporate bankruptcies before the default of Lehman Brothers in 2008.
-60
+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 valuations of Enron. The scandal cost Citigroup, JP Morgan, CIBC, Merrill Lynch, and other financial institutions more than $400 million in settlements with the SEC; Citigroup, JP Morgan, CIBC, Lehman Brothers, and Bank of America paid another
-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.
+$6.9 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
+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
-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 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
-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.
+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
-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
+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%.
-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.
+By mid-2003, the Fed had cut that rate to just 1%, the lowest in half a century, where it stayed for another year. In addition, to offset the market disruptions following the
-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. . . .
+9/11 attacks, the Fed flooded the financial markets with money by purchasing more than $150 billion in government securities and lending $45 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.
-The idea is that the Federal Reserve can be relied upon in times of crisis to come to DEREGULATION REDUX 61
+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 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
+The idea is that the Federal Reserve can be relied upon in times of crisis to come to the rescue, cutting interest rates and pumping in liquidity, thus providing a floor for equity prices."53 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
+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.
-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 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
+"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 good, you know, year-to-year compensation.” But the big payout was “when you retire.”59
-
-When the investment banks went public in the 1980s and 1990s, the close relationship between bankers’ decisions and their compensation broke down. They were now trading with shareholders’ money. Talented traders and managers once tethered to their firms were now free agents who could play companies against each other for more money. To keep them from leaving, firms began providing aggressive incentives, often tied to the price of their shares and often with accelerated payouts. To keep up, commercial banks did the same. Some included “clawback” provisions that would require the return of compensation under narrow circumstances, but those proved too limited to restrain the behavior of traders and managers.
+"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% greater than in other businesses—a considerably larger gap than before the Great Depression.
-Studies have found that the real value of executive pay, adjusted for inflation, grew DEREGULATION REDUX 6\f646
+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 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 good, you know, year-to-year compensation." But the big payout was "when you retire."59
-only 0.8\f642 a year during the \f6460 years after World War II, lagging companies’ increasing size.60 But the rate picked up during the 1970s and rose faster each decade, reaching
+When the investment banks went public in the 1980s and 1990s, the close relationship between bankers’ decisions and their compensation broke down. They were now trading with shareholders’ money. Talented traders and managers once tethered to their firms were now free agents who could play companies against each other for more money. To keep them from leaving, firms began providing aggressive incentives, often tied to the price of their shares and often with accelerated payouts. To keep up, commercial banks did the same. Some included "clawback" provisions that would require the return of compensation under narrow circumstances, but those proved too limited to restrain the behavior of traders and managers.
-10\f642 a year from 1995 to 1999.61 Much of the change reflected higher earnings in the financial sector, where by 2005 executives’ pay averaged \f653\f646.4 million annually, the highest of any industry. Though base salaries differed relatively little across sectors, banking and finance paid much higher bonuses and awarded more stock. And brokers and dealers did by far the best, averaging more than \f6537 million in compensation.62
+Studies have found that the real value of executive pay, adjusted for inflation, grew only 0.8% a year during the 30 years after World War II, lagging companies’ increasing size.60 But the rate picked up during the 1970s and rose faster each decade, reaching
-Both before and after going public, investment banks typically paid out half their revenues in compensation. For example, Goldman Sachs spent between 44\f642 and 49\f642
+10% a year from 1995 to 1999.61 Much of the change reflected higher earnings in the financial sector, where by 2005 executives’ pay averaged $3.4 million annually, the highest of any industry. Though base salaries differed relatively little across sectors, banking and finance paid much higher bonuses and awarded more stock. And brokers and dealers did by far the best, averaging more than $7 million in compensation.62
-a year between 2005 and 2008, when Morgan Stanley allotted between 46\f642 and 59\f642.
+Both before and after going public, investment banks typically paid out half their revenues in compensation. For example, Goldman Sachs spent between 44% and 49% a year between 2005 and 2008, when Morgan Stanley allotted between 46% and 59%.
-Merrill paid out similar percentages in 2005 and 2006, but gave 141\f642 in 2007—a year it suffered dramatic losses.6\f646
+Merrill paid out similar percentages in 2005 and 2006, but gave 141% in 2007—a year it suffered dramatic losses.63
-As the scale, revenue, and profitability of the firms grew, compensation packages soared for senior executives and other key employees. John Gutfreund, reported to be the highest-paid executive on Wall Street in the late 1980s, received \f653\f646.2 million in
+As the scale, revenue, and profitability of the firms grew, compensation packages soared for senior executives and other key employees. John Gutfreund, reported to be the highest-paid executive on Wall Street in the late 1980s, received $3.2 million in
1986 as CEO of Salomon Brothers.64 Stanley O’Neal’s package was worth more than
-\f65391 million in 2006, the last full year he was CEO of Merrill Lynch.65 In 2007, Lloyd Blankfein, CEO at Goldman Sachs, received \f65368.5 million;66 Richard Fuld, CEO of Lehman Brothers, and Jamie Dimon, CEO of JPMorgan Chase, received about \f653\f6464
+$91 million in 2006, the last full year he was CEO of Merrill Lynch.65 In 2007, Lloyd Blankfein, CEO at Goldman Sachs, received $68.5 million;66 Richard Fuld, CEO of Lehman Brothers, and Jamie Dimon, CEO of JPMorgan Chase, received about $34 million and $28 million, respectively.67 That year Wall Street paid workers in New York roughly $33 billion in year-end bonuses alone.68 Total compensation for the major U.S. banks and securities firms was estimated at $137 billion.69
-million and \f65328 million, respectively.67 That year Wall Street paid workers in New York roughly \f653\f646\f646 billion in year-end bonuses alone.68 Total compensation for the major U.S. banks and securities firms was estimated at \f6531\f6467 billion.69
-
-Stock options became a popular form of compensation, allowing employees to buy the company’s stock in the future at some predetermined price, and thus to reap rewards when the stock price was higher than that predetermined price. In fact, the option would have no value if the stock price was below that price. Encouraging the awarding of stock options was 199\f646 legislation making compensation in excess of \f6531
-
-million taxable to the corporation unless performance-based. Stock options had potentially unlimited upside, while the downside was simply to receive nothing if the stock didn’t rise to the predetermined price. The same applied to plans that tied pay to return on equity: they meant that executives could win more than they could lose.
+Stock options became a popular form of compensation, allowing employees to buy the company’s stock in the future at some predetermined price, and thus to reap rewards when the stock price was higher than that predetermined price. In fact, the option would have no value if the stock price was below that price. Encouraging the awarding of stock options was 1993 legislation making compensation in excess of $1 million taxable to the corporation unless performance-based. Stock options had potentially unlimited upside, while the downside was simply to receive nothing if the stock didn’t rise to the predetermined price. The same applied to plans that tied pay to return on equity: they meant that executives could win more than they could lose.
These pay structures had the unintended consequence of creating incentives to increase both risk and leverage, which could lead to larger jumps in a company’s stock price.
As these options motivated financial firms to take more risk and use more leverage, the evolution of the system provided the means. Shadow banking institutions faced few regulatory constraints on leverage; changes in regulations loosened the constraints on commercial banks. OTC derivatives allowing for enormous leverage proliferated. And risk management, thought to be keeping ahead of these developments, would fail to rein in the increasing risks.
-The dangers of the new pay structures were clear, but senior executives believed they were powerless to change it. Former Citigroup CEO Sandy Weill told the Commission, “I think if you look at the results of what happened on Wall Street, it became,
-
-
-
-64
-
-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
-
-‘Well, this one’s doing it, so how can I not do it, if I don’t do it, then the people are going to leave my place and go someplace else.’” Managing risk “became less of an important function in a broad base of companies, I would guess.”70
+The dangers of the new pay structures were clear, but senior executives believed they were powerless to change it. Former Citigroup CEO Sandy Weill told the Commission, "I think if you look at the results of what happened on Wall Street, it became, Well, this one’s doing it, so how can I not do it, if I don’t do it, then the people are going to leave my place and go someplace else.’" Managing risk "became less of an important function in a broad base of companies, I would guess."70
And regulatory entities, one source of checks on excessive risk taking, had challenges recruiting financial experts who could otherwise work in the private sector.
-Lord Adair Turner, chairman of the U.K. Financial Services Authority, told the Commission, “It’s not easy. This is like a continual process of, you know, high-skilled people versus high-skilled people, and the poachers are better paid than the game-keepers.”71 Bernanke said the same at an FCIC hearing: “It’s just simply never going to be the case that the government can pay what Wall Street can pay.”72
-
-Tying compensation to earnings also, in some cases, created the temptation to manipulate the numbers. Former Fannie Mae regulator Armando Falcon Jr. told the FCIC, “Fannie began the last decade with an ambitious goal—double earnings in 5
+Lord Adair Turner, chairman of the U.K. Financial Services Authority, told the Commission, "It’s not easy. This is like a continual process of, you know, high-skilled people versus high-skilled people, and the poachers are better paid than the game-keepers."71 Bernanke said the same at an FCIC hearing: "It’s just simply never going to be the case that the government can pay what Wall Street can pay."72
-years to \f6536.46 [per share]. A large part of the executives’ compensation was tied to meeting that goal.” Achieving it brought CEO Franklin Raines \f65352 million of his \f65390
+Tying compensation to earnings also, in some cases, created the temptation to manipulate the numbers. Former Fannie Mae regulator Armando Falcon Jr. told the FCIC, "Fannie began the last decade with an ambitious goal—double earnings in 5 years to $6.46 [per share]. A large part of the executives’ compensation was tied to meeting that goal." Achieving it brought CEO Franklin Raines $52 million of his $90 million pay from 1998 to 2003. However, Falcon said, the goal "turned out to be un-achievable without breaking rules and hiding risks. Fannie and Freddie executives worked hard to persuade investors that mortgage-related assets were a riskless investment, while at the same time covering up the volatility and risks of their own mortgage portfolios and balance sheets." Fannie’s estimate of how many mortgage holders would pay off was off by $400 million at year-end 1998, which meant no bonuses. So Fannie counted only half the $400 million on its books, enabling Raines and other executives to meet the earnings target and receive 100% of their bonuses.73
-million pay from 1998 to 200\f646. However, Falcon said, the goal “turned out to be un-achievable without breaking rules and hiding risks. Fannie and Freddie executives worked hard to persuade investors that mortgage-related assets were a riskless investment, while at the same time covering up the volatility and risks of their own mortgage portfolios and balance sheets.” Fannie’s estimate of how many mortgage holders would pay off was off by \f653400 million at year-end 1998, which meant no bonuses. So Fannie counted only half the \f653400 million on its books, enabling Raines and other executives to meet the earnings target and receive 100\f642 of their bonuses.7\f646
-
-Compensation structures were skewed all along the mortgage securitization chain, from people who originated mortgages to people on Wall Street who packaged them into securities. Regarding mortgage brokers, often the first link in the process, FDIC Chairman Sheila Bair told the FCIC that their “standard compensation practice . . . was based on the volume of loans originated rather than the performance and quality of the loans made.” She concluded, “The crisis has shown that most financial-institution compensation systems were not properly linked to risk management. Formula-driven compensation allows high short-term profits to be translated into generous bonus payments, without regard to any longer-term risks.”74 SEC Chairman Mary Schapiro told the FCIC, “Many major financial institutions created asymmetric compensation packages that paid employees enormous sums for short-term success, even if these same decisions result in significant long-term losses or failure for investors and taxpayers.”75
+Compensation structures were skewed all along the mortgage securitization chain, from people who originated mortgages to people on Wall Street who packaged them into securities. Regarding mortgage brokers, often the first link in the process, FDIC Chairman Sheila Bair told the FCIC that their "standard compensation practice . . . was based on the volume of loans originated rather than the performance and quality of the loans made." She concluded, "The crisis has shown that most financial-institution compensation systems were not properly linked to risk management. Formula-driven compensation allows high short-term profits to be translated into generous bonus payments, without regard to any longer-term risks."74 SEC Chairman Mary Schapiro told the FCIC, "Many major financial institutions created asymmetric compensation packages that paid employees enormous sums for short-term success, even if these same decisions result in significant long-term losses or failure for investors and taxpayers."75
FINANCIAL SECTOR GROWTH:
-“I THINK WE OVERDID FINANCE VERSUS THE REAL ECONOMY” For about two decades, beginning in the early 1980s, the financial sector grew faster than the rest of the economy—rising from about 5\f642 of gross domestic product (GDP) to about 8\f642 in the early 21st century. In 1980, financial sector profits were about 15\f642 of corporate profits. In 200\f646, they hit a high of \f646\f646\f642 but fell back to 27\f642
-
+"I THINK WE OVERDID FINANCE VERSUS THE REAL ECONOMY" For about two decades, beginning in the early 1980s, the financial sector grew faster than the rest of the economy—rising from about 5% of gross domestic product (GDP) to about 8% in the early 21st century. In 1980, financial sector profits were about 15% of corporate profits. In 2003, they hit a high of 33% but fell back to 27% in 2006, on the eve of the financial crisis. The largest firms became considerably larger. JP Morgan’s assets increased from $667 billion in 1999 to $2.2 trillion in
+2008, a compound annual growth rate of 16%. Bank of America and Citigroup grew by 14% and 12% a year, respectively, with Citigroup reaching $1.9 trillion in assets in
-DEREGULATION REDUX 65
+2008 (down from $2.2 trillion in 2007) and Bank of America $1.8 trillion. The investment banks also grew significantly from 2000 to 2007, often much faster than commercial banks. Goldman’s assets grew from $250 billion in 1999 to $1.1 trillion by 2007, an annual growth rate of 21%. At Lehman, assets rose from $192 billion to
-in 2006, on the eve of the financial crisis. The largest firms became considerably larger. JP Morgan’s assets increased from \f653667 billion in 1999 to \f6532.2 trillion in
+$691 billion, or 17%.76
-2008, a compound annual growth rate of 16\f642. Bank of America and Citigroup grew by 14\f642 and 12\f642 a year, respectively, with Citigroup reaching \f6531.9 trillion in assets in
-
-2008 (down from \f6532.2 trillion in 2007) and Bank of America \f6531.8 trillion. The investment banks also grew significantly from 2000 to 2007, often much faster than commercial banks. Goldman’s assets grew from \f653250 billion in 1999 to \f6531.1 trillion by 2007, an annual growth rate of 21\f642. At Lehman, assets rose from \f653192 billion to
-
-\f653691 billion, or 17\f642.76
-
-Fannie and Freddie grew quickly, too. Fannie’s assets and guaranteed mortgages increased from \f6531.4 trillion in 2000 to \f653\f646.2 trillion in 2008, or 11\f642 annually. At Freddie, they increased from \f6531 trillion to \f6532.2 trillion, or 10\f642 a year.77
+Fannie and Freddie grew quickly, too. Fannie’s assets and guaranteed mortgages increased from $1.4 trillion in 2000 to $3.2 trillion in 2008, or 11% annually. At Freddie, they increased from $1 trillion to $2.2 trillion, or 10% a year.77
As they grew, many financial firms added lots of leverage. That meant potentially higher returns for shareholders, and more money for compensation. Increasing leverage also meant less capital to absorb losses.
-Fannie and Freddie were the most leveraged. The law set the government-sponsored enterprises’ minimum capital requirement at 2.5\f642 of assets plus 0.45\f642 of the mortgage-backed securities they guaranteed. So they could borrow more than
+Fannie and Freddie were the most leveraged. The law set the government-sponsored enterprises’ minimum capital requirement at 2.5% of assets plus 0.45% of the mortgage-backed securities they guaranteed. So they could borrow more than
-\f653200 for each dollar of capital used to guarantee mortgage-backed securities. If they wanted to own the securities, they could borrow \f65340 for each dollar of capital. Combined, Fannie and Freddie owned or guaranteed \f6535.\f646 trillion of mortgage-related assets at the end of 2007 against just \f65370.7 billion of capital, a ratio of 75:1.
+$200 for each dollar of capital used to guarantee mortgage-backed securities. If they wanted to own the securities, they could borrow $40 for each dollar of capital. Combined, Fannie and Freddie owned or guaranteed $5.3 trillion of mortgage-related assets at the end of 2007 against just $70.7 billion of capital, a ratio of 75:1.
-From 2000 to 2007, large banks and thrifts generally had \f65316 to \f65322 in assets for each dollar of capital, for leverage ratios between 16:1 and:1. For some banks, leverage remained roughly constant. JP Morgan’s reported leverage was between 20:1
+From 2000 to 2007, large banks and thrifts generally had $16 to $22 in assets for each dollar of capital, for leverage ratios between 16:1 and:1. For some banks, leverage remained roughly constant. JP Morgan’s reported leverage was between 20:1
-and:1. Wells Fargo’s generally ranged between 16:1 and 17:1. Other banks upped their leverage. Bank of America’s rose from 18:1 in 2000 to 27:1 in 2007. Citigroup’s increased from 18:1 to:1, then shot up to \f6462:1 by the end of 2007, when Citi brought off-balance sheet assets onto the balance sheet. More than other banks, Citigroup held assets off of its balance sheet, in part to hold down capital requirements.
+and:1. Wells Fargo’s generally ranged between 16:1 and 17:1. Other banks upped their leverage. Bank of America’s rose from 18:1 in 2000 to 27:1 in 2007. Citigroup’s increased from 18:1 to:1, then shot up to 32:1 by the end of 2007, when Citi brought off-balance sheet assets onto the balance sheet. More than other banks, Citigroup held assets off of its balance sheet, in part to hold down capital requirements.
-In 2007, even after bringing \f65380 billion worth of assets on balance sheet, substantial assets remained off. If those had been included, leverage in 2007 would have been
+In 2007, even after bringing $80 billion worth of assets on balance sheet, substantial assets remained off. If those had been included, leverage in 2007 would have been
-48:1, or about 5\f646\f642 higher. In comparison, at Wells Fargo and Bank of America, including off-balance-sheet assets would have raised the 2007 leverage ratios 17\f642 and
+48:1, or about 53% higher. In comparison, at Wells Fargo and Bank of America, including off-balance-sheet assets would have raised the 2007 leverage ratios 17% and
-28\f642, respectively.78
+28%, respectively.78
Because investment banks were not subject to the same capital requirements as commercial and retail banks, they were given greater latitude to rely on their internal risk models in determining capital requirements, and they reported higher leverage.
-At Goldman Sachs, leverage increased from 17:1 in 2000 to \f6462:1 in 2007. Morgan Stanley and Lehman increased about 67\f642 and\f642, respectively, and both reached
+At Goldman Sachs, leverage increased from 17:1 in 2000 to 32:1 in 2007. Morgan Stanley and Lehman increased about 67% and%, respectively, and both reached
40:1 by the end of 2007.79 Several investment banks artificially lowered leverage ratios by selling assets right before the reporting period and subsequently buying them back.
-As the investment banks grew, their business models changed. Traditionally, investment banks advised and underwrote equity and debt for corporations, financial
-
-
+As the investment banks grew, their business models changed. Traditionally, investment banks advised and underwrote equity and debt for corporations, financial nstitutions, investment funds, governments, and individuals. An increasing amount of the investment banks’ revenues and earnings was generated by trading and investments, including securitization and derivatives activities. At Goldman, revenues from trading and principal investments increased from 39% of the total in 1997 to 68% in
-66
+2007. At Merrill Lynch, they generated 55% of revenue in 2006, up from 42% in 1997.
-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+At Lehman, similar activities generated up to 80% of pretax earnings in 2006, up from
-institutions, investment funds, governments, and individuals. An increasing amount of the investment banks’ revenues and earnings was generated by trading and investments, including securitization and derivatives activities. At Goldman, revenues from trading and principal investments increased from \f6469\f642 of the total in 1997 to 68\f642 in
+32% in 1997. At Bear Stearns, they accounted for more than 100% of pretax earnings in some years after 2002 because of pretax losses in other businesses.80
-2007. At Merrill Lynch, they generated 55\f642 of revenue in 2006, up from 42\f642 in 1997.
+Between 1978 and 2007, debt held by financial companies grew from $3 trillion to
-At Lehman, similar activities generated up to 80\f642 of pretax earnings in 2006, up from
-
-\f6462\f642 in 1997. At Bear Stearns, they accounted for more than 100\f642 of pretax earnings in some years after 2002 because of pretax losses in other businesses.80
-
-Between 1978 and 2007, debt held by financial companies grew from \f653\f646 trillion to
-
-\f653\f6466 trillion, more than doubling from 1\f6460\f642 to 270\f642 of GDP. Former Treasury Secretary John Snow told the FCIC that while the financial sector must play a “critical” role in allocating capital to the most productive uses, it was reasonable to ask whether over the last 20 or \f6460 years it had become too large. Financial firms had grown mainly by simply lending to each other, he said, not by creating opportunities for investment.81 In 1978, financial companies borrowed \f6531\f646 in the credit markets for every \f653100 borrowed by nonfinancial companies. By 2007, financial companies were borrowing \f65351 for every \f653100. “We have a lot more debt than we used to have, which means we have a much bigger financial sector,” said Snow. “I think we overdid finance versus the real economy and got it a little lopsided as a result.”82
+$36 trillion, more than doubling from 130% to 270% of GDP. Former Treasury Secretary John Snow told the FCIC that while the financial sector must play a "critical" role in allocating capital to the most productive uses, it was reasonable to ask whether over the last 20 or 30 years it had become too large. Financial firms had grown mainly by simply lending to each other, he said, not by creating opportunities for investment.81 In 1978, financial companies borrowed $13 in the credit markets for every $100 borrowed by nonfinancial companies. By 2007, financial companies were borrowing $51 for every $100. "We have a lot more debt than we used to have, which means we have a much bigger financial sector," said Snow. "I think we overdid finance versus the real economy and got it a little lopsided as a result."82
CONTENTS
-Mortgage securitization: “This stuff is so complicated how is anybody going to know1” ..............................................................................68
+Mortgage securitization: "This stuff is so complicated how is anybody going to know1" ..............................................................................68
-Greater access to lending: “A business where we can make some money”.............72
+Greater access to lending: "A business where we can make some money".............72
-Subprime lenders in turmoil: “Adverse market conditions”..................................74
+Subprime lenders in turmoil: "Adverse market conditions"..................................74
-The regulators: “Oh, I see” ...................................................................................75
+The regulators: "Oh, I see" ...................................................................................75
-In the early 1980s, subprime lenders such as Household Finance Corp. and thrifts such as Long Beach Savings and Loan made home equity loans, often second mortgages, to borrowers who had yet to establish credit histories or had troubled financial histories, sometimes reflecting setbacks such as unemployment, divorce, medical emergencies, and the like. Banks might have been unwilling to lend to these borrowers, but a subprime lender would if the borrower paid a higher interest rate to offset the extra risk. “No one can debate the need for legitimate non-prime (subprime) lending products,” Gail Burks, president of the Nevada Fair Housing Center, Inc., testified to the FCIC.1
+In the early 1980s, subprime lenders such as Household Finance Corp. and thrifts such as Long Beach Savings and Loan made home equity loans, often second mortgages, to borrowers who had yet to establish credit histories or had troubled financial histories, sometimes reflecting setbacks such as unemployment, divorce, medical emergencies, and the like. Banks might have been unwilling to lend to these borrowers, but a subprime lender would if the borrower paid a higher interest rate to offset the extra risk. "No one can debate the need for legitimate non-prime (subprime) lending products," Gail Burks, president of the Nevada Fair Housing Center, Inc., testified to the FCIC.1
Interest rates on subprime mortgages, with substantial collateral—the house—
weren’t as high as those for car loans, and were much less than credit cards. The advantages of a mortgage over other forms of debt were solidified in 1986 with the Tax Reform Act, which barred deducting interest payments on consumer loans but kept the deduction for mortgage interest payments.
-In the 1980s and into the early 1990s, before computerized “credit scoring”—a statistical technique used to measure a borrower’s creditworthiness—automated the assessment of risk, mortgage lenders (including subprime lenders) relied on other factors when underwriting mortgages. As Tom Putnam, a Sacramento-based mortgage banker, told the Commission, they traditionally lent based on the four C’s: credit (quantity, quality, and duration of the borrower’s credit obligations), capacity (amount and stability of income), capital (sufficient liquid funds to cover down payments, closing costs, and reserves), and collateral (value and condition of the property).2 Their decisions depended on judgments about how strength in one area, such as collateral, might offset weaknesses in others, such as credit. They underwrote borrowers one at a time, out of local offices.
-
-67
-
-
+In the 1980s and into the early 1990s, before computerized "credit scoring"—a statistical technique used to measure a borrower’s creditworthiness—automated the assessment of risk, mortgage lenders (including subprime lenders) relied on other factors when underwriting mortgages. As Tom Putnam, a Sacramento-based mortgage banker, told the Commission, they traditionally lent based on the four C’s: credit (quantity, quality, and duration of the borrower’s credit obligations), capacity (amount and stability of income), capital (sufficient liquid funds to cover down payments, closing costs, and reserves), and collateral (value and condition of the property).2 Their decisions depended on judgments about how strength in one area, such as collateral, might offset weaknesses in others, such as credit. They underwrote borrowers one at a time, out of local offices. In a few cases, such as CitiFinancial, subprime lending firms were part of a bank holding company, but most—including Household, Beneficial Finance, The Money Store, and Champion Mortgage—were independent consumer finance companies.
-68
+Without access to deposits, they generally funded themselves with short-term lines of credit, or "warehouse lines," from commercial or investment banks. In many cases, the finance companies did not keep the mortgages. Some sold the loans to the same banks extending the warehouse lines. The banks would securitize and sell the loans to investors or keep them on their balance sheets. In other cases, the finance company itself packaged and sold the loans—often partnering with the banks extending the warehouse lines. Meanwhile, the S&Ls that originated subprime loans generally financed their own mortgage operations and kept the loans on their balance sheets.
-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+MORTGAGE SECURITIZATION: "THIS STUFF IS
-In a few cases, such as CitiFinancial, subprime lending firms were part of a bank holding company, but most—including Household, Beneficial Finance, The Money Store, and Champion Mortgage—were independent consumer finance companies.
+SO COMPLICATED HOW IS ANYBODY GOING TO KNOW1 "
-Without access to deposits, they generally funded themselves with short-term lines of credit, or “warehouse lines,” from commercial or investment banks. In many cases, the finance companies did not keep the mortgages. Some sold the loans to the same banks extending the warehouse lines. The banks would securitize and sell the loans to investors or keep them on their balance sheets. In other cases, the finance company itself packaged and sold the loans—often partnering with the banks extending the warehouse lines. Meanwhile, the S&Ls that originated subprime loans generally financed their own mortgage operations and kept the loans on their balance sheets.
-
-MORTGAGE SECURITIZATION: “THIS STUFF IS
-
-SO COMPLICATED HOW IS ANYBODY GOING TO KNOW1 ”
-
-Debt outstanding in U.S. credit markets tripled during the 1980s, reaching \f6531\f646.8 trillion in 1990; 11\f642 was securitized mortgages and GSE debt. Later, mortgage securities made up 18\f642 of the debt markets, overtaking government Treasuries as the single largest component—a position they maintained through the financial crisis.\f646
+Debt outstanding in U.S. credit markets tripled during the 1980s, reaching $13.8 trillion in 1990; 11% was securitized mortgages and GSE debt. Later, mortgage securities made up 18% of the debt markets, overtaking government Treasuries as the single largest component—a position they maintained through the financial crisis.3
In the 1990s mortgage companies, banks, and Wall Street securities firms began securitizing mortgages (see figure 5.1). And more of them were subprime. Salomon Brothers, Merrill Lynch, and other Wall Street firms started packaging and selling
-“non-agency” mortgages—that is, loans that did not conform to Fannie’s and Freddie’s standards. Selling these required investors to adjust expectations. With securitizations handled by Fannie and Freddie, the question was not “will you get the money back” but “when,” former Salomon Brothers trader and CEO of PentAlpha Jim Callahan told the FCIC.4 With these new non-agency securities, investors had to worry about getting paid back, and that created an opportunity for S&P and Moody’s. As Lewis Ranieri, a pioneer in the market, told the Commission, when he presented the concept of non-agency securitization to policy makers, they asked, “‘This stuff is so complicated how is anybody going to know1 How are the buyers going to buy1’” Ranieri said, “One of the solutions was, it had to have a rating. And that put the rating services in the business.”5
+"non-agency" mortgages—that is, loans that did not conform to Fannie’s and Freddie’s standards. Selling these required investors to adjust expectations. With securitizations handled by Fannie and Freddie, the question was not "will you get the money back" but "when," former Salomon Brothers trader and CEO of PentAlpha Jim Callahan told the FCIC.4 With these new non-agency securities, investors had to worry about getting paid back, and that created an opportunity for S&P and Moody’s. As Lewis Ranieri, a pioneer in the market, told the Commission, when he presented the concept of non-agency securitization to policy makers, they asked, "‘This stuff is so complicated how is anybody going to know1 How are the buyers going to buy1’" Ranieri said, "One of the solutions was, it had to have a rating. And that put the rating services in the business."5
-Non-agency securitizations were only a few years old when they received a powerful stimulus from an unlikely source: the federal government. The savings and loan crisis had left Uncle Sam with \f653402 billion in loans and real estate from failed thrifts and banks. Congress established the Resolution Trust Corporation (RTC) in
+Non-agency securitizations were only a few years old when they received a powerful stimulus from an unlikely source: the federal government. The savings and loan crisis had left Uncle Sam with $402 billion in loans and real estate from failed thrifts and banks. Congress established the Resolution Trust Corporation (RTC) in
-1989 to offload mortgages and real estate, and sometimes the failed thrifts themselves, now owned by the government. While the RTC was able to sell \f6536.1 billion of these mortgages to Fannie and Freddie, most did not meet the GSEs’ standards.
+1989 to offload mortgages and real estate, and sometimes the failed thrifts themselves, now owned by the government. While the RTC was able to sell $6.1 billion of these mortgages to Fannie and Freddie, most did not meet the GSEs’ standards.
Some were what might be called subprime today, but others had outright documentation errors or servicing problems, not unlike the low-documentation loans that later became popular.6
+RTC officials soon concluded that they had neither the time nor the resources to sell off the assets in their portfolio one by one and thrift by thrift. They turned to the private sector, contracting with real estate and financial professionals to securitize some of the assets. By the time the RTC concluded its work, it had securitized $25 billion in residential mortgages.7 The RTC in effect helped expand the securitization of mortgages ineligible for GSE guarantees.8 In the early 1990s, as investors became more familiar with the securitization of these assets, mortgage specialists and Wall Street bankers got in on the action. Securitization and subprime originations grew hand in hand. As figure 5.2 shows, subprime originations increased from $70 billion in 1996 to $100 billion in 2000. The proportion securitized in the late 1990s peaked at
+56%, and subprime mortgage originations’ share of all originations hovered around
-SUBPRIME LENDING 69
-
-Funding for Mortgages
-
-The sources of funds for mortgages changed over the decades.
-
-IN PERCENT, BY SOURCE
-
-Savings & loans
-
-Government-sponsored enterprises
-
-60%
-
-54%
-
-50
-
-40
-
-30
-
-20
-
-4%
-
-10
-
-0
-
-’70
-
-’80
-
-’90
-
-’00
-
-’10
-
-’70
-
-’80
-
-’90
-
-’00
-
-’10
-
-Commercial banks & others
-
-Non-agency securities
-
-60%
-
-50
-
-40
-
-29%
-
-30
-
-13%
-
-20
-
-10
-
-0
-
-’70
-
-’80
-
-’90
-
-’00
-
-’10
-
-’70
-
-’80
+10%.
-’90
+Securitizations by the RTC and by Wall Street were similar to the Fannie and Freddie securitizations. The first step was to get principal and interest payments from a group of mortgages to flow into a single pool. But in "private-label" securities (that is, securitizations not done by Fannie or Freddie), the payments were then "tranched" in a way to protect some investors from losses. Investors in the tranches received different streams of principal and interest in different orders.
-’00
-
-’10
-
-SOURCE: Federal Reserve Flow of Funds Report
-
-Figure 5.1
-
-RTC officials soon concluded that they had neither the time nor the resources to sell off the assets in their portfolio one by one and thrift by thrift. They turned to the private sector, contracting with real estate and financial professionals to securitize some of the assets. By the time the RTC concluded its work, it had securitized \f65325 billion in residential mortgages.7 The RTC in effect helped expand the securitization of mortgages ineligible for GSE guarantees.8 In the early 1990s, as investors became
-
-
-
-70
-
-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
-
-Subprime Mortgage Originations
-
-In 2006, $600 billion of subprime loans were originated, most of which were securitized. That year, subprime lending accounted for 23.5% of all mortgage originations.
-
-IN BILLIONS OF DOLLARS
-
-23.5%
-
-$700
-
-Subprime share of entire
-
-22.7%
-
-20.9%
-
-mortgage market
-
-600
-
-Securitized
-
-500
-
-Non-securitized
-
-8.3%
-
-400
-
-10.6%
-
-10.1%
-
-10.4%
-
-7.6%
-
-7.4%
-
-300
-
-9.2%
-
-9.5%
-
-9.8%
-
-200
-
-100
-
-1.7%
-
-0
-
-’96
-
-’97
-
-’98
-
-’99
-
-’00
-
-’01
-
-’02
-
-’03
-
-’04
-
-’05
-
-’06
-
-’07
-
-’08
-
-
-
-
-
-2007, securities issued exceeded originations.
-
-SOURCE: Inside Mortgage Finance
-
-Figure 5.2
-
-more familiar with the securitization of these assets, mortgage specialists and Wall Street bankers got in on the action. Securitization and subprime originations grew hand in hand. As figure 5.2 shows, subprime originations increased from \f65370 billion in 1996 to \f653100 billion in 2000. The proportion securitized in the late 1990s peaked at
-
-56\f642, and subprime mortgage originations’ share of all originations hovered around
-
-10\f642.
-
-Securitizations by the RTC and by Wall Street were similar to the Fannie and Freddie securitizations. The first step was to get principal and interest payments from a group of mortgages to flow into a single pool. But in “private-label” securities (that is, securitizations not done by Fannie or Freddie), the payments were then “tranched” in a way to protect some investors from losses. Investors in the tranches received different streams of principal and interest in different orders.
-
-Most of the earliest private-label deals, in the late 1980s and early 1990s, used a rudimentary form of tranching. There were typically two tranches in each deal. The SUBPRIME LENDING 71
-
-less risky tranche received principal and interest payments first and was usually guaranteed by an insurance company. The more risky tranche received payments second, was not guaranteed, and was usually kept by the company that originated the mortgages.
+Most of the earliest private-label deals, in the late 1980s and early 1990s, used a rudimentary form of tranching. There were typically two tranches in each deal. The less risky tranche received principal and interest payments first and was usually guaranteed by an insurance company. The more risky tranche received payments second, was not guaranteed, and was usually kept by the company that originated the mortgages.
Within a decade, securitizations had become much more complex: they had more tranches, each with different payment streams and different risks, which were tailored to meet investors’ demands. The entire private-label mortgage securitization market—those who created, sold, and bought the investments—would become highly dependent on this slice-and-dice process, and regulators and market participants alike took for granted that it efficiently allocated risk to those best able and willing to bear that risk.
-To demonstrate how this process worked, we’ll describe a typical deal, named CMLTI 2006-NC2, involving \f653947 million in mortgage-backed bonds.9 In 2006, New Century Financial, a California-based lender, originated and sold 4,499 subprime mortgages to Citigroup, which sold them to a separate legal entity that Citigroup sponsored that would own the mortgages and issue the tranches. The entity purchased the loans with cash it had raised by selling the securities these loans would back. The entity had been created as a separate legal structure so that the assets would sit off Citigroup’s balance sheet, an arrangement with tax and regulatory benefits.
+To demonstrate how this process worked, we’ll describe a typical deal, named CMLTI 2006-NC2, involving $947 million in mortgage-backed bonds.9 In 2006, New Century Financial, a California-based lender, originated and sold 4,499 subprime mortgages to Citigroup, which sold them to a separate legal entity that Citigroup sponsored that would own the mortgages and issue the tranches. The entity purchased the loans with cash it had raised by selling the securities these loans would back. The entity had been created as a separate legal structure so that the assets would sit off Citigroup’s balance sheet, an arrangement with tax and regulatory benefits.
The 4,499 mortgages carried the rights to the borrowers’ monthly payments, which the Citigroup entity divided into 19 tranches of mortgage-backed securities; each tranche gave investors a different priority claim on the flow of payments from the borrowers, and a different interest rate and repayment schedule. The credit rating agencies assigned ratings to most of these tranches for investors, who—as securitization became increasingly complicated—came to rely more heavily on these ratings.
Tranches were assigned letter ratings by the rating agencies based on their riskiness.
-In this report, ratings are generally presented in S&P’s classification system, which assigns ratings such as “AAA” (the highest rating for the safest investments, referred to here as triple-A), “AA” (less safe than AAA), “A,” “BBB,” and “BB,” and further distinguishes ratings with “+” and “–.” Anything rated below “BBB-” is considered “junk.” Moody’s uses a similar system in which “Aaa” is highest, followed by “Aa,” “A,” “Baa,”
+In this report, ratings are generally presented in S&P’s classification system, which assigns ratings such as "AAA" (the highest rating for the safest investments, referred to here as triple-A), "AA" (less safe than AAA), "A," "BBB," and "BB," and further distinguishes ratings with "+" and "–." Anything rated below "BBB-" is considered "junk." Moody’s uses a similar system in which "Aaa" is highest, followed by "Aa," "A," "Baa,"
-“Ba,” and so forth. For example, an S&P rating of BBB would correspond to a Moody’s rating of Baa. In this Citigroup deal, the four senior tranches—the safest—
+"Ba," and so forth. For example, an S&P rating of BBB would correspond to a Moody’s rating of Baa. In this Citigroup deal, the four senior tranches—the safest—
were rated triple-A by the agencies.
-Below the senior tranches and next in line for payments were eleven “mezzanine” tranches—so named because they sat between the riskiest and the safest tranches.
+Below the senior tranches and next in line for payments were eleven "mezzanine" tranches—so named because they sat between the riskiest and the safest tranches.
These were riskier than the senior tranches and, because they paid off more slowly, carried a higher risk that an increase in interest rates would make the locked-in interest payments less valuable. As a result, they paid a correspondingly higher interest rate. Three of these tranches in the Citigroup deal were rated AA, three were A, three were BBB (the lowest investment-grade rating), and two were BB, or junk.
-The last to be paid was the most junior tranche, called the “equity,” “residual,” or
-
-“first-loss” tranche, set up to receive whatever cash flow was left over after all the other investors had been paid. This tranche would suffer the first losses from any
-
-
-
-72
-
-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+The last to be paid was the most junior tranche, called the "equity," "residual," or
-defaults of the mortgages in the pool. Commensurate with this high risk, it provided the highest yields (see figure 5.\f646). In the Citigroup deal, as was common, this piece of the deal was not rated at all. Citigroup and a hedge fund each held half the equity tranche.10
+"first-loss" tranche, set up to receive whatever cash flow was left over after all the other investors had been paid. This tranche would suffer the first losses from any efaults of the mortgages in the pool. Commensurate with this high risk, it provided the highest yields (see figure 5.3). In the Citigroup deal, as was common, this piece of the deal was not rated at all. Citigroup and a hedge fund each held half the equity tranche.10
-While investors in the lower-rated tranches received higher interest rates because they knew there was a risk of loss, investors in the triple-A tranches did not expect payments from the mortgages to stop. This expectation of safety was important, so the firms structuring securities focused on achieving high ratings. In the structure of this Citigroup deal, which was typical, \f6537\f6467 million, or 78\f642, was rated triple-A.
+While investors in the lower-rated tranches received higher interest rates because they knew there was a risk of loss, investors in the triple-A tranches did not expect payments from the mortgages to stop. This expectation of safety was important, so the firms structuring securities focused on achieving high ratings. In the structure of this Citigroup deal, which was typical, $737 million, or 78%, was rated triple-A.
GREATER ACCESS TO LENDING:
-“A BUSINESS WHERE WE CAN MAKE SOME MONEY”
+"A BUSINESS WHERE WE CAN MAKE SOME MONEY"
As private-label securitization began to take hold, new computer and modeling technologies were reshaping the mortgage market. In the mid-1990s, standardized data with loan-level information on mortgage performance became more widely available. Lenders underwrote mortgages using credit scores, such as the FICO score, developed by Fair Isaac Corporation. In 1994, Freddie Mac rolled out Loan Prospector, an automated system for mortgage underwriting for use by lenders, and Fannie Mae released its own system, Desktop Underwriter, two months later. The days of labori-ous, slow, and manual underwriting of individual mortgage applicants were over, lowering cost and broadening access to mortgages.
The CRA encouraged banks to lend to borrowers to whom they may have previously denied credit. While these borrowers often had lower-than-average income, a
-1997 study indicated that loans made under the CRA performed consistently with the rest of the banks’ portfolios, suggesting CRA lending was not riskier than the banks’ other lending.1\f646 “There is little or no evidence that banks’ safety and soundness have been compromised by such lending, and bankers often report sound business opportunities,” Federal Reserve Chairman Alan Greenspan said of CRA lending in 1998.14
+1997 study indicated that loans made under the CRA performed consistently with the rest of the banks’ portfolios, suggesting CRA lending was not riskier than the banks’ other lending.13 "There is little or no evidence that banks’ safety and soundness have been compromised by such lending, and bankers often report sound business opportunities," Federal Reserve Chairman Alan Greenspan said of CRA lending in 1998.14
-SUBPRIME LENDING 7\f646
-
Residential Mortgage-Backed Securities
Financial institutions packaged subprime, Alt-A and other mortgages into securities. As long as the housing market continued to boom, these securities would perform. But when the economy faltered and the mortgages defaulted, lower-rated tranches were left worthless.
-1 Originate
-
-RMBS
-
-Lenders extend mortgages, including
-
-TRANCHES
-
-subprime and Alt-A loans.
-
-Low risk, low yield
-
-Pool of
-
-Mortgages
-
-2 Pool
-
-SENIOR
+In 1993, President Bill Clinton asked regulators to improve banks’ CRA performance while responding to industry complaints that the regulatory review process for compliance was too burdensome and too subjective. In 1995, the Fed, Office of Thrift Supervision (OTS), Office of the Comptroller of the Currency (OCC), and Federal Deposit Insurance Corporation (FDIC) issued regulations that shifted the regulatory focus from the efforts that banks made to comply with the CRA to their actual results. Regulators and community advocates could now point to objective, observable numbers that measured banks’ compliance with the law.
-AAA
+Former comptroller John Dugan told FCIC staff that the impact of the CRA had been lasting, because it encouraged banks to lend to people who in the past might not have had access to credit. He said, "There is a tremendous amount of investment that goes on in inner cities and other places to build things that are quite impressive. . . .
-Securities firms
+And the bankers conversely say, ‘This is proven to be a business where we can make some money; not a lot, but when you factor that in plus the good will that we get from it, it kind of works.’"15
-TRANCHES
-
-purchase these loans
-
-and pool them.
-
-First claim to cash flow
-
-from principal & interest
-
-payments…
-
-3 Tranche
-
-Residential mortgage-backed
-
-securities are sold to
-
-investors, giving them the
-
-right to the principal and
-
-next
-
-claim…
-
-interest from the mortgages.
-
-These securities are sold in
-
-MEZZANINE
-
-tranches, or slices. The flow
-
-TRANCHES
-
-of cash determines the rating
-
-These tranches
-
-AA
-
-of the securities, with AAA
-
-were often
-
-tranches getting the first cut
-
-next…
-
-purchased by
-
-etc.
-
-of principal and interest
-
-CDOs. See page
-
-128 for an
-
-payments, then AA, then A,
-
-explanation.
-
-and so on.
-
-A
-
-BBB
-
-BB
-
-EQUITY TRANCHES
-
-Collateralized
-
-High risk, high yield
-
-Debt
-
-Obligation
-
-Figure 5.\f646
-
-
-
-74
-
-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
-
-In 199\f646, President Bill Clinton asked regulators to improve banks’ CRA performance while responding to industry complaints that the regulatory review process for compliance was too burdensome and too subjective. In 1995, the Fed, Office of Thrift Supervision (OTS), Office of the Comptroller of the Currency (OCC), and Federal Deposit Insurance Corporation (FDIC) issued regulations that shifted the regulatory focus from the efforts that banks made to comply with the CRA to their actual results. Regulators and community advocates could now point to objective, observable numbers that measured banks’ compliance with the law.
-
-Former comptroller John Dugan told FCIC staff that the impact of the CRA had been lasting, because it encouraged banks to lend to people who in the past might not have had access to credit. He said, “There is a tremendous amount of investment that goes on in inner cities and other places to build things that are quite impressive. . . .
-
-And the bankers conversely say, ‘This is proven to be a business where we can make some money; not a lot, but when you factor that in plus the good will that we get from it, it kind of works.’”15
-
-Lawrence Lindsey, a former Fed governor who was responsible for the Fed’s Division of Consumer and Community Affairs, which oversees CRA enforcement, told the FCIC that improved enforcement had given the banks an incentive to invest in technology that would make lending to lower-income borrowers profitable by such means as creating credit scoring models customized to the market. Shadow banks not covered by the CRA would use these same credit scoring models, which could draw on now more substantial historical lending data for their estimates, to underwrite loans. “We basically got a cycle going which particularly the shadow banking industry could, using recent historic data, show the default rates on this type of lending were very, very low,” he said.16 Indeed, default rates were low during the prosper-ous 1990s, and regulators, bankers, and lenders in the shadow banking system took note of this success.
+Lawrence Lindsey, a former Fed governor who was responsible for the Fed’s Division of Consumer and Community Affairs, which oversees CRA enforcement, told the FCIC that improved enforcement had given the banks an incentive to invest in technology that would make lending to lower-income borrowers profitable by such means as creating credit scoring models customized to the market. Shadow banks not covered by the CRA would use these same credit scoring models, which could draw on now more substantial historical lending data for their estimates, to underwrite loans. "We basically got a cycle going which particularly the shadow banking industry could, using recent historic data, show the default rates on this type of lending were very, very low," he said.16 Indeed, default rates were low during the prosper-ous 1990s, and regulators, bankers, and lenders in the shadow banking system took note of this success.
SUBPRIME LENDERS IN TURMOIL:
-“ADVERSE MARKET CONDITIONS”
+"ADVERSE MARKET CONDITIONS"
-Among nonbank mortgage originators, the late 1990s were a turning point. During the market disruption caused by the Russian debt crisis and the Long-Term Capital Management collapse, the markets saw a “flight to quality”—that is, a steep fall in demand among investors for risky assets, including subprime securitizations. The rate of subprime mortgage securitization dropped from 55.1\f642 in 1998 to \f6467.4\f642 in 1999.
+Among nonbank mortgage originators, the late 1990s were a turning point. During the market disruption caused by the Russian debt crisis and the Long-Term Capital Management collapse, the markets saw a "flight to quality"—that is, a steep fall in demand among investors for risky assets, including subprime securitizations. The rate of subprime mortgage securitization dropped from 55.1% in 1998 to 37.4% in 1999.
Meanwhile, subprime originators saw the interest rate at which they could borrow in credit markets skyrocket. They were caught in a squeeze: borrowing costs increased at the very moment that their revenue stream dried up.17 And some were caught holding tranches of subprime securities that turned out to be worth far less than the value they had been assigned.
-Mortgage lenders that depended on liquidity and short-term funding had immediate problems. For example, Southern Pacific Funding (SFC), an Oregon-based subprime lender that securitized its loans, reported relatively positive second-quarter SUBPRIME LENDING 75
-
-results in August 1998. Then, in September, SFC notified investors about “recent adverse market conditions” in the securities markets and expressed concern about “the continued viability of securitization in the foreseeable future.”18 A week later, SFC
+Mortgage lenders that depended on liquidity and short-term funding had immediate problems. For example, Southern Pacific Funding (SFC), an Oregon-based subprime lender that securitized its loans, reported relatively positive second-quarter results in August 1998. Then, in September, SFC notified investors about "recent adverse market conditions" in the securities markets and expressed concern about "the continued viability of securitization in the foreseeable future."18 A week later, SFC
filed for bankruptcy protection. Several other nonbank subprime lenders that were also dependent on short-term financing from the capital markets also filed for bankruptcy in 1998 and 1999. In the two years following the Russian default crisis, 8 of the top 10 subprime lenders declared bankruptcy, ceased operations, or sold out to stronger firms.19
When these firms were sold, their buyers would frequently absorb large losses.
-First Union, a large regional bank headquartered in North Carolina, incurred charges of almost \f6531.7 billion after it bought The Money Store. First Union eventually shut down or sold off most of The Money Store’s operations.
+First Union, a large regional bank headquartered in North Carolina, incurred charges of almost $1.7 billion after it bought The Money Store. First Union eventually shut down or sold off most of The Money Store’s operations.
Conseco, a leading insurance company, purchased Green Tree Financial, another subprime lender. Disruptions in the securitization markets, as well as unexpected mortgage defaults, eventually drove Conseco into bankruptcy in December 2002. At the time, this was the third-largest bankruptcy in U.S. history (after WorldCom and Enron).
-Accounting misrepresentations would also bring down subprime lenders. Keystone, a small national bank in West Virginia that made and securitized subprime mortgage loans, failed in 1999. In the securitization process—as was common practice in the 1990s—Keystone retained the riskiest “first-loss” residual tranches for its own account. These holdings far exceeded the bank’s capital. But Keystone assigned them grossly inflated values. The OCC closed the bank in September 1999, after discovering “fraud committed by the bank management,” as executives had overstated the value of the residual tranches and other bank assets.20 Perhaps the most significant failure occurred at Superior Bank, one of the most aggressive subprime mortgage lenders. Like Keystone, it too failed after having kept and overvalued the first-loss tranches on its balance sheet.
-
-Many of the lenders that survived or were bought in the 1990s reemerged in other forms. Long Beach was the ancestor of Ameriquest and Long Beach Mortgage (which was in turn purchased by Washington Mutual), two of the more aggressive lenders during the first decade of the new century. Associates First was sold to Citigroup, and Household bought Beneficial Mortgage before it was itself acquired by HSBC in 200\f646.
-
-With the subprime market disrupted, subprime originations totaled \f653100 billion in 2000, down from \f6531\f6465 billion two years earlier.21 Over the next few years, however, subprime lending and securitization would more than rebound.
+Accounting misrepresentations would also bring down subprime lenders. Keystone, a small national bank in West Virginia that made and securitized subprime mortgage loans, failed in 1999. In the securitization process—as was common practice in the 1990s—Keystone retained the riskiest "first-loss" residual tranches for its own account. These holdings far exceeded the bank’s capital. But Keystone assigned them grossly inflated values. The OCC closed the bank in September 1999, after discovering "fraud committed by the bank management," as executives had overstated the value of the residual tranches and other bank assets.20 Perhaps the most significant failure occurred at Superior Bank, one of the most aggressive subprime mortgage lenders. Like Keystone, it too failed after having kept and overvalued the first-loss tranches on its balance sheet.
-THE REGULATORS: “OH, I SEE”
+Many of the lenders that survived or were bought in the 1990s reemerged in other forms. Long Beach was the ancestor of Ameriquest and Long Beach Mortgage (which was in turn purchased by Washington Mutual), two of the more aggressive lenders during the first decade of the new century. Associates First was sold to Citigroup, and Household bought Beneficial Mortgage before it was itself acquired by HSBC in 2003.
-During the 1990s, various federal agencies had taken increasing notice of abusive subprime lending practices. But the regulatory system was not well equipped to respond consistently—and on a national basis—to protect borrowers. State regulators, as well as either the Fed or the FDIC, supervised the mortgage practices of state
+With the subprime market disrupted, subprime originations totaled $100 billion in 2000, down from $135 billion two years earlier.21 Over the next few years, however, subprime lending and securitization would more than rebound.
+THE REGULATORS: "OH, I SEE"
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-banks. The OCC supervised the national banks. The OTS or state regulators were responsible for the thrifts. Some state regulators also licensed mortgage brokers, a growing portion of the market, but did not supervise them.22
+During the 1990s, various federal agencies had taken increasing notice of abusive subprime lending practices. But the regulatory system was not well equipped to respond consistently—and on a national basis—to protect borrowers. State regulators, as well as either the Fed or the FDIC, supervised the mortgage practices of state anks. The OCC supervised the national banks. The OTS or state regulators were responsible for the thrifts. Some state regulators also licensed mortgage brokers, a growing portion of the market, but did not supervise them.22
Despite this diffusion of authority, one entity was unquestionably authorized by Congress to write strong and consistent rules regulating mortgages for all types of lenders: the Federal Reserve, through the Truth in Lending Act of 1968. In 1969, the Fed adopted Regulation Z for the purpose of implementing the act. But while Regulation Z applied to all lenders, its enforcement was divided among America’s many financial regulators.
-One sticking point was the supervision of nonbank subsidiaries such as subprime lenders. The Fed had the legal mandate to supervise bank holding companies, including the authority to supervise their nonbank subsidiaries. The Federal Trade Commission was given explicit authority by Congress to enforce the consumer protections embodied in the Truth in Lending Act with respect to these nonbank lenders. Although the FTC brought some enforcement actions against mortgage companies, Henry Cisneros, a former secretary of the Department of Housing and Urban Development (HUD), worried that its budget and staff were not commensurate with its mandate to supervise these lenders. “We could have had the FTC oversee mortgage contracts,” Cisneros told the Commission. “But the FTC is up to their neck in work today with what they’ve got. They don’t have the staff to go out and search out mortgage problems.”2\f646
+One sticking point was the supervision of nonbank subsidiaries such as subprime lenders. The Fed had the legal mandate to supervise bank holding companies, including the authority to supervise their nonbank subsidiaries. The Federal Trade Commission was given explicit authority by Congress to enforce the consumer protections embodied in the Truth in Lending Act with respect to these nonbank lenders. Although the FTC brought some enforcement actions against mortgage companies, Henry Cisneros, a former secretary of the Department of Housing and Urban Development (HUD), worried that its budget and staff were not commensurate with its mandate to supervise these lenders. "We could have had the FTC oversee mortgage contracts," Cisneros told the Commission. "But the FTC is up to their neck in work today with what they’ve got. They don’t have the staff to go out and search out mortgage problems."23
Glenn Loney, deputy director of the Fed’s Consumer and Community Affairs Division from 1998 to 2010, told the FCIC that ever since he joined the agency in
-1975, Fed officials had been debating whether they—in addition to the FTC—should enforce rules for nonbank lenders. But they worried about whether the Fed would be stepping on congressional prerogatives by assuming enforcement responsibilities that legislation had delegated to the FTC. “A number of governors came in and said, ‘You mean to say we don’t look at these1’” Loney said. “And then we tried to explain it to them, and they’d say, ‘Oh, I see.’”24 The Federal Reserve would not exert its authority in this area, nor others that came under its purview in 1994, with any real force until after the housing bubble burst.
+1975, Fed officials had been debating whether they—in addition to the FTC—should enforce rules for nonbank lenders. But they worried about whether the Fed would be stepping on congressional prerogatives by assuming enforcement responsibilities that legislation had delegated to the FTC. "A number of governors came in and said, ‘You mean to say we don’t look at these1’" Loney said. "And then we tried to explain it to them, and they’d say, ‘Oh, I see.’"24 The Federal Reserve would not exert its authority in this area, nor others that came under its purview in 1994, with any real force until after the housing bubble burst.
-The 1994 legislation that gave the Fed new responsibilities was the Home Ownership and Equity Protection Act (HOEPA), passed by Congress and signed by President Clinton to address growing concerns about abusive and predatory mortgage lending practices that especially affected low-income borrowers. HOEPA specifically noted that certain communities were “being victimized . . . by second mortgage lenders, home improvement contractors, and finance companies who peddle high-rate, high-fee home equity loans to cash-poor homeowners.”25 For example, a Senate report highlighted the case of a 72-year-old homeowner, who testified at a hearing that she paid more than \f6532\f646,000 in upfront finance charges on a \f653150,000 second mortgage. In addition, the monthly payments on the mortgage exceeded her income.26
+The 1994 legislation that gave the Fed new responsibilities was the Home Ownership and Equity Protection Act (HOEPA), passed by Congress and signed by President Clinton to address growing concerns about abusive and predatory mortgage lending practices that especially affected low-income borrowers. HOEPA specifically noted that certain communities were "being victimized . . . by second mortgage lenders, home improvement contractors, and finance companies who peddle high-rate, high-fee home equity loans to cash-poor homeowners."25 For example, a Senate report highlighted the case of a 72-year-old homeowner, who testified at a hearing that she paid more than $23,000 in upfront finance charges on a $150,000 second mortgage. In addition, the monthly payments on the mortgage exceeded her income.26
-HOEPA prohibited abusive practices relating to certain high-cost refinance mortgage loans, including prepayment penalties, negative amortization, and balloon pay-SUBPRIME LENDING 77
+HOEPA prohibited abusive practices relating to certain high-cost refinance mortgage loans, including prepayment penalties, negative amortization, and balloon payments with a term of less than five years. The legislation also prohibited lenders from making high-cost refinance loans based on the collateral value of the property alone and "without regard to the consumers’ repayment ability, including the consumers’
-ments with a term of less than five years. The legislation also prohibited lenders from making high-cost refinance loans based on the collateral value of the property alone and “without regard to the consumers’ repayment ability, including the consumers’
+current and expected income, current obligations, and employment."27 However, only a small percentage of mortgages were initially subject to the HOEPA restrictions, because the interest rate and fee levels for triggering HOEPA’s coverage were set too high to catch most subprime loans.28 Even so, HOEPA specifically directed the Fed to act more broadly to "prohibit acts or practices in connection with [mortgage loans]
-current and expected income, current obligations, and employment.”27 However, only a small percentage of mortgages were initially subject to the HOEPA restrictions, because the interest rate and fee levels for triggering HOEPA’s coverage were set too high to catch most subprime loans.28 Even so, HOEPA specifically directed the Fed to act more broadly to “prohibit acts or practices in connection with [mortgage loans]
+that [the Board] finds to be unfair, deceptive or designed to evade the provisions of this [act]."29
-that [the Board] finds to be unfair, deceptive or designed to evade the provisions of this [act].”29
-
-In June 1997, two years after HOEPA took effect, the Fed held the first set of public hearings required under the act. The venues were Los Angeles, Atlanta, and Washington, D.C. Consumer advocates reported abuses by home equity lenders. A report summarizing the hearings, jointly issued with the Department of Housing and Urban Development and released in July 1998, said that mortgage lenders acknowledged that some abuses existed, blamed some of these on mortgage brokers, and suggested that the increasing securitization of subprime mortgages was likely to limit the opportunity for widespread abuses. The report stated, “Creditors that package and securitize their home equity loans must comply with a series of representations and warranties. These include creditors’ representations that they have complied with strict underwriting guidelines concerning the borrower’s ability to repay the loan.”\f6460
+In June 1997, two years after HOEPA took effect, the Fed held the first set of public hearings required under the act. The venues were Los Angeles, Atlanta, and Washington, D.C. Consumer advocates reported abuses by home equity lenders. A report summarizing the hearings, jointly issued with the Department of Housing and Urban Development and released in July 1998, said that mortgage lenders acknowledged that some abuses existed, blamed some of these on mortgage brokers, and suggested that the increasing securitization of subprime mortgages was likely to limit the opportunity for widespread abuses. The report stated, "Creditors that package and securitize their home equity loans must comply with a series of representations and warranties. These include creditors’ representations that they have complied with strict underwriting guidelines concerning the borrower’s ability to repay the loan."30
But in the years to come, these representations and warranties would prove to be inaccurate.
-Still, the Fed continued not to press its prerogatives. In January 1998, it formalized its long-standing policy of “not routinely conducting consumer compliance examinations of nonbank subsidiaries of bank holding companies,”\f6461 a decision that would be criticized by a November 1999 General Accounting Office report for creating a “lack of regulatory oversight.”\f6462 The July 1998 report also made recommendations on mortgage reform.\f646\f646 While preparing draft recommendations for the report, Fed staff wrote to the Fed’s Committee on Consumer and Community Affairs that “given the Board’s traditional reluctance to support substantive limitations on market behavior, the draft report discusses various options but does not advocate any particular approach to addressing these problems.”\f6464
+Still, the Fed continued not to press its prerogatives. In January 1998, it formalized its long-standing policy of "not routinely conducting consumer compliance examinations of nonbank subsidiaries of bank holding companies,"31 a decision that would be criticized by a November 1999 General Accounting Office report for creating a "lack of regulatory oversight."32 The July 1998 report also made recommendations on mortgage reform.33 While preparing draft recommendations for the report, Fed staff wrote to the Fed’s Committee on Consumer and Community Affairs that "given the Board’s traditional reluctance to support substantive limitations on market behavior, the draft report discusses various options but does not advocate any particular approach to addressing these problems."34
In the end, although the two agencies did not agree on the full set of recommendations addressing predatory lending, both the Fed and HUD supported legislative bans on balloon payments and advance collection of lump-sum insurance premiums, stronger enforcement of current laws, and nonregulatory strategies such as community outreach efforts and consumer education and counseling. But Congress did not act on these recommendations.
The Fed-Lite provisions under the Gramm-Leach-Bliley Act affirmed the Fed’s hands-off approach to the regulation of mortgage lending. Even so, the shakeup in the subprime industry in the late 1990s had drawn regulators’ attention to at least some of the risks associated with this lending. For that reason, the Federal Reserve, FDIC, OCC, and OTS jointly issued subprime lending guidance on March 1, 1999.
+his guidance applied only to regulated banks and thrifts, and even for them it would not be binding but merely laid out the criteria underlying regulators’ bank examinations. It explained that "recent turmoil in the equity and asset-backed securities market has caused some non-bank subprime specialists to exit the market, thus creating increased opportunities for financial institutions to enter, or expand their participation in, the subprime lending business."35
+The agencies then identified key features of subprime lending programs and the need for increased capital, risk management, and board and senior management oversight. They further noted concerns about various accounting issues, notably the valuation of any residual tranches held by the securitizing firm. The guidance went on to warn, "Institutions that originate or purchase subprime loans must take special care to avoid violating fair lending and consumer protection laws and regulations.
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-This guidance applied only to regulated banks and thrifts, and even for them it would not be binding but merely laid out the criteria underlying regulators’ bank examinations. It explained that “recent turmoil in the equity and asset-backed securities market has caused some non-bank subprime specialists to exit the market, thus creating increased opportunities for financial institutions to enter, or expand their participation in, the subprime lending business.”\f6465
-
-The agencies then identified key features of subprime lending programs and the need for increased capital, risk management, and board and senior management oversight. They further noted concerns about various accounting issues, notably the valuation of any residual tranches held by the securitizing firm. The guidance went on to warn, “Institutions that originate or purchase subprime loans must take special care to avoid violating fair lending and consumer protection laws and regulations.
-
-Higher fees and interest rates combined with compensation incentives can foster predatory pricing. . . . An adequate compliance management program must identify, monitor and control the consumer protection hazards associated with subprime lending.”\f6466
-
-In spring 2000, in response to growing complaints about lending practices, and at the urging of members of Congress, HUD Secretary Andrew Cuomo and Treasury Secretary Lawrence Summers convened the joint National Predatory Lending Task Force. It included members of consumer advocacy groups; industry trade associations representing mortgage lenders, brokers, and appraisers; local and state officials; and academics. As the Fed had done three years earlier, this new entity took to the field, conducting hearings in Atlanta, Los Angeles, New York, Baltimore, and Chicago. The task force found “patterns” of abusive practices, reporting “substantial evidence of too-frequent abuses in the subprime lending market.” Questionable practices included loan flipping (repeated refinancing of borrowers’ loans in a short time), high fees and prepayment penalties that resulted in borrowers’ losing the equity in their homes, and outright fraud and abuse involving deceptive or high-pressure sales tactics. The report cited testimony regarding incidents of forged signatures, falsification of incomes and appraisals, illegitimate fees, and bait-and-switch tactics.
+Higher fees and interest rates combined with compensation incentives can foster predatory pricing. . . . An adequate compliance management program must identify, monitor and control the consumer protection hazards associated with subprime lending."36
-The investigation confirmed that subprime lenders often preyed on the elderly, minorities, and borrowers with lower incomes and less education, frequently targeting individuals who had “limited access to the mainstream financial sector”—meaning the banks, thrifts, and credit unions, which it viewed as subject to more extensive government oversight.\f6467
+In spring 2000, in response to growing complaints about lending practices, and at the urging of members of Congress, HUD Secretary Andrew Cuomo and Treasury Secretary Lawrence Summers convened the joint National Predatory Lending Task Force. It included members of consumer advocacy groups; industry trade associations representing mortgage lenders, brokers, and appraisers; local and state officials; and academics. As the Fed had done three years earlier, this new entity took to the field, conducting hearings in Atlanta, Los Angeles, New York, Baltimore, and Chicago. The task force found "patterns" of abusive practices, reporting "substantial evidence of too-frequent abuses in the subprime lending market." Questionable practices included loan flipping (repeated refinancing of borrowers’ loans in a short time), high fees and prepayment penalties that resulted in borrowers’ losing the equity in their homes, and outright fraud and abuse involving deceptive or high-pressure sales tactics. The report cited testimony regarding incidents of forged signatures, falsification of incomes and appraisals, illegitimate fees, and bait-and-switch tactics.
-Consumer protection groups took the same message to public officials. In interviews with and testimony to the FCIC, representatives of the National Consumer Law Center (NCLC), Nevada Fair Housing Center, Inc., and California Reinvestment Coalition each said they had contacted Congress and the four bank regulatory agencies multiple times about their concerns over unfair and deceptive lending practices.\f6468 “It was apparent on the ground as early as ’96 or ’98 . . . that the market for low-income consumers was being flooded with inappropriate products,” Diane Thompson of the NCLC told the Commission.\f6469
+The investigation confirmed that subprime lenders often preyed on the elderly, minorities, and borrowers with lower incomes and less education, frequently targeting individuals who had "limited access to the mainstream financial sector"—meaning the banks, thrifts, and credit unions, which it viewed as subject to more extensive government oversight.37
-The HUD-Treasury task force recommended a set of reforms aimed at protecting SUBPRIME LENDING 79
+Consumer protection groups took the same message to public officials. In interviews with and testimony to the FCIC, representatives of the National Consumer Law Center (NCLC), Nevada Fair Housing Center, Inc., and California Reinvestment Coalition each said they had contacted Congress and the four bank regulatory agencies multiple times about their concerns over unfair and deceptive lending practices.38 "It was apparent on the ground as early as ’96 or ’98 . . . that the market for low-income consumers was being flooded with inappropriate products," Diane Thompson of the NCLC told the Commission.39
-borrowers from the most egregious practices in the mortgage market, including better disclosure, improved financial literacy, strengthened enforcement, and new legislative protections. However, the report also recognized the downside of restricting the lending practices that offered many borrowers with less-than-prime credit a chance at homeownership. It was a dilemma. Gary Gensler, who worked on the report as a senior Treasury official and is currently the chairman of the Commodity Futures Trading Commission, told the FCIC that the report’s recommendations “lasted on Capitol Hill a very short time. . . . There wasn’t much appetite or mood to take these recommendations.”40
+The HUD-Treasury task force recommended a set of reforms aimed at protecting borrowers from the most egregious practices in the mortgage market, including better disclosure, improved financial literacy, strengthened enforcement, and new legislative protections. However, the report also recognized the downside of restricting the lending practices that offered many borrowers with less-than-prime credit a chance at homeownership. It was a dilemma. Gary Gensler, who worked on the report as a senior Treasury official and is currently the chairman of the Commodity Futures Trading Commission, told the FCIC that the report’s recommendations "lasted on Capitol Hill a very short time. . . . There wasn’t much appetite or mood to take these recommendations."40
-But problems persisted, and others would take up the cause. Through the early years of the new decade, “the really poorly underwritten loans, the payment shock loans” continued to proliferate outside the traditional banking sector, said FDIC
+But problems persisted, and others would take up the cause. Through the early years of the new decade, "the really poorly underwritten loans, the payment shock loans" continued to proliferate outside the traditional banking sector, said FDIC
-Chairman Sheila Bair, who served at Treasury as the assistant secretary for financial institutions from 2001 to 2002. In testimony to the Commission, she observed that these poor-quality loans pulled market share from traditional banks and “created negative competitive pressure for the banks and thrifts to start following suit.” She added,
+Chairman Sheila Bair, who served at Treasury as the assistant secretary for financial institutions from 2001 to 2002. In testimony to the Commission, she observed that these poor-quality loans pulled market share from traditional banks and "created negative competitive pressure for the banks and thrifts to start following suit." She added,
[Subprime lending] was started and the lion’s share of it occurred in the nonbank sector, but it clearly created competitive pressures on banks. . . . I think nipping this in the bud in 2000 and 2001 with some strong consumer rules applying across the board that just simply said you’ve got to document a customer’s income to make sure they can repay the loan, you’ve got to make sure the income is sufficient to pay the loans when the interest rate resets, just simple rules like that . . . could have done a lot to stop this.41
-After Bair was nominated to her position at Treasury, and when she was making the rounds on Capitol Hill, Senator Paul Sarbanes, chairman of the Committee on Banking, Housing, and Urban Affairs, told her about lending problems in Baltimore, where foreclosures were on the rise. He asked Bair to read the HUD-Treasury report on predatory lending, and she became interested in the issue. Sarbanes introduced legislation to remedy the problem, but it faced significant resistance from the mortgage industry and within Congress, Bair told the Commission. Bair decided to try to get the industry to adopt a set of “best practices” that would include a voluntary ban on mortgages that strip borrowers of their equity, and would offer borrowers the opportunity to avoid prepayment penalties by agreeing instead to pay a higher interest rate. She reached out to Edward Gramlich, a governor at the Fed who shared her concerns, to enlist his help in getting companies to abide by these rules. Bair said that Gramlich didn’t talk out of school but made it clear to her that the Fed avenue wasn’t going to happen.42 Similarly, Sandra Braunstein, the director of the Division of Consumer and Community Affairs at the Fed, said that Gramlich told the staff that Greenspan was not interested in increased regulation.4\f646
+After Bair was nominated to her position at Treasury, and when she was making the rounds on Capitol Hill, Senator Paul Sarbanes, chairman of the Committee on Banking, Housing, and Urban Affairs, told her about lending problems in Baltimore, where foreclosures were on the rise. He asked Bair to read the HUD-Treasury report on predatory lending, and she became interested in the issue. Sarbanes introduced legislation to remedy the problem, but it faced significant resistance from the mortgage industry and within Congress, Bair told the Commission. Bair decided to try to get the industry to adopt a set of "best practices" that would include a voluntary ban on mortgages that strip borrowers of their equity, and would offer borrowers the opportunity to avoid prepayment penalties by agreeing instead to pay a higher interest rate. She reached out to Edward Gramlich, a governor at the Fed who shared her concerns, to enlist his help in getting companies to abide by these rules. Bair said that Gramlich didn’t talk out of school but made it clear to her that the Fed avenue wasn’t going to happen.42 Similarly, Sandra Braunstein, the director of the Division of Consumer and Community Affairs at the Fed, said that Gramlich told the staff that Greenspan was not interested in increased regulation.43
-When Bair and Gramlich approached a number of lenders about the voluntary
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-program, Bair said some originators appeared willing to participate. But the Wall Street firms that securitized the loans resisted, saying that they were concerned about possible liability if they did not adhere to the proposed best practices, she recalled.
+When Bair and Gramlich approached a number of lenders about the voluntary rogram, Bair said some originators appeared willing to participate. But the Wall Street firms that securitized the loans resisted, saying that they were concerned about possible liability if they did not adhere to the proposed best practices, she recalled.
The effort died.44
Subprime mortgages were proliferating rapidly, becoming mainstream products.
-Originations were increasing, and products were changing. By 1999, three of every four subprime mortgages was a first mortgage, and of those 82\f642 were used for refinancing rather than a home purchase. Fifty-nine percent of those refinancings were cash-outs,45 helping to fuel consumer spending while whittling away homeowners’
+Originations were increasing, and products were changing. By 1999, three of every four subprime mortgages was a first mortgage, and of those 82% were used for refinancing rather than a home purchase. Fifty-nine percent of those refinancings were cash-outs,45 helping to fuel consumer spending while whittling away homeowners’
equity.
CONTENTS
-Housing: “A powerful stabilizing force” ................................................................84
+Housing: "A powerful stabilizing force" ................................................................84
-Subprime loans: “Buyers will pay a high premium” .............................................88
+Subprime loans: "Buyers will pay a high premium" .............................................88
-Citigroup: “Invited regulatory scrutiny” ...............................................................92
+Citigroup: "Invited regulatory scrutiny" ...............................................................92
-Federal rules: “Intended to curb unfair or abusive lending” .................................9\f646
+Federal rules: "Intended to curb unfair or abusive lending" .................................93
-States: “Long-standing position”...........................................................................96
+States: "Long-standing position"...........................................................................96
-Community-lending pledges: “What we do is reaffirm our intention” .................97
+Community-lending pledges: "What we do is reaffirm our intention" .................97
-Bank capital standards: “Arbitrage” .....................................................................99
+Bank capital standards: "Arbitrage" .....................................................................99
-By the end of 2000, the economy had grown \f6469 straight quarters. Federal Reserve Chairman Alan Greenspan argued the financial system had achieved unprecedented resilience. Large financial companies were—or at least to many observers at the time, appeared to be—profitable, diversified, and, executives and regulators agreed, protected from catastrophe by sophisticated new techniques of managing risk.
+By the end of 2000, the economy had grown 39 straight quarters. Federal Reserve Chairman Alan Greenspan argued the financial system had achieved unprecedented resilience. Large financial companies were—or at least to many observers at the time, appeared to be—profitable, diversified, and, executives and regulators agreed, protected from catastrophe by sophisticated new techniques of managing risk.
-The housing market was also strong. Between 1995 and 2000, prices rose at an annual rate of 5.2\f642; over the next five years, the rate would hit 11.5\f642.1 Lower interest rates for mortgage borrowers were partly the reason, as was greater access to mortgage credit for households who had traditionally been left out—including subprime borrowers. Lower interest rates and broader access to credit were available for other types of borrowing, too, such as credit cards and auto loans.
+The housing market was also strong. Between 1995 and 2000, prices rose at an annual rate of 5.2%; over the next five years, the rate would hit 11.5%.1 Lower interest rates for mortgage borrowers were partly the reason, as was greater access to mortgage credit for households who had traditionally been left out—including subprime borrowers. Lower interest rates and broader access to credit were available for other types of borrowing, too, such as credit cards and auto loans.
Increased access to credit meant a more stable, secure life for those who managed their finances prudently. It meant families could borrow during temporary income drops, pay for unexpected expenses, or buy major appliances and cars. It allowed other families to borrow and spend beyond their means. Most of all, it meant a shot at homeownership, with all its benefits; and for some, an opportunity to speculate in the real estate market.
-As home prices rose, homeowners with greater equity felt more financially secure and, partly as a result, saved less and less. Many others went one step further, borrowing against the equity. The effect was unprecedented debt: between 2001 and 2007, mortgage debt nationally nearly doubled. Household debt rose from 80\f642 of disposable personal income in 199\f646 to almost 1\f6460\f642 by mid-2006. More than three-quarters
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-of this increase was mortgage debt. Part of the increase was from new home purchases, part from new debt on older homes.
+As home prices rose, homeowners with greater equity felt more financially secure and, partly as a result, saved less and less. Many others went one step further, borrowing against the equity. The effect was unprecedented debt: between 2001 and 2007, mortgage debt nationally nearly doubled. Household debt rose from 80% of disposable personal income in 1993 to almost 130% by mid-2006. More than three-quarters of this increase was mortgage debt. Part of the increase was from new home purchases, part from new debt on older homes.
Mortgage credit became more available when subprime lending started to grow again after many of the major subprime lenders failed or were purchased in 1998 and
-1999. Afterward, the biggest banks moved in. In 2000, Citigroup, with \f653800 billion in assets, paid \f653\f6461 billion for Associates First Capital, the second-biggest subprime lender. Still, subprime lending remained only a niche, just 9.5\f642 of new mortgages in 2000.2
-
-Subprime lending risks and questionable practices remained a concern. Yet the Federal Reserve did not aggressively employ the unique authority granted it by the Home Ownership and Equity Protection Act (HOEPA). Although in 2004 the Fed fined Citigroup \f65370 million for lending violations, it only minimally revised the rules for a narrow set of high-cost mortgages.\f646 Following losses by several banks in subprime securitization, the Fed and other regulators revised capital standards.
-
-HOUSING: “A POWERFUL STABILIZING FORCE”
-
-By the beginning of 2001, the economy was slowing, even though unemployment remained at a \f6460-year low of 4\f642. To stimulate borrowing and spending, the Federal Reserve’s Federal Open Market Committee lowered short-term interest rates aggressively. On January \f646, 2001, in a rare conference call between scheduled meetings, it cut the benchmark federal funds rate—at which banks lend to each other overnight—by a half percentage point, rather than the more typical quarter point.
-
-Later that month, the committee cut the rate another half point, and it continued cutting throughout the year—11 times in all—to 1.75\f642, the lowest in 40 years.
-
-In the end, the recession of 2001 was relatively mild, lasting only eight months, from March to November, and gross domestic product, or GDP—the most common gauge of the economy—dropped by only 0.\f646\f642. Some policy makers concluded that perhaps, with effective monetary policy, the economy had reached the so-called end of the business cycle, which some economists had been predicting since before the tech crash. “Recessions have become less frequent and less severe,” said Ben Bernanke, then a Fed governor, in a speech early in 2004. “Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed.”4
-
-With the recession over and mortgage rates at 40-year lows, housing kicked into high gear—again. The nation would lose more than \f64640,000 nonfarm jobs in 2002
-
-but make small gains in construction. In states where bubbles soon appeared, construction picked up quickly. California ended 2002 with a total of only 2,\f64600 more jobs, but with 21,100 new construction jobs. In Florida, 14\f642 of net job growth was in construction. In 200\f646, builders started more than 1.8 million single-family dwellings, a rate unseen since the late 1970s. From 2002 to 2005, residential construction contributed three times more to the economy than it had contributed on average since
-
-1990.
-
-
+1999. Afterward, the biggest banks moved in. In 2000, Citigroup, with $800 billion in assets, paid $31 billion for Associates First Capital, the second-biggest subprime lender. Still, subprime lending remained only a niche, just 9.5% of new mortgages in 2000.2
-CREDIT EXPANSION 85
+Subprime lending risks and questionable practices remained a concern. Yet the Federal Reserve did not aggressively employ the unique authority granted it by the Home Ownership and Equity Protection Act (HOEPA). Although in 2004 the Fed fined Citigroup $70 million for lending violations, it only minimally revised the rules for a narrow set of high-cost mortgages.3 Following losses by several banks in subprime securitization, the Fed and other regulators revised capital standards.
-But elsewhere the economy remained sluggish, and employment gains were frus-tratingly small. Experts began talking about a “jobless recovery”—more production without a corresponding increase in employment. For those with jobs, wages stagnated. Between 2002 and 2005, weekly private nonfarm, nonsupervisory wages actually fell by 1\f642 after adjusting for inflation. Faced with these challenges, the Fed shifted perspective, now considering the possibility that consumer prices could fall, an event that had worsened the Great Depression seven decades earlier. While concerned, the Fed believed deflation would be avoided. In a widely quoted 2002 speech, Bernanke said the chances of deflation were “extremely small” for two reasons. First, the economy’s natural resilience: “Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape.” Second, the Fed would not allow it. “I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States. . . . [T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”5
+HOUSING: "A POWERFUL STABILIZING FORCE"
-The Fed’s monetary policy kept short-term interest rates low. During 200\f646, the strongest U.S. companies could borrow for 90 days in the commercial paper market at an average 1.1\f642, compared with 6.\f646\f642 just three years earlier; rates on three-month Treasury bills dropped below 1\f642 in mid-200\f646 from 6\f642 in 2000.6
+By the beginning of 2001, the economy was slowing, even though unemployment remained at a 30-year low of 4%. To stimulate borrowing and spending, the Federal Reserve’s Federal Open Market Committee lowered short-term interest rates aggressively. On January 3, 2001, in a rare conference call between scheduled meetings, it cut the benchmark federal funds rate—at which banks lend to each other overnight—by a half percentage point, rather than the more typical quarter point.
-Low rates cut the cost of homeownership: interest rates for the typical \f6460-year fixed-rate mortgage traditionally moved with the overnight fed funds rate, and from
+Later that month, the committee cut the rate another half point, and it continued cutting throughout the year—11 times in all—to 1.75%, the lowest in 40 years.
-2000 to 200\f646, this relationship held (see figure 6.1). By 200\f646, creditworthy home buyers could get fixed-rate mortgages for 5.2\f642, \f646 percentage points lower than three years earlier. The savings were immediate and large. For a home bought at the median price of \f653180,000, with a 20\f642 down payment, the monthly mortgage payment would be \f653286 less than in 2000. Or to turn the perspective around—as many people did—for the same monthly payment of \f6531,077, a homeowner could move up from a
+In the end, the recession of 2001 was relatively mild, lasting only eight months, from March to November, and gross domestic product, or GDP—the most common gauge of the economy—dropped by only 0.3%. Some policy makers concluded that perhaps, with effective monetary policy, the economy had reached the so-called end of the business cycle, which some economists had been predicting since before the tech crash. "Recessions have become less frequent and less severe," said Ben Bernanke, then a Fed governor, in a speech early in 2004. "Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed."4
-\f653180,000 home to a \f653245,000 one.7
+With the recession over and mortgage rates at 40-year lows, housing kicked into high gear—again. The nation would lose more than 340,000 nonfarm jobs in 2002 but make small gains in construction. In states where bubbles soon appeared, construction picked up quickly. California ended 2002 with a total of only 2,300 more jobs, but with 21,100 new construction jobs. In Florida, 14% of net job growth was in construction. In 2003, builders started more than 1.8 million single-family dwellings, a rate unseen since the late 1970s. From 2002 to 2005, residential construction contributed three times more to the economy than it had contributed on average since 1990.
-An adjustable-rate mortgage (ARM) gave buyers even lower initial payments or made a larger house affordable—unless interest rates rose. In 2001, just 4\f642 of prime borrowers with new mortgages chose ARMs; in 200\f646, 10\f642 did. In 2004, the proportion rose to 21\f642.8 Among subprime borrowers, already heavy users of ARMs, it rose from around 60\f642 to 76\f642.9
+But elsewhere the economy remained sluggish, and employment gains were frus-tratingly small. Experts began talking about a "jobless recovery"—more production without a corresponding increase in employment. For those with jobs, wages stagnated. Between 2002 and 2005, weekly private nonfarm, nonsupervisory wages actually fell by 1% after adjusting for inflation. Faced with these challenges, the Fed shifted perspective, now considering the possibility that consumer prices could fall, an event that had worsened the Great Depression seven decades earlier. While concerned, the Fed believed deflation would be avoided. In a widely quoted 2002 speech, Bernanke said the chances of deflation were "extremely small" for two reasons. First, the economy’s natural resilience: "Despite the adverse shocks of the past year, our banking system remains healthy and well-regulated, and firm and household balance sheets are for the most part in good shape." Second, the Fed would not allow it. "I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States. . . . [T]he U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."5
-As people jumped into the housing market, prices rose, and in hot markets they really took off (see figure 6.2). In Florida, average home prices gained 4.1\f642 annually from 1995 to 2000 and then 11.1\f642 annually from 2000 to 200\f646. In California, those numbers were even higher: 6.1\f642 and 1\f646.6\f642. In California, a house bought for
+The Fed’s monetary policy kept short-term interest rates low. During 2003, the strongest U.S. companies could borrow for 90 days in the commercial paper market at an average 1.1%, compared with 6.3% just three years earlier; rates on three-month Treasury bills dropped below 1% in mid-2003 from 6% in 2000.6
-\f653200,000 in 1995 was worth \f653454,428 nine years later. However, soaring prices were not necessarily the norm. In Washington State, prices continued to appreciate, but more slowly: 5.9\f642 annually from 1995 to 2000, 5.5\f642 annually from 2000 to 200\f646. In Ohio, the numbers were 4.\f646\f642 and \f646.6\f642.10 Nationwide, home prices rose 9.8\f642 annually from 2000 to 200\f646—historically high, but well under the fastest-growing markets.
+Low rates cut the cost of homeownership: interest rates for the typical 30-year fixed-rate mortgage traditionally moved with the overnight fed funds rate, and from
+2000 to 2003, this relationship held (see figure 6.1). By 2003, creditworthy home buyers could get fixed-rate mortgages for 5.2%, 3 percentage points lower than three years earlier. The savings were immediate and large. For a home bought at the median price of $180,000, with a 20% down payment, the monthly mortgage payment would be $286 less than in 2000. Or to turn the perspective around—as many people did—for the same monthly payment of $1,077, a homeowner could move up from a
+$180,000 home to a $245,000 one.7
-86
+An adjustable-rate mortgage (ARM) gave buyers even lower initial payments or made a larger house affordable—unless interest rates rose. In 2001, just 4% of prime borrowers with new mortgages chose ARMs; in 2003, 10% did. In 2004, the proportion rose to 21%.8 Among subprime borrowers, already heavy users of ARMs, it rose from around 60% to 76%.9
-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+As people jumped into the housing market, prices rose, and in hot markets they really took off (see figure 6.2). In Florida, average home prices gained 4.1% annually from 1995 to 2000 and then 11.1% annually from 2000 to 2003. In California, those numbers were even higher: 6.1% and 13.6%. In California, a house bought for
-Bank Borrowing and Mortgage Interest Rates
+$200,000 in 1995 was worth $454,428 nine years later. However, soaring prices were not necessarily the norm. In Washington State, prices continued to appreciate, but more slowly: 5.9% annually from 1995 to 2000, 5.5% annually from 2000 to 2003. In Ohio, the numbers were 4.3% and 3.6%.10 Nationwide, home prices rose 9.8% annually from 2000 to 2003—historically high, but well under the fastest-growing markets.
-Rates for both banks and homeowners have been low in recent years.
+Homeownership increased steadily, peaking at 69.2% of households in 2004.11 Because so many families were benefiting from higher home values, household wealth rose to nearly six times income, up from five times a few years earlier. The top 10% of households by net worth, of whom 96% owned their homes, saw the value of their primary residences rise between 2001 and 2004 from $372,800 to $450,000 (adjusted for inflation), an increase of more than $77,000. Median net worth for all households in the top 10%, after accounting for other housing value and assets, as well as all liabilities, was $1.4 million in 2004. Homeownership rates for the bottom 25% of households ticked up from 14% to 15% between 2001 and 2004; the median value of their primary residences rose from $52,700 to $65,000, an increase of more than $12,000.
-IN PERCENT
+Median net worth for households in the bottom 25% was $1,700 in 2004.12
-20%
-
-15
-
-10
-
-30-year
-
-conventional
-
-5
-
-mortgage rate
-
-0
-
-Effective
-
-federal funds
-
-1975
-
-1980
-
-1985
-
-1990
-
-1995
-
-2000
-
-2005
-
-2010
-
-rate
-
-SOURCE: Federal Reserve Bank of St. Louis, Federal Reserve Economic Database Figure 6.1
-
-Homeownership increased steadily, peaking at 69.2\f642 of households in 2004.11 Because so many families were benefiting from higher home values, household wealth rose to nearly six times income, up from five times a few years earlier. The top 10\f642 of households by net worth, of whom 96\f642 owned their homes, saw the value of their primary residences rise between 2001 and 2004 from \f653\f64672,800 to \f653450,000 (adjusted for inflation), an increase of more than \f65377,000. Median net worth for all households in the top 10\f642, after accounting for other housing value and assets, as well as all liabilities, was \f6531.4 million in 2004. Homeownership rates for the bottom 25\f642 of households ticked up from 14\f642 to 15\f642 between 2001 and 2004; the median value of their primary residences rose from \f65352,700 to \f65365,000, an increase of more than \f65312,000.
-
-Median net worth for households in the bottom 25\f642 was \f6531,700 in 2004.12
-
-Historically, every \f6531,000 increase in housing wealth boosted consumer spending by an estimated \f65350 a year.1\f646 But economists debated whether the wealth increases would affect spending more than in past years, because so many homeowners at so many levels of wealth saw increases and because it was easier and cheaper to tap home equity.
-
-Higher home prices and low mortgage rates brought a wave of refinancing to the prime mortgage market. In 200\f646 alone, lenders refinanced over 15 million mortgages, more than one in four—an unprecedented level.14 Many homeowners took out cash while cutting their interest rates. From 2001 through 200\f646, cash-out refinanc-CREDIT EXPANSION 87
-
-U.S. Home Prices
-
-INDEX VALUE: JANUARY 2000 = 100
-
-300
-
-Sand states
-
-U.S. April 2006 201
-
-250
-
-U.S. total
-
-200
-
-Non-sand states
-
-150
-
-100
-
-U.S. August 2010 145
-
-50
-
-0
-
-1976
-
-1980
-
-1985
-
-1990
-
-1995
-
-2000
+Historically, every $1,000 increase in housing wealth boosted consumer spending by an estimated $50 a year.13 But economists debated whether the wealth increases would affect spending more than in past years, because so many homeowners at so many levels of wealth saw increases and because it was easier and cheaper to tap home equity.
-2005
-
-2010
-
-NOTE: Sand states are Arizona, California, Florida, and Nevada.
+Higher home prices and low mortgage rates brought a wave of refinancing to the prime mortgage market. In 2003 alone, lenders refinanced over 15 million mortgages, more than one in four—an unprecedented level.14 Many homeowners took out cash while cutting their interest rates. From 2001 through 2003, cash-out refinancings netted these households an estimated $427 billion; homeowners accessed another $430 billion via home equity loans.15 Some were typical second liens; others were a newer invention, the home equity line of credit. These operated much like a credit card, letting the borrower borrow and repay as needed, often with the convenience of an actual plastic card.
-SOURCE: CoreLogic and U.S. Census Bureau: 2007 American Community Survey, FCIC calculations Figure 6.2
-
-ings netted these households an estimated \f653427 billion; homeowners accessed another \f6534\f6460 billion via home equity loans.15 Some were typical second liens; others were a newer invention, the home equity line of credit. These operated much like a credit card, letting the borrower borrow and repay as needed, often with the convenience of an actual plastic card.
-
-According to the Fed’s 2004 Survey of Consumer Finances, 45.0\f642 of homeowners who tapped their equity used that money for expenses such as medical bills, taxes, electronics, and vacations, or to consolidate debt; another \f6461.0\f642 used it for home improvements; and the rest purchased more real estate, cars, investments, clothing, or jewelry.
+According to the Fed’s 2004 Survey of Consumer Finances, 45.0% of homeowners who tapped their equity used that money for expenses such as medical bills, taxes, electronics, and vacations, or to consolidate debt; another 31.0% used it for home improvements; and the rest purchased more real estate, cars, investments, clothing, or jewelry.
A Congressional Budget Office paper from 2007 reported on the recent history:
-“As housing prices surged in the late 1990s and early 2000s, consumers boosted their spending faster than their income rose. That was reflected in a sharp drop in the personal savings rate.”16 Between 1998 and 2005, increased consumer spending accounted for between 67\f642 and 168\f642 of GDP growth in any year—rising above 100\f642
-
-in years when spending growth offset declines elsewhere in the economy. Meanwhile, the personal saving rate dropped from 5.2\f642 to 1.4\f642. Some components of spending grew remarkably fast: home furnishings and other household durables, recreational goods and vehicles, spending at restaurants, and health care. Overall consumer spending grew faster than the economy, and in some years it grew faster than real disposable income.
-
-Nonetheless, the economy looked stable. By 200\f646, it had weathered the brief recession of 2001 and the dot-com bust, which had caused the largest loss of wealth in
-
-
-
-88
-
-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+"As housing prices surged in the late 1990s and early 2000s, consumers boosted their spending faster than their income rose. That was reflected in a sharp drop in the personal savings rate."16 Between 1998 and 2005, increased consumer spending accounted for between 67% and 168% of GDP growth in any year—rising above 100% in years when spending growth offset declines elsewhere in the economy. Meanwhile, the personal saving rate dropped from 5.2% to 1.4%. Some components of spending grew remarkably fast: home furnishings and other household durables, recreational goods and vehicles, spending at restaurants, and health care. Overall consumer spending grew faster than the economy, and in some years it grew faster than real disposable income.
-decades. With new financial products like the home equity line of credit, households could borrow against their homes to compensate for investment losses or unemployment. Deflation, against which the Fed had struck preemptively, did not materialize.
+Nonetheless, the economy looked stable. By 2003, it had weathered the brief recession of 2001 and the dot-com bust, which had caused the largest loss of wealth in ecades. With new financial products like the home equity line of credit, households could borrow against their homes to compensate for investment losses or unemployment. Deflation, against which the Fed had struck preemptively, did not materialize.
-At a congressional hearing in November 2002, Greenspan acknowledged—at least implicitly—that after the dot-com bubble burst, the Fed cut interest rates in part to promote housing. Greenspan argued that the Fed’s low-interest-rate policy had stimulated the economy by encouraging home sales and housing starts with “mortgage interest rates that are at lows not seen in decades.” As Greenspan explained, “Mortgage markets have also been a powerful stabilizing force over the past two years of economic distress by facilitating the extraction of some of the equity that home -
+At a congressional hearing in November 2002, Greenspan acknowledged—at least implicitly—that after the dot-com bubble burst, the Fed cut interest rates in part to promote housing. Greenspan argued that the Fed’s low-interest-rate policy had stimulated the economy by encouraging home sales and housing starts with "mortgage interest rates that are at lows not seen in decades." As Greenspan explained, "Mortgage markets have also been a powerful stabilizing force over the past two years of economic distress by facilitating the extraction of some of the equity that home -
-owners had built up.”17 In February 2004, he reiterated his point, referring to “a large extraction of cash from home equity.”18
+owners had built up."17 In February 2004, he reiterated his point, referring to "a large extraction of cash from home equity."18
-SUBPRIME LOANS: “BUYERS WILL PAY A HIGH PREMIUM”
+SUBPRIME LOANS: "BUYERS WILL PAY A HIGH PREMIUM"
-The subprime market roared back from its shakeout in the late 1990s. The value of subprime loans originated almost doubled from 2001 through 200\f646, to \f653\f64610 billion.
+The subprime market roared back from its shakeout in the late 1990s. The value of subprime loans originated almost doubled from 2001 through 2003, to $310 billion.
-In 2000, 52\f642 of these were securitized; in 200\f646, 6\f646\f642.19 Low interest rates spurred this boom, which would have long-term repercussions, but so did increasingly widespread computerized credit scores, the growing statistical history on subprime borrowers, and the scale of the firms entering the market.
+In 2000, 52% of these were securitized; in 2003, 63%.19 Low interest rates spurred this boom, which would have long-term repercussions, but so did increasingly widespread computerized credit scores, the growing statistical history on subprime borrowers, and the scale of the firms entering the market.
-Subprime was dominated by a narrowing field of ever-larger firms; the marginal players from the past decade had merged or vanished. By 200\f646, the top 25 subprime lenders made 9\f646\f642 of all subprime loans, up from 47\f642 in 1996.20
+Subprime was dominated by a narrowing field of ever-larger firms; the marginal players from the past decade had merged or vanished. By 2003, the top 25 subprime lenders made 93% of all subprime loans, up from 47% in 1996.20
There were now three main kinds of companies in the subprime origination and securitization business: commercial banks and thrifts, Wall Street investment banks, and independent mortgage lenders. Some of the biggest banks and thrifts—Citigroup, National City Bank, HSBC, and Washington Mutual—spent billions on boosting subprime lending by creating new units, acquiring firms, or offering financing to other mortgage originators. Almost always, these operations were sequestered in nonbank subsidiaries, leaving them in a regulatory no-man’s-land.
-CREDIT EXPANSION 89
+New Century and Ameriquest were especially aggressive. New Century’s "Focus
-New Century and Ameriquest were especially aggressive. New Century’s “Focus
+2000" plan concentrated on "originating loans with characteristics for which whole loan buyers will pay a high premium."23 Those "whole loan buyers" were the firms on Wall Street that purchased loans and, most often, bundled them into mortgage-backed securities. They were eager customers. In 2003, New Century sold $20.8 billion in whole loans, up from $3.1 billion three years before,24 launching the firm from tenth to second place among subprime originators. Three-quarters went to two securitizing firms—Morgan Stanley and Credit Suisse—but New Century reassured its investors that there were "many more prospective buyers."25
-2000” plan concentrated on “originating loans with characteristics for which whole loan buyers will pay a high premium.”2\f646 Those “whole loan buyers” were the firms on Wall Street that purchased loans and, most often, bundled them into mortgage-backed securities. They were eager customers. In 200\f646, New Century sold \f65320.8 billion in whole loans, up from \f653\f646.1 billion three years before,24 launching the firm from tenth to second place among subprime originators. Three-quarters went to two securitizing firms—Morgan Stanley and Credit Suisse—but New Century reassured its investors that there were “many more prospective buyers.”25
+Ameriquest, in particular, pursued volume. According to the company’s public statements, it paid its account executives less per mortgage than the competition, but it encouraged them to make up the difference by underwriting more loans. "Our people make more volume per employee than the rest of the industry," Aseem Mital, CEO of Ameriquest, said in 2005. The company cut costs elsewhere in the origination process, too. The back office for the firm’s retail division operated in assembly-line fashion, Mital told a reporter for American Banker; the work was divided into specialized tasks, including data entry, underwriting, customer service, account management, and funding. Ameriquest used its savings to undercut by as much as
-Ameriquest, in particular, pursued volume. According to the company’s public statements, it paid its account executives less per mortgage than the competition, but it encouraged them to make up the difference by underwriting more loans. “Our people make more volume per employee than the rest of the industry,” Aseem Mital, CEO of Ameriquest, said in 2005. The company cut costs elsewhere in the origination process, too. The back office for the firm’s retail division operated in assembly-line fashion, Mital told a reporter for American Banker; the work was divided into specialized tasks, including data entry, underwriting, customer service, account management, and funding. Ameriquest used its savings to undercut by as much as
+0.55% what competing originators charged securitizing firms, according to an industry analyst’s estimate. Between 2000 and 2003, Ameriquest loan origination rose from an estimated $4 billion to $39 billion annually. That vaulted the firm from eleventh to first place among subprime originators. "They are clearly the aggressor," Countrywide CEO Angelo Mozilo told his investors in 2005.26 By 2005, Countrywide was third on the list.
-0.55\f642 what competing originators charged securitizing firms, according to an industry analyst’s estimate. Between 2000 and 200\f646, Ameriquest loan origination rose from an estimated \f6534 billion to \f653\f6469 billion annually. That vaulted the firm from eleventh to first place among subprime originators. “They are clearly the aggressor,” Countrywide CEO Angelo Mozilo told his investors in 2005.26 By 2005, Countrywide was third on the list.
-
-The subprime players followed diverse strategies. Lehman and Countrywide pursued a “vertically integrated” model, involving them in every link of the mortgage chain: originating and funding the loans, packaging them into securities, and finally selling the securities to investors. Others concentrated on niches: New Century, for example, mainly originated mortgages for immediate sale to other firms in the chain.
+The subprime players followed diverse strategies. Lehman and Countrywide pursued a "vertically integrated" model, involving them in every link of the mortgage chain: originating and funding the loans, packaging them into securities, and finally selling the securities to investors. Others concentrated on niches: New Century, for example, mainly originated mortgages for immediate sale to other firms in the chain.
When originators made loans to hold through maturity—an approach known as originate-to-hold—they had a clear incentive to underwrite carefully and consider the risks. However, when they originated mortgages to sell, for securitization or otherwise—known as originate-to-distribute—they no longer risked losses if the loan defaulted. As long as they made accurate representations and warranties, the only risk was to their reputations if a lot of their loans went bad—but during the boom, loans were not going bad. In total, this originate-to-distribute pipeline carried more than half of all mortgages before the crisis, and a much larger piece of subprime mortgages.
For decades, a version of the originate-to-distribute model produced safe mortgages. Fannie and Freddie had been buying prime, conforming mortgages since the
-1970s, protected by strict underwriting standards. But some saw that the model now had problems. “If you look at how many people are playing, from the real estate agent all the way through to the guy who is issuing the security and the underwriter and the underwriting group and blah, blah, blah, then nobody in this entire chain is responsible to anybody,” Lewis Ranieri, an early leader in securitization, told the FCIC,
-
-
-
-90
-
-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
-
-not the outcome he and other investment bankers had expected. “None of us wrote and said, ‘Oh, by the way, you have to be responsible for your actions,’” Ranieri said.
+1970s, protected by strict underwriting standards. But some saw that the model now had problems. "If you look at how many people are playing, from the real estate agent all the way through to the guy who is issuing the security and the underwriter and the underwriting group and blah, blah, blah, then nobody in this entire chain is responsible to anybody," Lewis Ranieri, an early leader in securitization, told the FCIC, ot the outcome he and other investment bankers had expected. "None of us wrote and said, ‘Oh, by the way, you have to be responsible for your actions,’" Ranieri said.
-“It was pretty self-evident.”27
+"It was pretty self-evident."27
The starting point for many mortgages was a mortgage broker. These independent brokers, with access to a variety of lenders, worked with borrowers to complete the application process. Using brokers allowed more rapid expansion, with no need to build branches; lowered costs, with no need for full-time salespeople; and extended geographic reach.
-For brokers, compensation generally came as up-front fees—from the borrower, from the lender, or both—so the loan’s performance mattered little. These fees were often paid without the borrower’s knowledge. Indeed, many borrowers mistakenly believed the mortgage brokers acted in borrowers’ best interest.28 One common fee paid by the lender to the broker was the “yield spread premium”: on higher-interest loans, the lending bank would pay the broker a higher premium, giving the incentive to sign the borrower to the highest possible rate. “If the broker decides he’s going to try and make more money on the loan, then he’s going to raise the rate,” said Jay Jeffries, a former sales manager for Fremont Investment & Loan, to the Commission. “We’ve got a higher rate loan, we’re paying the broker for that yield spread premium.”29
-
-In theory, borrowers are the first defense against abusive lending. By shopping around, they should realize, for example, if a broker is trying to sell them a higher-priced loan or to place them in a subprime loan when they would qualify for a less-expensive prime loan. But many borrowers do not understand the most basic aspects of their mortgage. A study by two Federal Reserve economists estimated at least \f6468\f642
+For brokers, compensation generally came as up-front fees—from the borrower, from the lender, or both—so the loan’s performance mattered little. These fees were often paid without the borrower’s knowledge. Indeed, many borrowers mistakenly believed the mortgage brokers acted in borrowers’ best interest.28 One common fee paid by the lender to the broker was the "yield spread premium": on higher-interest loans, the lending bank would pay the broker a higher premium, giving the incentive to sign the borrower to the highest possible rate. "If the broker decides he’s going to try and make more money on the loan, then he’s going to raise the rate," said Jay Jeffries, a former sales manager for Fremont Investment & Loan, to the Commission. "We’ve got a higher rate loan, we’re paying the broker for that yield spread premium."29
-of borrowers with adjustable-rate mortgages did not understand how much their interest rates could reset at one time, and more than half underestimated how high their rates could reach over the years.\f6460 The same lack of awareness extended to other terms of the loan—for example, the level of documentation provided to the lender.
+In theory, borrowers are the first defense against abusive lending. By shopping around, they should realize, for example, if a broker is trying to sell them a higher-priced loan or to place them in a subprime loan when they would qualify for a less-expensive prime loan. But many borrowers do not understand the most basic aspects of their mortgage. A study by two Federal Reserve economists estimated at least 38% of borrowers with adjustable-rate mortgages did not understand how much their interest rates could reset at one time, and more than half underestimated how high their rates could reach over the years.30 The same lack of awareness extended to other terms of the loan—for example, the level of documentation provided to the lender.
-“Most borrowers didn’t even realize that they were getting a no-doc loan,” said Michael Calhoun, president of the Center for Responsible Lending. “They’d come in with their W-2 and end up with a no-doc loan simply because the broker was getting paid more and the lender was getting paid more and there was extra yield left over for Wall Street because the loan carried a higher interest rate.”\f6461
+"Most borrowers didn’t even realize that they were getting a no-doc loan," said Michael Calhoun, president of the Center for Responsible Lending. "They’d come in with their W-2 and end up with a no-doc loan simply because the broker was getting paid more and the lender was getting paid more and there was extra yield left over for Wall Street because the loan carried a higher interest rate."31
-And borrowers with less access to credit are particularly ill equipped to challenge the more experienced person across the desk. “While many [consumers] believe they are pretty good at dealing with day-to-day financial matters, in actuality they engage in financial behaviors that generate expenses and fees: overdrawing checking accounts, making late credit card payments, or exceeding limits on credit card charges,” Annamaria Lusardi, a professor of economics at Dartmouth College, told the FCIC.
+And borrowers with less access to credit are particularly ill equipped to challenge the more experienced person across the desk. "While many [consumers] believe they are pretty good at dealing with day-to-day financial matters, in actuality they engage in financial behaviors that generate expenses and fees: overdrawing checking accounts, making late credit card payments, or exceeding limits on credit card charges," Annamaria Lusardi, a professor of economics at Dartmouth College, told the FCIC.
-“Comparing terms of financial contracts and shopping around before making financial decisions are not at all common among the population.”\f6462
+"Comparing terms of financial contracts and shopping around before making financial decisions are not at all common among the population."32
Recall our case study securitization deal discussed earlier—in which New Century sold 4,499 mortgages to Citigroup, which then sold them to the securitization trust, which then bundled them into 19 tranches for sale to investors. Out of those
-4,499 mortgages, brokers originated \f646,466 on behalf of New Century. For each, the CREDIT EXPANSION 91
-
-brokers received an average fee from the borrowers of \f653\f646,756, or 1.81\f642 of the loan amount. On top of that, the brokers also received yield spread premiums from New Century for 1,744 of these loans, averaging \f6532,585 each. In total, the brokers received more than \f65317.5 million in fees for the \f646,466 loans.\f646\f646
-
-Critics argued that with this much money at stake, mortgage brokers had every incentive to seek “the highest combination of fees and mortgage interest rates the market will bear.”\f6464 Herb Sandler, the founder and CEO of the thrift Golden West Financial Corporation, told the FCIC that brokers were the “whores of the world.”\f6465 As the housing and mortgage market boomed, so did the brokers. Wholesale Access, which tracks the mortgage industry, reported that from 2000 to 200\f646, the number of brokerage firms rose from about \f6460,000 to 50,000. In 2000, brokers originated 55\f642 of loans; in
+4,499 mortgages, brokers originated 3,466 on behalf of New Century. For each, the brokers received an average fee from the borrowers of $3,756, or 1.81% of the loan amount. On top of that, the brokers also received yield spread premiums from New Century for 1,744 of these loans, averaging $2,585 each. In total, the brokers received more than $17.5 million in fees for the 3,466 loans.33
-200\f646, they peaked at 68\f642.\f6466 JP Morgan CEO Jamie Dimon testified to the FCIC that his firm eventually ended its broker-originated business in 2009 after discovering the loans had more than twice the losses of the loans that JP Morgan itself originated.\f6467
+Critics argued that with this much money at stake, mortgage brokers had every incentive to seek "the highest combination of fees and mortgage interest rates the market will bear."34 Herb Sandler, the founder and CEO of the thrift Golden West Financial Corporation, told the FCIC that brokers were the "whores of the world."35 As the housing and mortgage market boomed, so did the brokers. Wholesale Access, which tracks the mortgage industry, reported that from 2000 to 2003, the number of brokerage firms rose from about 30,000 to 50,000. In 2000, brokers originated 55% of loans; in
-As the housing market expanded, another problem emerged, in subprime and prime mortgages alike: inflated appraisals. For the lender, inflated appraisals meant greater losses if a borrower defaulted. But for the borrower or for the broker or loan officer who hired the appraiser, an inflated value could make the difference between closing and losing the deal. Imagine a home selling for \f653200,000 that an appraiser says is actually worth only \f653175,000. In this case, a bank won’t lend a borrower, say,
+2003, they peaked at 68%.36 JP Morgan CEO Jamie Dimon testified to the FCIC that his firm eventually ended its broker-originated business in 2009 after discovering the loans had more than twice the losses of the loans that JP Morgan itself originated.37
-\f653180,000 to buy the home. The deal dies. Sure enough, appraisers began feeling pressure. One 200\f646 survey found that 55\f642 of the appraisers had felt pressed to inflate the value of homes; by 2006, this had climbed to 90\f642. The pressure came most frequently from the mortgage brokers, but appraisers reported it from real estate agents, lenders, and in many cases borrowers themselves. Most often, refusal to raise the appraisal meant losing the client.\f6468 Dennis J. Black, president of the Florida appraisal and brokerage services firm D. J. Black & Co. and an appraiser with 24 years’ experience, held continuing education sessions all over the country for the National Association of Independent Fee Appraisers. He heard complaints from the appraisers that they had been pressured to ignore missing kitchens, damaged walls, and inoperable mechanical systems. Black told the FCIC, “The story I have heard most often is the client saying he could not use the appraisal because the value was [not] what they needed.”\f6469 The client would hire somebody else.
+As the housing market expanded, another problem emerged, in subprime and prime mortgages alike: inflated appraisals. For the lender, inflated appraisals meant greater losses if a borrower defaulted. But for the borrower or for the broker or loan officer who hired the appraiser, an inflated value could make the difference between closing and losing the deal. Imagine a home selling for $200,000 that an appraiser says is actually worth only $175,000. In this case, a bank won’t lend a borrower, say,
-Changes in regulations reinforced the trend toward laxer appraisal standards, as Karen Mann, a Sacramento appraiser with \f6460 years’ experience, explained in testimony to the FCIC. In 1994, the Federal Reserve, Office of the Comptroller of the Currency, Office of Thrift Supervision, and Federal Deposit Insurance Corporation loosened the appraisal requirements for the lenders they regulated by raising from
+$180,000 to buy the home. The deal dies. Sure enough, appraisers began feeling pressure. One 2003 survey found that 55% of the appraisers had felt pressed to inflate the value of homes; by 2006, this had climbed to 90%. The pressure came most frequently from the mortgage brokers, but appraisers reported it from real estate agents, lenders, and in many cases borrowers themselves. Most often, refusal to raise the appraisal meant losing the client.38 Dennis J. Black, president of the Florida appraisal and brokerage services firm D. J. Black & Co. and an appraiser with 24 years’ experience, held continuing education sessions all over the country for the National Association of Independent Fee Appraisers. He heard complaints from the appraisers that they had been pressured to ignore missing kitchens, damaged walls, and inoperable mechanical systems. Black told the FCIC, "The story I have heard most often is the client saying he could not use the appraisal because the value was [not] what they needed."39 The client would hire somebody else.
-\f653100,000 to \f653250,000 the minimum home value at which an appraisal from a licensed professional was required. In addition, Mann cited the lack of oversight of appraisers, noting, “We had a vast increase of licensed appraisers in [California] in spite of the lack of qualified/experienced trainers.”40 The Bakersfield appraiser Gary Crabtree told the FCIC that California’s Office of Real Estate Appraisers had eight investigators to supervise 21,000 appraisers.41
+Changes in regulations reinforced the trend toward laxer appraisal standards, as Karen Mann, a Sacramento appraiser with 30 years’ experience, explained in testimony to the FCIC. In 1994, the Federal Reserve, Office of the Comptroller of the Currency, Office of Thrift Supervision, and Federal Deposit Insurance Corporation loosened the appraisal requirements for the lenders they regulated by raising from
+$100,000 to $250,000 the minimum home value at which an appraisal from a licensed professional was required. In addition, Mann cited the lack of oversight of appraisers, noting, "We had a vast increase of licensed appraisers in [California] in spite of the lack of qualified/experienced trainers."40 The Bakersfield appraiser Gary Crabtree told the FCIC that California’s Office of Real Estate Appraisers had eight investigators to supervise 21,000 appraisers.41
-
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-
-In 2005, the four bank regulators issued new guidance to strengthen appraisals.
+n 2005, the four bank regulators issued new guidance to strengthen appraisals.
They recommended that an originator’s loan production staff not select appraisers.
-That led Washington Mutual to use an “appraisal management company,” First American Corporation, to choose appraisers. Nevertheless, in 2007 the New York State attorney general sued First American: relying on internal company documents, the complaint alleged the corporation improperly let Washington Mutual’s loan production staff “hand-pick appraisers who bring in appraisal values high enough to permit WaMu’s loans to close, and improperly permit[ted] WaMu to pressure . . .
+That led Washington Mutual to use an "appraisal management company," First American Corporation, to choose appraisers. Nevertheless, in 2007 the New York State attorney general sued First American: relying on internal company documents, the complaint alleged the corporation improperly let Washington Mutual’s loan production staff "hand-pick appraisers who bring in appraisal values high enough to permit WaMu’s loans to close, and improperly permit[ted] WaMu to pressure . . .
-appraisers to change appraisal values that are too low to permit loans to close.”42
+appraisers to change appraisal values that are too low to permit loans to close."42
-CITIGROUP: “INVITED REGULATORY SCRUTINY”
+CITIGROUP: "INVITED REGULATORY SCRUTINY"
-As subprime originations grew, Citigroup decided to expand, with troubling consequences. Barely a year after the Gramm-Leach-Bliley Act validated its 1998 merger with Travelers, Citigroup made its next big move. In September 2000, it paid \f653\f6461 billion for Associates First, then the second-largest subprime lender in the country (after Household Finance.). Such a merger would usually have required approval from the Federal Reserve and the other bank regulators, because Associates First owned three small banks (in Utah, Delaware, and South Dakota). But because these banks were specialized, a provision tucked away in Gramm-Leach-Bliley kept the Fed out of the mix. The OCC, FDIC, and New York State banking regulators reviewed the deal.
+As subprime originations grew, Citigroup decided to expand, with troubling consequences. Barely a year after the Gramm-Leach-Bliley Act validated its 1998 merger with Travelers, Citigroup made its next big move. In September 2000, it paid $31 billion for Associates First, then the second-largest subprime lender in the country (after Household Finance.). Such a merger would usually have required approval from the Federal Reserve and the other bank regulators, because Associates First owned three small banks (in Utah, Delaware, and South Dakota). But because these banks were specialized, a provision tucked away in Gramm-Leach-Bliley kept the Fed out of the mix. The OCC, FDIC, and New York State banking regulators reviewed the deal.
-Consumer groups fought it, citing a long record of alleged lending abuses by Associates First, including high prepayment penalties, excessive fees, and other opaque charges in loan documents—all targeting unsophisticated borrowers who typically could not evaluate the forms. “It’s simply unacceptable to have the largest bank in America take over the icon of predatory lending,” said Martin Eakes, founder of a nonprofit community lender in North Carolina.4\f646
+Consumer groups fought it, citing a long record of alleged lending abuses by Associates First, including high prepayment penalties, excessive fees, and other opaque charges in loan documents—all targeting unsophisticated borrowers who typically could not evaluate the forms. "It’s simply unacceptable to have the largest bank in America take over the icon of predatory lending," said Martin Eakes, founder of a nonprofit community lender in North Carolina.43
-Advocates for the merger argued that a large bank under a rigorous regulator could reform the company, and Citigroup promised to take strong actions. Regulators approved the merger in November 2000, and by the next summer Citigroup had started suspending mortgage purchases from close to two-thirds of the brokers and half the banks that had sold loans to Associates First. “We were aware that brokers were at the heart of that public discussion and were at the heart of a lot of the [controversial] cases,” said Pam Flaherty, a Citigroup senior vice president for community relations and outreach.44
+Advocates for the merger argued that a large bank under a rigorous regulator could reform the company, and Citigroup promised to take strong actions. Regulators approved the merger in November 2000, and by the next summer Citigroup had started suspending mortgage purchases from close to two-thirds of the brokers and half the banks that had sold loans to Associates First. "We were aware that brokers were at the heart of that public discussion and were at the heart of a lot of the [controversial] cases," said Pam Flaherty, a Citigroup senior vice president for community relations and outreach.44
-The merger exposed Citigroup to enhanced regulatory scrutiny. In 2001, the Federal Trade Commission, which regulates independent mortgage companies’ compliance with consumer protection laws, launched an investigation into Associates First’s premerger business and found that the company had pressured borrowers to refinance into expensive mortgages and to buy expensive mortgage insurance. In 2002, Citigroup reached a record \f653215 million civil settlement with the FTC over Associates’ “systematic and widespread deceptive and abusive lending practices.”45
+The merger exposed Citigroup to enhanced regulatory scrutiny. In 2001, the Federal Trade Commission, which regulates independent mortgage companies’ compliance with consumer protection laws, launched an investigation into Associates First’s premerger business and found that the company had pressured borrowers to refinance into expensive mortgages and to buy expensive mortgage insurance. In 2002, Citigroup reached a record $215 million civil settlement with the FTC over Associates’ "systematic and widespread deceptive and abusive lending practices."45
-In 2001, the New York Fed used the occasion of Citigroup’s next proposed acquisition—European American Bank on Long Island, New York—to launch its own in-CREDIT EXPANSION 9\f646
+In 2001, the New York Fed used the occasion of Citigroup’s next proposed acquisition—European American Bank on Long Island, New York—to launch its own investigation of CitiFinancial, which now contained Associates First. "The manner in which [Citigroup] approached that transaction invited regulatory scrutiny," former Fed Governor Mark Olson told the FCIC. "They bought a passel of problems for themselves and it was at least a two-year [issue]."46 The Fed eventually accused Citi -
-vestigation of CitiFinancial, which now contained Associates First. “The manner in which [Citigroup] approached that transaction invited regulatory scrutiny,” former Fed Governor Mark Olson told the FCIC. “They bought a passel of problems for themselves and it was at least a two-year [issue].”46 The Fed eventually accused Citi -
-
-Financial of converting unsecured personal loans (usually for borrowers in financial trouble) into home equity loans without properly assessing the borrower’s ability to repay. Reviewing lending practices from 2000 and 2001, the Fed also accused the unit of selling credit insurance to borrowers without checking if they would qualify for a mortgage without it. For these violations and for impeding its investigation, the Fed in 2004 assessed \f65370 million in penalties. The company said it expected to pay another \f653\f6460 million in restitution to borrowers.47
+Financial of converting unsecured personal loans (usually for borrowers in financial trouble) into home equity loans without properly assessing the borrower’s ability to repay. Reviewing lending practices from 2000 and 2001, the Fed also accused the unit of selling credit insurance to borrowers without checking if they would qualify for a mortgage without it. For these violations and for impeding its investigation, the Fed in 2004 assessed $70 million in penalties. The company said it expected to pay another $30 million in restitution to borrowers.47
FEDERAL RULES:
-“INTENDED TO CURB UNFAIR OR ABUSIVE LENDING”
+"INTENDED TO CURB UNFAIR OR ABUSIVE LENDING"
-As Citigroup was buying Associates First in 2000, the Federal Reserve revisited the rules protecting borrowers from predatory conduct. It conducted its second round of hearings on the Home Ownership and Equity Protection Act (HOEPA), and subsequently the staff offered two reform proposals. The first would have effectively barred lenders from granting any mortgage—not just the limited set of high-cost loans defined by HOEPA—solely on the value of the collateral and without regard to the borrower’s ability to repay. For high-cost loans, the lender would have to verify and document the borrower’s income and debt; for other loans, the documentation standard was weaker, as the lender could rely on the borrower’s payment history and the like. The staff memo explained this would mainly “affect lenders who make no-documentation loans.” The second proposal addressed practices such as deceptive advertisements, misrepresenting loan terms, and having consumers sign blank documents—acts that involve fraud, deception, or misrepresentations.48
+As Citigroup was buying Associates First in 2000, the Federal Reserve revisited the rules protecting borrowers from predatory conduct. It conducted its second round of hearings on the Home Ownership and Equity Protection Act (HOEPA), and subsequently the staff offered two reform proposals. The first would have effectively barred lenders from granting any mortgage—not just the limited set of high-cost loans defined by HOEPA—solely on the value of the collateral and without regard to the borrower’s ability to repay. For high-cost loans, the lender would have to verify and document the borrower’s income and debt; for other loans, the documentation standard was weaker, as the lender could rely on the borrower’s payment history and the like. The staff memo explained this would mainly "affect lenders who make no-documentation loans." The second proposal addressed practices such as deceptive advertisements, misrepresenting loan terms, and having consumers sign blank documents—acts that involve fraud, deception, or misrepresentations.48
-Despite evidence of predatory tactics from their own hearings and from the recently released HUD-Treasury report, Fed officials remained divided on how aggressively to strengthen borrower protections. They grappled with the same trade-off that the HUD-Treasury report had recently noted. “We want to encourage the growth in the subprime lending market,” Fed Governor Edward Gramlich remarked at the Financial Services Roundtable in early 2004. “But we also don’t want to encourage the abuses; indeed, we want to do what we can to stop these abuses.”49 Fed General Counsel Scott Alvarez told the FCIC, “There was concern that if you put out a broad rule, you would stop things that were not unfair and deceptive because you were trying to get at the bad practices and you just couldn’t think of all of the details you would need. And if you did think of all of the details, you’d end up writing a rule that people could get around very easily.”50
+Despite evidence of predatory tactics from their own hearings and from the recently released HUD-Treasury report, Fed officials remained divided on how aggressively to strengthen borrower protections. They grappled with the same trade-off that the HUD-Treasury report had recently noted. "We want to encourage the growth in the subprime lending market," Fed Governor Edward Gramlich remarked at the Financial Services Roundtable in early 2004. "But we also don’t want to encourage the abuses; indeed, we want to do what we can to stop these abuses."49 Fed General Counsel Scott Alvarez told the FCIC, "There was concern that if you put out a broad rule, you would stop things that were not unfair and deceptive because you were trying to get at the bad practices and you just couldn’t think of all of the details you would need. And if you did think of all of the details, you’d end up writing a rule that people could get around very easily."50
Greenspan, too, later said that to prohibit certain products might be harmful.
-“These and other kinds of loan products, when made to borrowers meeting appropriate underwriting standards, should not necessarily be regarded as improper,” he said, “and on the contrary facilitated the national policy of making homeownership
-
-
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-more broadly available.”51 Instead, at least for certain violations of consumer protection laws, he suggested another approach: “If there is egregious fraud, if there is egregious practice, one doesn’t need supervision and regulation, what one needs is law enforcement.”52 But the Federal Reserve would not use the legal system to rein in predatory lenders. From 2000 to the end of Greenspan’s tenure in 2006, the Fed referred to the Justice Department only three institutions for fair lending violations related to mortgages: First American Bank, in Carpentersville, Illinois; Desert Community Bank, in Victorville, California; and the New York branch of Société Générale, a large French bank.
-
-Fed officials rejected the staff proposals. After some wrangling, in December 2001
-
-the Fed did modify HOEPA, but only at the margins. Explaining its actions, the board highlighted compromise: “The final rule is intended to curb unfair or abusive lending practices without unduly interfering with the flow of credit, creating unnecessary creditor burden, or narrowing consumers’ options in legitimate transactions.” The status quo would change little. Fed economists had estimated the percentage of subprime loans covered by HOEPA would increase from 9\f642 to as much as \f6468\f642 under the new regulations.5\f646 But lenders changed the terms of mortgages to avoid the new rules’ revised interest rate and fee triggers. By late 2005, it was clear that the new regulations would end up covering only about 1\f642 of subprime loans.54 Nevertheless, reflecting on the Federal Reserve’s efforts, Greenspan contended in an FCIC interview that the Fed had developed a set of rules that have held up to this day.55
+"These and other kinds of loan products, when made to borrowers meeting appropriate underwriting standards, should not necessarily be regarded as improper," he said, "and on the contrary facilitated the national policy of making homeownership ore broadly available."51 Instead, at least for certain violations of consumer protection laws, he suggested another approach: "If there is egregious fraud, if there is egregious practice, one doesn’t need supervision and regulation, what one needs is law enforcement."52 But the Federal Reserve would not use the legal system to rein in predatory lenders. From 2000 to the end of Greenspan’s tenure in 2006, the Fed referred to the Justice Department only three institutions for fair lending violations related to mortgages: First American Bank, in Carpentersville, Illinois; Desert Community Bank, in Victorville, California; and the New York branch of Société Générale, a large French bank.
-This was a missed opportunity, says FDIC Chairman Sheila Bair, who described the “one bullet” that might have prevented the financial crisis: “I absolutely would have been over at the Fed writing rules, prescribing mortgage lending standards across the board for everybody, bank and nonbank, that you cannot make a mortgage unless you have documented income that the borrower can repay the loan.”56
+Fed officials rejected the staff proposals. After some wrangling, in December 2001 the Fed did modify HOEPA, but only at the margins. Explaining its actions, the board highlighted compromise: "The final rule is intended to curb unfair or abusive lending practices without unduly interfering with the flow of credit, creating unnecessary creditor burden, or narrowing consumers’ options in legitimate transactions." The status quo would change little. Fed economists had estimated the percentage of subprime loans covered by HOEPA would increase from 9% to as much as 38% under the new regulations.53 But lenders changed the terms of mortgages to avoid the new rules’ revised interest rate and fee triggers. By late 2005, it was clear that the new regulations would end up covering only about 1% of subprime loans.54 Nevertheless, reflecting on the Federal Reserve’s efforts, Greenspan contended in an FCIC interview that the Fed had developed a set of rules that have held up to this day.55
-The Fed held back on enforcement and supervision, too. While discussing HOEPA rule changes in 2000, the staff of the Fed’s Division of Consumer and Community Affairs also proposed a pilot program to examine lending practices at bank holding companies’ nonbank subsidiaries,57 such as CitiFinancial and HSBC Finance, whose influence in the subprime market was growing. The nonbank subsidiaries were subject to enforcement actions by the Federal Trade Commission, while the banks and thrifts were overseen by their primary regulators. As the holding company regulator, the Fed had the authority to examine nonbank subsidiaries for “compliance with the [Bank Holding Company Act] or any other Federal law that the Board has specific jurisdiction to enforce”; however, the consumer protection laws did not explicitly give the Fed enforcement authority in this area.58
+This was a missed opportunity, says FDIC Chairman Sheila Bair, who described the "one bullet" that might have prevented the financial crisis: "I absolutely would have been over at the Fed writing rules, prescribing mortgage lending standards across the board for everybody, bank and nonbank, that you cannot make a mortgage unless you have documented income that the borrower can repay the loan."56
-The Fed resisted routine examinations of these companies, and despite the support of Fed Governor Gramlich, the initiative stalled. Sandra Braunstein, then a staff member in the Fed’s Consumer and Community Affairs Division and now its director, told the FCIC that Greenspan and other officials were concerned that routinely examining the nonbank subsidiaries could create an uneven playing field because the subsidiaries had to compete with the independent mortgage companies, over which CREDIT EXPANSION 95
+The Fed held back on enforcement and supervision, too. While discussing HOEPA rule changes in 2000, the staff of the Fed’s Division of Consumer and Community Affairs also proposed a pilot program to examine lending practices at bank holding companies’ nonbank subsidiaries,57 such as CitiFinancial and HSBC Finance, whose influence in the subprime market was growing. The nonbank subsidiaries were subject to enforcement actions by the Federal Trade Commission, while the banks and thrifts were overseen by their primary regulators. As the holding company regulator, the Fed had the authority to examine nonbank subsidiaries for "compliance with the [Bank Holding Company Act] or any other Federal law that the Board has specific jurisdiction to enforce"; however, the consumer protection laws did not explicitly give the Fed enforcement authority in this area.58
-the Fed had no supervisory authority (although the Fed’s HOEPA rules applied to all lenders).59 In an interview with the FCIC, Greenspan went further, arguing that with or without a mandate, the Fed lacked sufficient resources to examine the nonbank subsidiaries. Worse, the former chairman said, inadequate regulation sends a misleading message to the firms and the market; if you examine an organization incompletely, it tends to put a sign in their window that it was examined by the Fed, and partial supervision is dangerous because it creates a Good Housekeeping stamp.60
+The Fed resisted routine examinations of these companies, and despite the support of Fed Governor Gramlich, the initiative stalled. Sandra Braunstein, then a staff member in the Fed’s Consumer and Community Affairs Division and now its director, told the FCIC that Greenspan and other officials were concerned that routinely examining the nonbank subsidiaries could create an uneven playing field because the subsidiaries had to compete with the independent mortgage companies, over which the Fed had no supervisory authority (although the Fed’s HOEPA rules applied to all lenders).59 In an interview with the FCIC, Greenspan went further, arguing that with or without a mandate, the Fed lacked sufficient resources to examine the nonbank subsidiaries. Worse, the former chairman said, inadequate regulation sends a misleading message to the firms and the market; if you examine an organization incompletely, it tends to put a sign in their window that it was examined by the Fed, and partial supervision is dangerous because it creates a Good Housekeeping stamp.60
But if resources were the issue, the Fed chairman could have argued for more. The Fed draws income from interest on the Treasury bonds it owns, so it did not have to ask Congress for appropriations. It was always mindful, however, that it could be subject to a government audit of its finances.
In the same FCIC interview, Greenspan recalled that he sat in countless meetings on consumer protection, but that he couldn’t pretend to have the kind of expertise on this subject that the staff had.61
-Gramlich, who chaired the Fed’s consumer subcommittee, favored tighter supervision of all subprime lenders—including units of banks, thrifts, bank holding companies, and state-chartered mortgage companies. He acknowledged that because such oversight would extend Fed authority to firms (such as independent mortgage companies) whose lending practices were not subject to routine supervision, the change would require congressional legislation “and might antagonize the states.” But without such oversight, the mortgage business was “like a city with a murder law, but no cops on the beat.”62 In an interview in 2007, Gramlich told the Wall Street Journal that he privately urged Greenspan to clamp down on predatory lending. Greenspan demurred and, lacking support on the board, Gramlich backed away. Gramlich told the Journal, “He was opposed to it, so I did not really pursue it.”6\f646 (Gramlich died in
+Gramlich, who chaired the Fed’s consumer subcommittee, favored tighter supervision of all subprime lenders—including units of banks, thrifts, bank holding companies, and state-chartered mortgage companies. He acknowledged that because such oversight would extend Fed authority to firms (such as independent mortgage companies) whose lending practices were not subject to routine supervision, the change would require congressional legislation "and might antagonize the states." But without such oversight, the mortgage business was "like a city with a murder law, but no cops on the beat."62 In an interview in 2007, Gramlich told the Wall Street Journal that he privately urged Greenspan to clamp down on predatory lending. Greenspan demurred and, lacking support on the board, Gramlich backed away. Gramlich told the Journal, "He was opposed to it, so I did not really pursue it."63 (Gramlich died in
2008 of leukemia, at age 68.)
-The Fed’s failure to stop predatory practices infuriated consumer advocates and some members of Congress. Critics charged that accounts of abuses were brushed off as anecdotal. Patricia McCoy, a law professor at the University of Connecticut who served on the Fed’s Consumer Advisory Council between 2002 and 2004, was familiar with the Fed’s reaction to stories of individual consumers. “That is classic Fed mindset,” said McCoy. “If you cannot prove that it is a broad-based problem that threatens systemic consequences, then you will be dismissed.” It frustrated Margot Saunders of the National Consumer Law Center: “I stood up at a Fed meeting in 2005
+The Fed’s failure to stop predatory practices infuriated consumer advocates and some members of Congress. Critics charged that accounts of abuses were brushed off as anecdotal. Patricia McCoy, a law professor at the University of Connecticut who served on the Fed’s Consumer Advisory Council between 2002 and 2004, was familiar with the Fed’s reaction to stories of individual consumers. "That is classic Fed mindset," said McCoy. "If you cannot prove that it is a broad-based problem that threatens systemic consequences, then you will be dismissed." It frustrated Margot Saunders of the National Consumer Law Center: "I stood up at a Fed meeting in 2005 and said, ‘How many anecdotes makes it real1 . . . How many tens [of] thousands of anecdotes will it take to convince you that this is a trend1’"64
-and said, ‘How many anecdotes makes it real1 . . . How many tens [of] thousands of anecdotes will it take to convince you that this is a trend1’”64
+The Fed’s reluctance to take action trumped the 2000 HUD-Treasury report and reports issued by the General Accounting Office in 1999 and 2004.65 The Fed did not begin routinely examining subprime subsidiaries until a pilot program in July 2007, under new chairman Ben Bernanke.66 The Fed did not issue new rules under HOEPA until July 2008, a year after the subprime market had shut down. These rules banned deceptive practices in a much broader category of "higher-priced mortgage loans"; moreover, they prohibited making those loans without regard to the borrower’s ability o pay, and required companies to verify income and assets.67 The rules would not take effect until October 1, 2009, which was too little, too late.
-The Fed’s reluctance to take action trumped the 2000 HUD-Treasury report and reports issued by the General Accounting Office in 1999 and 2004.65 The Fed did not begin routinely examining subprime subsidiaries until a pilot program in July 2007, under new chairman Ben Bernanke.66 The Fed did not issue new rules under HOEPA until July 2008, a year after the subprime market had shut down. These rules banned deceptive practices in a much broader category of “higher-priced mortgage loans”; moreover, they prohibited making those loans without regard to the borrower’s ability
+Looking back, Fed General Counsel Alvarez said his institution succumbed to the climate of the times. He told the FCIC, "The mind-set was that there should be no regulation; the market should take care of policing, unless there already is an identified problem. . . . We were in the reactive mode because that’s what the mind-set was of the ‘90s and the early 2000s." The strong housing market also reassured people. Alvarez noted the long history of low mortgage default rates and the desire to help people who traditionally had few dealings with banks become homeowners.68
+STATES: "LONG\f6baSTANDING POSITION"
+As the Fed balked, many states proceeded on their own, enacting "mini-HOEPA" laws and undertaking vigorous enforcement. They would face opposition from two federal regulators, the OCC and the OTS.
-96
+In 1999, North Carolina led the way, establishing a fee trigger of 5%: that is, for the most part any mortgage with points and fees at origination of more than 5% of the loan qualified as "high-cost mortgage" subject to state regulations. This was considerably lower than the 8% set by the Fed’s 2001 HOEPA regulations. Other provisions addressed an even broader class of loans, banning prepayment penalties for mortgage loans under $150,000 and prohibiting repeated refinancing, known as loan
-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+"flipping."69
-to pay, and required companies to verify income and assets.67 The rules would not take effect until October 1, 2009, which was too little, too late.
+These rules did not apply to federally chartered thrifts. In 1996, the Office of Thrift Supervision reasserted its "long-standing position" that its regulations "occupy the entire field of lending regulation for federal savings associations, leaving no room for state regulation." Exempting states from "a hodgepodge of conflicting and over-lapping state lending requirements," the OTS said, would let thrifts deliver "low-cost credit to the public free from undue regulatory duplication and burden." Meanwhile,
-Looking back, Fed General Counsel Alvarez said his institution succumbed to the climate of the times. He told the FCIC, “The mind-set was that there should be no regulation; the market should take care of policing, unless there already is an identified problem. . . . We were in the reactive mode because that’s what the mind-set was of the ‘90s and the early 2000s.” The strong housing market also reassured people. Alvarez noted the long history of low mortgage default rates and the desire to help people who traditionally had few dealings with banks become homeowners.68
+"the elaborate network of federal borrower-protection statutes" would protect consumers.70
-STATES: “LONG\f6baSTANDING POSITION”
+Nevertheless, other states copied North Carolina’s tactic. State attorneys general launched thousands of enforcement actions, including more than 3,000 in 2006 alone.71 By 2007, 29 states and the District of Columbia would pass some form of anti-predatory lending legislation. In some cases, two or more states teamed up to produce large settlements: in 2002, for example, a suit by Illinois, Massachusetts, and Minnesota recovered more than $50 million from First Alliance Mortgage Company, even though the firm had filed for bankruptcy. Also that year, Household Finance—
-As the Fed balked, many states proceeded on their own, enacting “mini-HOEPA” laws and undertaking vigorous enforcement. They would face opposition from two federal regulators, the OCC and the OTS.
+later acquired by HSBC—was ordered to pay $484 million in penalties and restitution to consumers. In 2006, a coalition of 49 states and the District of Columbia settled with Ameriquest for $325 million and required the company to follow restrictions on its lending practices.
-In 1999, North Carolina led the way, establishing a fee trigger of 5\f642: that is, for the most part any mortgage with points and fees at origination of more than 5\f642 of the loan qualified as “high-cost mortgage” subject to state regulations. This was considerably lower than the 8\f642 set by the Fed’s 2001 HOEPA regulations. Other provisions addressed an even broader class of loans, banning prepayment penalties for mortgage loans under \f653150,000 and prohibiting repeated refinancing, known as loan
-
-“flipping.”69
-
-These rules did not apply to federally chartered thrifts. In 1996, the Office of Thrift Supervision reasserted its “long-standing position” that its regulations “occupy the entire field of lending regulation for federal savings associations, leaving no room for state regulation.” Exempting states from “a hodgepodge of conflicting and over-lapping state lending requirements,” the OTS said, would let thrifts deliver “low-cost credit to the public free from undue regulatory duplication and burden.” Meanwhile,
-
-“the elaborate network of federal borrower-protection statutes” would protect consumers.70
-
-Nevertheless, other states copied North Carolina’s tactic. State attorneys general launched thousands of enforcement actions, including more than \f646,000 in 2006
-
-alone.71 By 2007, 29 states and the District of Columbia would pass some form of anti-predatory lending legislation. In some cases, two or more states teamed up to produce large settlements: in 2002, for example, a suit by Illinois, Massachusetts, and Minnesota recovered more than \f65350 million from First Alliance Mortgage Company, even though the firm had filed for bankruptcy. Also that year, Household Finance—
-
-later acquired by HSBC—was ordered to pay \f653484 million in penalties and restitution to consumers. In 2006, a coalition of 49 states and the District of Columbia settled with Ameriquest for \f653\f64625 million and required the company to follow restrictions on its lending practices.
-
-As we will see, however, these efforts would be severely hindered with respect to national banks when the OCC in 2004 officially joined the OTS in constraining states CREDIT EXPANSION 97
-
-from taking such actions. “The federal regulators’ refusal to reform [predatory] practices and products served as an implicit endorsement of their legality,” Illinois Attorney General Lisa Madigan testified to the Commission.72
+As we will see, however, these efforts would be severely hindered with respect to national banks when the OCC in 2004 officially joined the OTS in constraining states from taking such actions. "The federal regulators’ refusal to reform [predatory] practices and products served as an implicit endorsement of their legality," Illinois Attorney General Lisa Madigan testified to the Commission.72
COMMUNITY\f6baLENDING PLEDGES:
-“WHAT WE DO IS REAFFIRM OUR INTENTION”
+"WHAT WE DO IS REAFFIRM OUR INTENTION"
-While consumer groups unsuccessfully lobbied the Fed for more protection against predatory lenders, they also lobbied the banks to invest in and loan to low- and moderate-income communities. The resulting promises were sometimes called “CRA commitments” or “community development” commitments. These pledges were not required under law, including the Community Reinvestment Act of 1977; in fact, they were often outside the scope of the CRA. For example, they frequently involved lending to individuals whose incomes exceeded those covered by the CRA, lending in geographic areas not covered by the CRA, or lending to minorities, on which the CRA is silent. The banks would either sign agreements with community groups or else unilaterally pledge to lend to and invest in specific communities or populations.
+While consumer groups unsuccessfully lobbied the Fed for more protection against predatory lenders, they also lobbied the banks to invest in and loan to low- and moderate-income communities. The resulting promises were sometimes called "CRA commitments" or "community development" commitments. These pledges were not required under law, including the Community Reinvestment Act of 1977; in fact, they were often outside the scope of the CRA. For example, they frequently involved lending to individuals whose incomes exceeded those covered by the CRA, lending in geographic areas not covered by the CRA, or lending to minorities, on which the CRA is silent. The banks would either sign agreements with community groups or else unilaterally pledge to lend to and invest in specific communities or populations.
-Banks often made these commitments when courting public opinion during the merger mania at the turn of the 21st century. One of the most notable promises was made by Citigroup soon after its merger with Travelers in 1998: a \f653115 billion lending and investment commitment, some of which would include mortgages. Later, Citigroup made a \f653120 billion commitment when it acquired California Federal Bank in
+Banks often made these commitments when courting public opinion during the merger mania at the turn of the 21st century. One of the most notable promises was made by Citigroup soon after its merger with Travelers in 1998: a $115 billion lending and investment commitment, some of which would include mortgages. Later, Citigroup made a $120 billion commitment when it acquired California Federal Bank in
-2002. When merging with FleetBoston Financial Corporation in 2004, Bank of America announced its largest commitment to date: \f653750 billion over 10 years. Chase announced commitments of \f65318.1 billion and \f653800 billion, respectively, in its mergers with Chemical Bank and Bank One. The National Community Reinvestment Coalition, an advocacy group, eventually tallied more than \f6534.5 trillion in commitments from 1977 to 2007; mortgage lending made up a significant portion of them.7\f646
+2002. When merging with FleetBoston Financial Corporation in 2004, Bank of America announced its largest commitment to date: $750 billion over 10 years. Chase announced commitments of $18.1 billion and $800 billion, respectively, in its mergers with Chemical Bank and Bank One. The National Community Reinvestment Coalition, an advocacy group, eventually tallied more than $4.5 trillion in commitments from 1977 to 2007; mortgage lending made up a significant portion of them.73
Although banks touted these commitments in press releases, the NCRC says it and other community groups could not verify this lending happened.74 The FCIC
-sent a series of requests to Bank of America, JP Morgan, Citigroup, and Wells Fargo, the nation’s four largest banks, regarding their “CRA and community lending commitments.” In response, the banks indicated they had fulfilled most promises. According to the documents provided, the value of commitments to community groups was much smaller than the larger unilateral pledges by the banks. Further, the pledges generally covered broader categories than did the CRA, including mortgages to minority borrowers and to borrowers with up-to-median income. For example, only\f642 of the mortgages made under JP Morgan’s \f653800 billion “community development initiative” would have fallen under the CRA.75 Bank of America, which would count all low- and moderate-income and minority lending as satisfying its pledges, stated that just over half were likely to meet CRA requirements.
-
-Many of these loans were not very risky. This is not surprising, because such broad definitions necessarily included loans to borrowers with strong credit histories—low
-
+sent a series of requests to Bank of America, JP Morgan, Citigroup, and Wells Fargo, the nation’s four largest banks, regarding their "CRA and community lending commitments." In response, the banks indicated they had fulfilled most promises. According to the documents provided, the value of commitments to community groups was much smaller than the larger unilateral pledges by the banks. Further, the pledges generally covered broader categories than did the CRA, including mortgages to minority borrowers and to borrowers with up-to-median income. For example, only% of the mortgages made under JP Morgan’s $800 billion "community development initiative" would have fallen under the CRA.75 Bank of America, which would count all low- and moderate-income and minority lending as satisfying its pledges, stated that just over half were likely to meet CRA requirements.
-
-98
-
-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
-
-income and weak or subprime credit are not the same. In fact, Citigroup’s 2002 pledge of \f65380 billion in mortgage lending “consisted of entirely prime loans” to low- and moderate-income households, low- and moderate-income neighborhoods, and minority borrowers. These loans performed well.76 JP Morgan’s largest commitment to a community group was to the Chicago CRA Coalition: \f65312 billion in loans over 11
-
-years. Of loans issued between 2004 and 2006, fewer than 5\f642 have been 90-or-more-days delinquent, even as of late 2010.77 Wachovia made \f65312 billion in mortgage loans between 2004 and 2006 under its \f653100 billion in unilateral pledges: only about 7.\f646\f642
-
-were ever more than 90 days delinquent over the life of the loan, compared with an estimated national average of 14\f642.78 The better performance was partly the result of Wachovia’s lending concentration in the relatively stable Southeast, and partly a reflection of the credit profile of many of these borrowers.
+Many of these loans were not very risky. This is not surprising, because such broad definitions necessarily included loans to borrowers with strong credit histories—low ncome and weak or subprime credit are not the same. In fact, Citigroup’s 2002 pledge of $80 billion in mortgage lending "consisted of entirely prime loans" to low- and moderate-income households, low- and moderate-income neighborhoods, and minority borrowers. These loans performed well.76 JP Morgan’s largest commitment to a community group was to the Chicago CRA Coalition: $12 billion in loans over 11 years. Of loans issued between 2004 and 2006, fewer than 5% have been 90-or-more-days delinquent, even as of late 2010.77 Wachovia made $12 billion in mortgage loans between 2004 and 2006 under its $100 billion in unilateral pledges: only about 7.3% were ever more than 90 days delinquent over the life of the loan, compared with an estimated national average of 14%.78 The better performance was partly the result of Wachovia’s lending concentration in the relatively stable Southeast, and partly a reflection of the credit profile of many of these borrowers.
During the early years of the CRA, the Federal Reserve Board, when considering whether to approve mergers, gave some weight to commitments made to regulators.
-This changed in February 1989, when the board denied Continental Bank’s application to merge with Grand Canyon State Bank, saying the bank’s commitment to improve community service could not offset its poor lending record.79 In April 1989, the FDIC, OCC, and Federal Home Loan Bank Board (the precursor of the OTS) joined the Fed in announcing that commitments to regulators about lending would be considered only when addressing “specific problems in an otherwise satisfactory record.”80
-
-Internal documents, and its public statements, show the Fed never considered pledges to community groups in evaluating mergers and acquisitions, nor did it enforce them. As Glenn Loney, a former Fed official, told Commission staff, “At the very beginning, [we] said we’re not going to be in a posture where the Fed’s going to be sort of coercing banks into making deals with . . . community groups so that they can get their applications through.”81
+This changed in February 1989, when the board denied Continental Bank’s application to merge with Grand Canyon State Bank, saying the bank’s commitment to improve community service could not offset its poor lending record.79 In April 1989, the FDIC, OCC, and Federal Home Loan Bank Board (the precursor of the OTS) joined the Fed in announcing that commitments to regulators about lending would be considered only when addressing "specific problems in an otherwise satisfactory record."80
-In fact, the rules implementing the 1995 changes to the CRA made it clear that the Federal Reserve would not consider promises to third parties or enforce prior agreements with those parties. The rules state “an institution’s record of fulfilling these types of agreements [with third parties] is not an appropriate CRA performance criterion.”82 Still, the banks highlighted past acts and assurances for the future. In 1998, for example, when NationsBank said it was merging with BankAmerica, it also announced a 10-year, \f653\f64650 billion initiative that included pledges of \f653115 billion for affordable housing, \f653\f6460 billion for consumer lending, \f653180 billion for small businesses, and \f65325 and \f65310 billion for economic and community development, respectively.
+Internal documents, and its public statements, show the Fed never considered pledges to community groups in evaluating mergers and acquisitions, nor did it enforce them. As Glenn Loney, a former Fed official, told Commission staff, "At the very beginning, [we] said we’re not going to be in a posture where the Fed’s going to be sort of coercing banks into making deals with . . . community groups so that they can get their applications through."81
-This merger was perhaps the most controversial of its time because of the size of the two banks. The Fed held four public hearings and received more than 1,600 comments. Supporters touted the community investment commitment, while opponents decried its lack of specificity. The Fed’s internal staff memorandum recommending approval repeated the Fed’s insistence on not considering these promises: “The Board considers CRA agreements to be agreements between private parties and has not facilitated, monitored, judged, required, or enforced agreements or specific portions of agreements. . . . NationsBank remains obligated to meet the credit needs of its entire CREDIT EXPANSION 99
+In fact, the rules implementing the 1995 changes to the CRA made it clear that the Federal Reserve would not consider promises to third parties or enforce prior agreements with those parties. The rules state "an institution’s record of fulfilling these types of agreements [with third parties] is not an appropriate CRA performance criterion."82 Still, the banks highlighted past acts and assurances for the future. In 1998, for example, when NationsBank said it was merging with BankAmerica, it also announced a 10-year, $350 billion initiative that included pledges of $115 billion for affordable housing, $30 billion for consumer lending, $180 billion for small businesses, and $25 and $10 billion for economic and community development, respectively.
-community, including [low- and moderate-income] areas, with or without private agreements.”8\f646
+This merger was perhaps the most controversial of its time because of the size of the two banks. The Fed held four public hearings and received more than 1,600 comments. Supporters touted the community investment commitment, while opponents decried its lack of specificity. The Fed’s internal staff memorandum recommending approval repeated the Fed’s insistence on not considering these promises: "The Board considers CRA agreements to be agreements between private parties and has not facilitated, monitored, judged, required, or enforced agreements or specific portions of agreements. . . . NationsBank remains obligated to meet the credit needs of its entire community, including [low- and moderate-income] areas, with or without private agreements."83
-In its public order approving the merger, the Federal Reserve mentioned the commitment but then went on to state that “an applicant must demonstrate a satisfactory record of performance under the CRA without reliance on plans or commitments for future action. . . . The Board believes that the CRA plan—whether made as a plan or as an enforceable commitment—has no relevance in this case without the demonstrated record of performance of the companies involved.”84
+In its public order approving the merger, the Federal Reserve mentioned the commitment but then went on to state that "an applicant must demonstrate a satisfactory record of performance under the CRA without reliance on plans or commitments for future action. . . . The Board believes that the CRA plan—whether made as a plan or as an enforceable commitment—has no relevance in this case without the demonstrated record of performance of the companies involved."84
-So were these commitments a meaningful step, or only a gesture1 Lloyd Brown, a managing director at Citigroup, told the FCIC that most of the commitments would have been fulfilled in the normal course of business.85 Speaking of the 2007 merger with Countrywide, Andrew Plepler, head of Global Corporate Social Responsibility at Bank of America, told the FCIC: “At a time of mergers, there is a lot of concern, sometimes, that one plus one will not equal two in the eyes of communities where the acquired bank has been investing. . . . So, what we do is reaffirm our intention to continue to lend and invest so that the communities where we live and work will continue to economically thrive.” He explained further that the pledge amount was arrived at by working “closely with our business partners” who project current levels of business activity that qualifies toward community lending goals into the future to assure the community that past lending and investing practices will continue.86
+So were these commitments a meaningful step, or only a gesture1 Lloyd Brown, a managing director at Citigroup, told the FCIC that most of the commitments would have been fulfilled in the normal course of business.85 Speaking of the 2007 merger with Countrywide, Andrew Plepler, head of Global Corporate Social Responsibility at Bank of America, told the FCIC: "At a time of mergers, there is a lot of concern, sometimes, that one plus one will not equal two in the eyes of communities where the acquired bank has been investing. . . . So, what we do is reaffirm our intention to continue to lend and invest so that the communities where we live and work will continue to economically thrive." He explained further that the pledge amount was arrived at by working "closely with our business partners" who project current levels of business activity that qualifies toward community lending goals into the future to assure the community that past lending and investing practices will continue.86
In essence, banks promised to keep doing what they had been doing, and community groups had the assurance that they would.
-BANK CAPITAL STANDARDS: “ARBITRAGE”
+BANK CAPITAL STANDARDS: "ARBITRAGE"
Although the Federal Reserve had decided against stronger protections for consumers, it internalized the lessons of 1998 and 1999, when the first generation of subprime lenders put themselves at serious risk; some, such as Keystone Bank and Superior Bank, collapsed when the values of the subprime securitized assets they held proved to be inflated. In response, the Federal Reserve and other regulators re-worked the capital requirements on securitization by banks and thrifts.
-In October 2001, they introduced the “Recourse Rule” governing how much capital a bank needed to hold against securitized assets. If a bank retained an interest in a residual tranche of a mortgage security, as Keystone, Superior, and others had done, it would have to keep a dollar in capital for every dollar of residual interest. That seemed to make sense, since the bank, in this instance, would be the first to take losses on the loans in the pool. Under the old rules, banks held only 8\f642 in capital to protect against losses on residual interests and any other exposures they retained in securitizations; Keystone and others had been allowed to seriously understate their risks and to not hold sufficient capital. Ironically, because the new rule made the capital charge on residual interests 100\f642, it increased banks’ incentive to sell the residual interests in securitizations—so that they were no longer the first to lose when the loans went bad.
+In October 2001, they introduced the "Recourse Rule" governing how much capital a bank needed to hold against securitized assets. If a bank retained an interest in a residual tranche of a mortgage security, as Keystone, Superior, and others had done, it would have to keep a dollar in capital for every dollar of residual interest. That seemed to make sense, since the bank, in this instance, would be the first to take losses on the loans in the pool. Under the old rules, banks held only 8% in capital to protect against losses on residual interests and any other exposures they retained in securitizations; Keystone and others had been allowed to seriously understate their risks and to not hold sufficient capital. Ironically, because the new rule made the capital charge on residual interests 100%, it increased banks’ incentive to sell the residual interests in securitizations—so that they were no longer the first to lose when the loans went bad.
+he Recourse Rule also imposed a new framework for asset-backed securities.
-
-100
-
-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
-
-The Recourse Rule also imposed a new framework for asset-backed securities.
-
-The capital requirement would be directly linked to the rating agencies’ assessment of the tranches. Holding securities rated AAA or AA required far less capital than holding lower-rated investments. For example, \f653100 invested in AAA or AA mortgage-backed securities required holding only \f6531.60 in capital (the same as for securities backed by government-sponsored enterprises). But the same amount invested in anything with a BB rating required \f65316 in capital, or 10 times more.
+The capital requirement would be directly linked to the rating agencies’ assessment of the tranches. Holding securities rated AAA or AA required far less capital than holding lower-rated investments. For example, $100 invested in AAA or AA mortgage-backed securities required holding only $1.60 in capital (the same as for securities backed by government-sponsored enterprises). But the same amount invested in anything with a BB rating required $16 in capital, or 10 times more.
Banks could reduce the capital they were required to hold for a pool of mortgages simply by securitizing them, rather than holding them on their books as whole loans.
-If a bank kept \f653100 in mortgages on its books, it might have to set aside about \f6535, including \f6534 in capital against unexpected losses and \f6531 in reserves against expected losses. But if the bank created a \f653100 mortgage-backed security, sold that security in tranches, and then bought all the tranches, the capital requirement would be about
+If a bank kept $100 in mortgages on its books, it might have to set aside about $5, including $4 in capital against unexpected losses and $1 in reserves against expected losses. But if the bank created a $100 mortgage-backed security, sold that security in tranches, and then bought all the tranches, the capital requirement would be about
-\f6534.10.87 “Regulatory capital arbitrage does play a role in bank decision making,” said David Jones, a Fed economist who wrote an article about the subject in 2000, in an FCIC interview. But “it is not the only thing that matters.”88
+$4.10.87 "Regulatory capital arbitrage does play a role in bank decision making," said David Jones, a Fed economist who wrote an article about the subject in 2000, in an FCIC interview. But "it is not the only thing that matters."88
-And a final comparison: under bank regulatory capital standards, a \f653100 triple-A corporate bond required \f6538 in capital—five times as much as the triple-A mortgage-backed security. Unlike the corporate bond, it was ultimately backed by real estate.
+And a final comparison: under bank regulatory capital standards, a $100 triple-A corporate bond required $8 in capital—five times as much as the triple-A mortgage-backed security. Unlike the corporate bond, it was ultimately backed by real estate.
-The new requirements put the rating agencies in the driver’s seat. How much capital a bank held depended in part on the ratings of the securities it held. Tying capital standards to the views of rating agencies would come in for criticism after the crisis began. It was “a dangerous crutch,” former Treasury Secretary Henry Paulson testified to the Commission.89 However, the Fed’s Jones noted it was better than the alternative—“to let the banks rate their own exposures.” That alternative
+The new requirements put the rating agencies in the driver’s seat. How much capital a bank held depended in part on the ratings of the securities it held. Tying capital standards to the views of rating agencies would come in for criticism after the crisis began. It was "a dangerous crutch," former Treasury Secretary Henry Paulson testified to the Commission.89 However, the Fed’s Jones noted it was better than the alternative—"to let the banks rate their own exposures." That alternative
-“would be terrible,” he said, noting that banks had been coming to the Fed and arguing for lower capital requirements on the grounds that the rating agencies were too conservative.90
+"would be terrible," he said, noting that banks had been coming to the Fed and arguing for lower capital requirements on the grounds that the rating agencies were too conservative.90
Meanwhile, banks and regulators were not prepared for significant losses on triple-A mortgage-backed securities, which were, after all, supposed to be among the safest investments. Nor were they prepared for ratings downgrades due to expected losses, which would require banks to post more capital. And were downgrades to occur at the moment the banks wanted to sell their securities to raise capital, there would be no buyers. All these things would occur within a few years.
-CREDIT EXPANSION 101
-
-COMMISSION CONCLUSIONS ON CHAPTER 6
-
The Commission concludes that there was untrammeled growth in risky mortgages. Unsustainable, toxic loans polluted the financial system and fueled the housing bubble.
Subprime lending was supported in significant ways by major financial institutions. Some firms, such as Citigroup, Lehman Brothers, and Morgan Stanley, acquired subprime lenders. In addition, major financial institutions facilitated the growth in subprime mortgage–lending companies with lines of credit, securitization, purchase guarantees and other mechanisms.
CONTENTS
-Foreign investors: “An irresistible profit opportunity” .........................................10\f646
+Foreign investors: "An irresistible profit opportunity" .........................................103
-Mortgages: “A good loan” ...................................................................................104
+Mortgages: "A good loan" ...................................................................................104
-Federal regulators: “Immunity from many state laws is a significant benefit” ....111
+Federal regulators: "Immunity from many state laws is a significant benefit" ....111
-Mortgage securities players: “Wall Street was very hungry for our product” ......11\f646
+Mortgage securities players: "Wall Street was very hungry for our product" ......113
-Moody’s: “Given a blank check”..........................................................................118
+Moody’s: "Given a blank check"..........................................................................118
-Fannie Mae and Freddie Mac: “Less competitive in the marketplace”................122
+Fannie Mae and Freddie Mac: "Less competitive in the marketplace"................122
In 2004, commercial banks, thrifts, and investment banks caught up with Fannie Mae and Freddie Mac in securitizing home loans. By 2005, they had taken the lead.
-The two government-sponsored enterprises maintained their monopoly on securitizing prime mortgages below their loan limits, but the wave of home refinancing by prime borrowers spurred by very low, steady interest rates petered out. Meanwhile, Wall Street focused on the higher-yield loans that the GSEs could not purchase and securitize—loans too large, called jumbo loans, and nonprime loans that didn’t meet the GSEs’ standards. The nonprime loans soon became the biggest part of the market—“subprime” loans for borrowers with weak credit and “Alt-A” loans, with characteristics riskier than prime loans, to borrowers with strong credit.1
+The two government-sponsored enterprises maintained their monopoly on securitizing prime mortgages below their loan limits, but the wave of home refinancing by prime borrowers spurred by very low, steady interest rates petered out. Meanwhile, Wall Street focused on the higher-yield loans that the GSEs could not purchase and securitize—loans too large, called jumbo loans, and nonprime loans that didn’t meet the GSEs’ standards. The nonprime loans soon became the biggest part of the market—"subprime" loans for borrowers with weak credit and "Alt-A" loans, with characteristics riskier than prime loans, to borrowers with strong credit.1
-By 2005 and 2006, Wall Street was securitizing one-third more loans than Fannie and Freddie. In just two years, private-label mortgage-backed securities had grown more than \f6460\f642, reaching \f6531.15 trillion in 2006; 71\f642 were subprime or Alt-A.2
+By 2005 and 2006, Wall Street was securitizing one-third more loans than Fannie and Freddie. In just two years, private-label mortgage-backed securities had grown more than 30%, reaching $1.15 trillion in 2006; 71% were subprime or Alt-A.2
-Many investors preferred securities highly rated by the rating agencies—or were encouraged or restricted by regulations to buy them. And with yields low on other highly rated assets, investors hungered for Wall Street mortgage securities backed by higher-yield mortgages—those loans made to subprime borrowers, those with nontraditional features, those with limited or no documentation (“no-doc loans”), or those that failed in some other way to meet strong underwriting standards.
+Many investors preferred securities highly rated by the rating agencies—or were encouraged or restricted by regulations to buy them. And with yields low on other highly rated assets, investors hungered for Wall Street mortgage securities backed by higher-yield mortgages—those loans made to subprime borrowers, those with nontraditional features, those with limited or no documentation ("no-doc loans"), or those that failed in some other way to meet strong underwriting standards.
-“Securitization could be seen as a factory line,” former Citigroup CEO Charles Prince told the FCIC. “As more and more and more of these subprime mortgages were created as raw material for the securitization process, not surprisingly in hindsight, more and more of it was of lower and lower quality. And at the end of that
+"Securitization could be seen as a factory line," former Citigroup CEO Charles Prince told the FCIC. "As more and more and more of these subprime mortgages were created as raw material for the securitization process, not surprisingly in hindsight, more and more of it was of lower and lower quality. And at the end of that
102
-THE MORTGAGE MACHINE 10\f646
-
-process, the raw material going into it was actually bad quality, it was toxic quality, and that is what ended up coming out the other end of the pipeline. Wall Street obviously participated in that flow of activity.”\f646
+process, the raw material going into it was actually bad quality, it was toxic quality, and that is what ended up coming out the other end of the pipeline. Wall Street obviously participated in that flow of activity."3
-The origination and securitization of these mortgages also relied on short-term financing from the shadow banking system. Unlike banks and thrifts with access to deposits, investment banks relied more on money market funds and other investors for cash; commercial paper and repo loans were the main sources. With house prices already up 91\f642 from 1995 to 200\f646, this flood of money and the securitization apparatus helped boost home prices another \f6466\f642 from the beginning of 2004 until the peak in April 2006—even as homeownership was falling. The biggest gains over this period were in the “sand states”: places like the Los Angeles suburbs (54\f642), Las Vegas (\f6466\f642), and Orlando (72\f642).
+The origination and securitization of these mortgages also relied on short-term financing from the shadow banking system. Unlike banks and thrifts with access to deposits, investment banks relied more on money market funds and other investors for cash; commercial paper and repo loans were the main sources. With house prices already up 91% from 1995 to 2003, this flood of money and the securitization apparatus helped boost home prices another 36% from the beginning of 2004 until the peak in April 2006—even as homeownership was falling. The biggest gains over this period were in the "sand states": places like the Los Angeles suburbs (54%), Las Vegas (36%), and Orlando (72%).
FOREIGN INVESTORS:
-“AN IRRESISTIBLE PROFIT OPPORTUNITY”
-
-From June 200\f646 through June 2004, the Federal Reserve kept the federal funds rate low at 1\f642 to stimulate the economy following the 2001 recession. Over the next two years, as deflation fears waned, the Fed gradually raised rates to 5.25\f642 in 17 quarter-point increases.
-
-In the view of some, the Fed simply kept rates too low too long. John Taylor, a Stanford economist and former under secretary of treasury for international affairs, blamed the crisis primarily on this action. If the Fed had followed its usual pattern, he told the FCIC, short-term interest rates would have been much higher, discouraging excessive investment in mortgages. “The boom in housing construction starts would have been much more mild, might not even call it a boom, and the bust as well would have been mild,” Taylor said.4 Others were more blunt: “Greenspan bailed out the world’s largest equity bubble with the world’s largest real estate bubble,” wrote William A. Fleckenstein, the president of a Seattle-based money management firm.5
-
-Ben Bernanke and Alan Greenspan disagree. Both the current and former Fed chairman argue that deciding to purchase a home depends on long-term interest rates on mortgages, not the short-term rates controlled by the Fed, and that short-term and long-term rates had become de-linked. “Between 1971 and 2002, the fed funds rate and the mortgage rate moved in lock-step,” Greenspan said.6 When the Fed started to raise rates in 2004, officials expected mortgage rates to rise, too, slowing growth. Instead, mortgage rates continued to fall for another year. The construction industry continued to build houses, peaking at an annualized rate of 2.27 million starts in January 2006—more than a \f6460-year high.
+"AN IRRESISTIBLE PROFIT OPPORTUNITY"
-As Greenspan told Congress in 2005, this was a “conundrum.”7 One theory pointed to foreign money. Developing countries were booming and—vulnerable to financial problems in the past—encouraged strong saving. Investors in these countries placed their savings in apparently safe and high-yield securities in the United States. Fed Chairman Bernanke called it a “global savings glut.”8
+From June 2003 through June 2004, the Federal Reserve kept the federal funds rate low at 1% to stimulate the economy following the 2001 recession. Over the next two years, as deflation fears waned, the Fed gradually raised rates to 5.25% in 17 quarter-point increases.
+In the view of some, the Fed simply kept rates too low too long. John Taylor, a Stanford economist and former under secretary of treasury for international affairs, blamed the crisis primarily on this action. If the Fed had followed its usual pattern, he told the FCIC, short-term interest rates would have been much higher, discouraging excessive investment in mortgages. "The boom in housing construction starts would have been much more mild, might not even call it a boom, and the bust as well would have been mild," Taylor said.4 Others were more blunt: "Greenspan bailed out the world’s largest equity bubble with the world’s largest real estate bubble," wrote William A. Fleckenstein, the president of a Seattle-based money management firm.5
+Ben Bernanke and Alan Greenspan disagree. Both the current and former Fed chairman argue that deciding to purchase a home depends on long-term interest rates on mortgages, not the short-term rates controlled by the Fed, and that short-term and long-term rates had become de-linked. "Between 1971 and 2002, the fed funds rate and the mortgage rate moved in lock-step," Greenspan said.6 When the Fed started to raise rates in 2004, officials expected mortgage rates to rise, too, slowing growth. Instead, mortgage rates continued to fall for another year. The construction industry continued to build houses, peaking at an annualized rate of 2.27 million starts in January 2006—more than a 30-year high.
-104
+As Greenspan told Congress in 2005, this was a "conundrum."7 One theory pointed to foreign money. Developing countries were booming and—vulnerable to financial problems in the past—encouraged strong saving. Investors in these countries placed their savings in apparently safe and high-yield securities in the United States. Fed Chairman Bernanke called it a "global savings glut."8
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+s the United States ran a large current account deficit, flows into the country were unprecedented. Over six years from 2000 to 2006, U.S. Treasury debt held by foreign official public entities rose from $0.6 trillion to $1.43 trillion; as a percentage of U.S. debt held by the public, these holdings increased from 18.2% to 28.8%. Foreigners also bought securities backed by Fannie and Freddie, which, with their implicit government guarantee, seemed nearly as safe as Treasuries. As the Asian financial crisis ended in 1998, foreign holdings of GSE securities held steady at the level of almost 10 years earlier, about $186 billion. By 2000—just two years later—
-As the United States ran a large current account deficit, flows into the country were unprecedented. Over six years from 2000 to 2006, U.S. Treasury debt held by foreign official public entities rose from \f6530.6 trillion to \f6531.4\f646 trillion; as a percentage of U.S. debt held by the public, these holdings increased from 18.2\f642 to 28.8\f642. Foreigners also bought securities backed by Fannie and Freddie, which, with their implicit government guarantee, seemed nearly as safe as Treasuries. As the Asian financial crisis ended in 1998, foreign holdings of GSE securities held steady at the level of almost 10 years earlier, about \f653186 billion. By 2000—just two years later—
+foreigners owned $348 billion in GSE securities; by 2004, $875 billion. "You had a huge inflow of liquidity. A very unique kind of situation where poor countries like China were shipping money to advanced countries because their financial systems were so weak that they [were] better off shipping [money] to countries like the United States rather than keeping it in their own countries," former Fed governor Frederic Mishkin told the FCIC. "The system was awash with liquidity, which helped lower long-term interest rates."9
-foreigners owned \f653\f64648 billion in GSE securities; by 2004, \f653875 billion. “You had a huge inflow of liquidity. A very unique kind of situation where poor countries like China were shipping money to advanced countries because their financial systems were so weak that they [were] better off shipping [money] to countries like the United States rather than keeping it in their own countries,” former Fed governor Frederic Mishkin told the FCIC. “The system was awash with liquidity, which helped lower long-term interest rates.”9
+Foreign investors sought other high-grade debt almost as safe as Treasuries and GSE securities but with a slightly higher return. They found the triple-A assets pour-ing from the Wall Street mortgage securitization machine. As overseas demand drove up prices for securitized debt, it "created an irresistible profit opportunity for the U.S.
-Foreign investors sought other high-grade debt almost as safe as Treasuries and GSE securities but with a slightly higher return. They found the triple-A assets pour-ing from the Wall Street mortgage securitization machine. As overseas demand drove up prices for securitized debt, it “created an irresistible profit opportunity for the U.S.
+financial system: to engineer ‘quasi’ safe debt instruments by bundling riskier assets and selling the senior tranches," Pierre-Olivier Gourinchas, an economist at the University of California, Berkeley, told the FCIC.10
-financial system: to engineer ‘quasi’ safe debt instruments by bundling riskier assets and selling the senior tranches,” Pierre-Olivier Gourinchas, an economist at the University of California, Berkeley, told the FCIC.10
-
-Paul Krugman, an economist at Princeton University, told the FCIC, “It’s hard to envisage us having had this crisis without considering international monetary capital movements. The U.S. housing bubble was financed by large capital inflows. So were Spanish and Irish and Baltic bubbles. It’s a combination of, in the narrow sense, of a less regulated financial system and a world that was increasingly wide open for big international capital movements.”11
+Paul Krugman, an economist at Princeton University, told the FCIC, "It’s hard to envisage us having had this crisis without considering international monetary capital movements. The U.S. housing bubble was financed by large capital inflows. So were Spanish and Irish and Baltic bubbles. It’s a combination of, in the narrow sense, of a less regulated financial system and a world that was increasingly wide open for big international capital movements."11
It was an ocean of money.
-MORTGAGES: “A GOOD LOAN”
-
-The refinancing boom was over, but originators still needed mortgages to sell to the Street. They needed new products that, as prices kept rising, could make expensive homes more affordable to still-eager borrowers. The solution was riskier, more aggressive, mortgage products that brought higher yields for investors but correspondingly greater risks for borrowers. “Holding a subprime loan has become something of a high-stakes wager,” the Center for Responsible Lending warned in 2006.12
-
-Subprime mortgages rose from 8\f642 of mortgage originations in 200\f646 to 20\f642 in
-
-2005.1\f646About 70\f642 of subprime borrowers used hybrid adjustable-rate mortgages (ARMs) such as 2/28s and \f646/27s—mortgages whose low “teaser” rate lasts for the first two or three years, and then adjusts periodically thereafter.14 Prime borrowers also used more alternative mortgages. The dollar volume of Alt-A securitization rose almost \f64650\f642 from 200\f646 to 2005.15 In general, these loans made borrowers’ monthly THE MORTGAGE MACHINE 105
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-mortgage payments on ever more expensive homes affordable—at least initially. Popular Alt-A products included interest-only mortgages and payment-option ARMs.
+MORTGAGES: "A GOOD LOAN"
-Option ARMs let borrowers pick their payment each month, including payments that actually increased the principal—any shortfall on the interest payment was added to the principal, something called negative amortization. If the balance got large enough, the loan would convert to a fixed-rate mortgage, increasing the monthly payment—perhaps dramatically. Option ARMs rose from 2\f642 of mortgages in 200\f646 to 9\f642 in 2006. 16
+The refinancing boom was over, but originators still needed mortgages to sell to the Street. They needed new products that, as prices kept rising, could make expensive homes more affordable to still-eager borrowers. The solution was riskier, more aggressive, mortgage products that brought higher yields for investors but correspondingly greater risks for borrowers. "Holding a subprime loan has become something of a high-stakes wager," the Center for Responsible Lending warned in 2006.12
-Simultaneously, underwriting standards for nonprime and prime mortgages weakened. Combined loan-to-value ratios—reflecting first, second, and even third mortgages—rose. Debt-to-income ratios climbed, as did loans made for non-owner-occupied properties. Fannie Mae and Freddie Mac’s market share shrank from 57\f642
+Subprime mortgages rose from 8% of mortgage originations in 2003 to 20% in
-of all mortgages purchased in 200\f646 to 42\f642 in 2004, and down to \f6467\f642 by 2006.17 Taking their place were private-label securitizations—meaning those not issued and guaranteed by the GSEs.
+2005.13About 70% of subprime borrowers used hybrid adjustable-rate mortgages (ARMs) such as 2/28s and 3/27s—mortgages whose low "teaser" rate lasts for the first two or three years, and then adjusts periodically thereafter.14 Prime borrowers also used more alternative mortgages. The dollar volume of Alt-A securitization rose almost 350% from 2003 to 2005.15 In general, these loans made borrowers’ monthly mortgage payments on ever more expensive homes affordable—at least initially. Popular Alt-A products included interest-only mortgages and payment-option ARMs.
-In this new market, originators competed fiercely; Countrywide Financial Corporation took the crown.18 It was the biggest mortgage originator from 2004 until the market collapsed in 2007. Even after Countrywide nearly failed, buckling under a mortgage portfolio with loans that its co-founder and CEO Angelo Mozilo once called “toxic,” Mozilo would describe his 40-year-old company to the Commission as having helped 25 million people buy homes and prevented social unrest by extending loans to minorities, historically the victims of discrimination: “Countrywide was one of the greatest companies in the history of this country and probably made more difference to society, to the integrity of our society, than any company in the history of America.”19 Lending to home buyers was only part of the business. Countrywide’s President and COO David Sambol told the Commission, as long as a loan did not harm the company from a financial or reputation standpoint, Countrywide was “a seller of securities to Wall Street.” Countrywide’s essential business strategy was
+Option ARMs let borrowers pick their payment each month, including payments that actually increased the principal—any shortfall on the interest payment was added to the principal, something called negative amortization. If the balance got large enough, the loan would convert to a fixed-rate mortgage, increasing the monthly payment—perhaps dramatically. Option ARMs rose from 2% of mortgages in 2003 to 9% in 2006. 16
-“originating what was salable in the secondary market.”20 The company sold or securitized 87\f642 of the \f6531.5 trillion in mortgages it originated between 2002 and 2005.
+Simultaneously, underwriting standards for nonprime and prime mortgages weakened. Combined loan-to-value ratios—reflecting first, second, and even third mortgages—rose. Debt-to-income ratios climbed, as did loans made for non-owner-occupied properties. Fannie Mae and Freddie Mac’s market share shrank from 57% of all mortgages purchased in 2003 to 42% in 2004, and down to 37% by 2006.17 Taking their place were private-label securitizations—meaning those not issued and guaranteed by the GSEs.
-In 2004, Mozilo announced a very aggressive goal of gaining “market dominance” by capturing \f6460\f642 of the origination market.21 His share at the time was 12\f642. But Countrywide was not unique: Ameriquest, New Century, Washington Mutual, and others all pursued loans as aggressively. They competed by originating types of mortgages created years before as niche products, but now transformed into riskier, mass-market versions. “The definition of a good loan changed from ‘one that pays’ to ‘one that could be sold,’” Patricia Lindsay, formerly a fraud specialist at New Century, told the FCIC.22
+In this new market, originators competed fiercely; Countrywide Financial Corporation took the crown.18 It was the biggest mortgage originator from 2004 until the market collapsed in 2007. Even after Countrywide nearly failed, buckling under a mortgage portfolio with loans that its co-founder and CEO Angelo Mozilo once called "toxic," Mozilo would describe his 40-year-old company to the Commission as having helped 25 million people buy homes and prevented social unrest by extending loans to minorities, historically the victims of discrimination: "Countrywide was one of the greatest companies in the history of this country and probably made more difference to society, to the integrity of our society, than any company in the history of America."19 Lending to home buyers was only part of the business. Countrywide’s President and COO David Sambol told the Commission, as long as a loan did not harm the company from a financial or reputation standpoint, Countrywide was "a seller of securities to Wall Street." Countrywide’s essential business strategy was
-2/28s and \f646/27s: “Adjust for the affordability”
+"originating what was salable in the secondary market."20 The company sold or securitized 87% of the $1.5 trillion in mortgages it originated between 2002 and 2005.
-Historically, 2/28s or \f646/27s, also known as hybrid ARMs, let credit-impaired borrowers repair their credit. During the first two or three years, a lower interest rate meant a manageable payment schedule and enabled borrowers to demonstrate they could make timely payments. Eventually the interest rates would rise sharply, and payments
+In 2004, Mozilo announced a very aggressive goal of gaining "market dominance" by capturing 30% of the origination market.21 His share at the time was 12%. But Countrywide was not unique: Ameriquest, New Century, Washington Mutual, and others all pursued loans as aggressively. They competed by originating types of mortgages created years before as niche products, but now transformed into riskier, mass-market versions. "The definition of a good loan changed from ‘one that pays’ to ‘one that could be sold,’" Patricia Lindsay, formerly a fraud specialist at New Century, told the FCIC.22
+2/28s and 3/27s: "Adjust for the affordability"
+Historically, 2/28s or 3/27s, also known as hybrid ARMs, let credit-impaired borrowers repair their credit. During the first two or three years, a lower interest rate meant a manageable payment schedule and enabled borrowers to demonstrate they could make timely payments. Eventually the interest rates would rise sharply, and payments ould double or even triple, leaving borrowers with few alternatives: if they had established their creditworthiness, they could refinance into a similar mortgage or one with a better interest rate, often with the same lender;23 if unable to refinance, the borrower was unlikely to be able to afford the new higher payments and would have to sell the home and repay the mortgage. If they could not sell or make the higher payments, they would have to default.
-106
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-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
-
-could double or even triple, leaving borrowers with few alternatives: if they had established their creditworthiness, they could refinance into a similar mortgage or one with a better interest rate, often with the same lender;2\f646 if unable to refinance, the borrower was unlikely to be able to afford the new higher payments and would have to sell the home and repay the mortgage. If they could not sell or make the higher payments, they would have to default.
+But as house prices rose after 2000, the 2/28s and 3/27s acquired a new role: helping to get people into homes or to move up to bigger homes. "As homes got less and less affordable, you would adjust for the affordability in the mortgage because you couldn’t really adjust people’s income," Andrew Davidson, the president of Andrew Davidson & Co. and a veteran of the mortgage markets, told the FCIC.24 Lenders qualified borrowers at low teaser rates, with little thought to what might happen when rates reset. Hybrid ARMs became the workhorses of the subprime securitization market.
-But as house prices rose after 2000, the 2/28s and \f646/27s acquired a new role: helping to get people into homes or to move up to bigger homes. “As homes got less and less affordable, you would adjust for the affordability in the mortgage because you couldn’t really adjust people’s income,” Andrew Davidson, the president of Andrew Davidson & Co. and a veteran of the mortgage markets, told the FCIC.24 Lenders qualified borrowers at low teaser rates, with little thought to what might happen when rates reset. Hybrid ARMs became the workhorses of the subprime securitization market.
+Consumer protection groups such as the Leadership Conference on Civil Rights railed against 2/28s and 3/27s, which, they said, neither rehabilitated credit nor turned renters into owners. David Berenbaum from the National Community Reinvestment Coalition testified to Congress in the summer of 2007: "The industry has flooded the market with exotic mortgage lending such as 2/28 and 3/27 ARMs. These exotic subprime mortgages overwhelm borrowers when interest rates shoot up after an introductory time period."25 To their critics, they were simply a way for lenders to strip equity from low-income borrowers. The loans came with big fees that got rolled into the mortgage, increasing the chances that the mortgage could be larger than the home’s value at the reset date. If the borrower could not refinance, the lender would foreclose—and then own the home in a rising real estate market.
-Consumer protection groups such as the Leadership Conference on Civil Rights railed against 2/28s and \f646/27s, which, they said, neither rehabilitated credit nor turned renters into owners. David Berenbaum from the National Community Reinvestment Coalition testified to Congress in the summer of 2007: “The industry has flooded the market with exotic mortgage lending such as 2/28 and \f646/27 ARMs. These exotic subprime mortgages overwhelm borrowers when interest rates shoot up after an introductory time period.”25 To their critics, they were simply a way for lenders to strip equity from low-income borrowers. The loans came with big fees that got rolled into the mortgage, increasing the chances that the mortgage could be larger than the home’s value at the reset date. If the borrower could not refinance, the lender would foreclose—and then own the home in a rising real estate market.
-
-Option ARMs: “Our most profitable mortgage loan”
+Option ARMs: "Our most profitable mortgage loan"
When they were originally introduced in the 1980s, option ARMs were niche products, too, but by 2004 they too became loans of choice because their payments were lower than more traditional mortgages. During the housing boom, many borrowers repeatedly made only the minimum payments required, adding to the principal balance of their loan every month.
-An early seller of option ARMs was Golden West Savings, an Oakland, California–based thrift founded in 1929 and acquired in 196\f646 by Marion and Herbert Sandler. In 1975, the Sandlers merged Golden West with World Savings; Golden West Financial Corp., the parent company, operated branches under the name World Savings Bank. The thrift issued about \f653274 billion in option ARMs between 1981 and
+An early seller of option ARMs was Golden West Savings, an Oakland, California–based thrift founded in 1929 and acquired in 1963 by Marion and Herbert Sandler. In 1975, the Sandlers merged Golden West with World Savings; Golden West Financial Corp., the parent company, operated branches under the name World Savings Bank. The thrift issued about $274 billion in option ARMs between 1981 and
2005.26 Unlike other mortgage companies, Golden West held onto them.
-Sandler told the FCIC that Golden West’s option ARMs—marketed as “Pick-a-Pay” loans—had the lowest losses in the industry for that product. Even in 2005—the last year prior to its acquisition by Wachovia—when its portfolio was almost entirely in option ARMs, Golden West’s losses were low by industry standards. Sandler attributed Golden West’s performance to its diligence in running simulations about what THE MORTGAGE MACHINE 107
-
-would happen to its loans under various scenarios—for example, if interest rates went up or down or if house prices dropped 5\f642, even 10\f642. “For a quarter of a century, it worked exactly as the simulations showed that it would,” Sandler said. “And we have never been able to identify a single loan that was delinquent because of the structure of the loan, much less a loss or foreclosure.”27 But after Wachovia acquired Golden West in 2006 and the housing market soured, charge-offs on the Pick-a-Pay portfolio would suddenly jump from 0.04\f642 to 2.69\f642 by September 2008. And foreclosures would climb.
-
-Early in the decade, banks and thrifts such as Countrywide and Washington Mutual increased their origination of option ARM loans, changing the product in ways that made payment shocks more likely. At Golden West, after 10 years, or if the principal balance grew to 125\f642 of its original size, the Pick-a-Pay mortgage would recast into a new fixed-rate mortgage. At Countrywide and Washington Mutual, the new loans would recast in as little as five years, or when the balance hit just 110\f642 of the original size. They also offered lower teaser rates—as low as 1\f642—and loan-to-value ratios as high as 100\f642. All of these features raised the chances that the borrower’s required payment could rise more sharply, more quickly, and with less cushion.
+Sandler told the FCIC that Golden West’s option ARMs—marketed as "Pick-a-Pay" loans—had the lowest losses in the industry for that product. Even in 2005—the last year prior to its acquisition by Wachovia—when its portfolio was almost entirely in option ARMs, Golden West’s losses were low by industry standards. Sandler attributed Golden West’s performance to its diligence in running simulations about what would happen to its loans under various scenarios—for example, if interest rates went up or down or if house prices dropped 5%, even 10%. "For a quarter of a century, it worked exactly as the simulations showed that it would," Sandler said. "And we have never been able to identify a single loan that was delinquent because of the structure of the loan, much less a loss or foreclosure."27 But after Wachovia acquired Golden West in 2006 and the housing market soured, charge-offs on the Pick-a-Pay portfolio would suddenly jump from 0.04% to 2.69% by September 2008. And foreclosures would climb.
-In 2002, Washington Mutual was the second-largest mortgage originator, just ahead of Countrywide. It had offered the option ARM since 1986, and in 200\f646, as cited by the Senate Permanent Subcommittee on Investigations, the originator conducted a study “to explore what Washington Mutual could do to increase sales of Option ARMs, our most profitable mortgage loan.”28 A focus group made clear that few customers were requesting option ARMs and that “this is not a product that sells itself.”29 The study found “the best selling point for the Option Arm” was to show consumers “how much lower their monthly payment would be by choosing the Option Arm versus a fixed-rate loan.”\f6460 The study also revealed that many WaMu brokers
+Early in the decade, banks and thrifts such as Countrywide and Washington Mutual increased their origination of option ARM loans, changing the product in ways that made payment shocks more likely. At Golden West, after 10 years, or if the principal balance grew to 125% of its original size, the Pick-a-Pay mortgage would recast into a new fixed-rate mortgage. At Countrywide and Washington Mutual, the new loans would recast in as little as five years, or when the balance hit just 110% of the original size. They also offered lower teaser rates—as low as 1%—and loan-to-value ratios as high as 100%. All of these features raised the chances that the borrower’s required payment could rise more sharply, more quickly, and with less cushion.
-“felt these loans were ‘bad’ for customers.”\f6461 One member of the focus group remarked, “A lot of (Loan) Consultants don’t believe in it . . . and don’t think [it’s] good for the customer. You’re going to have to change the mindset.”\f6462
+In 2002, Washington Mutual was the second-largest mortgage originator, just ahead of Countrywide. It had offered the option ARM since 1986, and in 2003, as cited by the Senate Permanent Subcommittee on Investigations, the originator conducted a study "to explore what Washington Mutual could do to increase sales of Option ARMs, our most profitable mortgage loan."28 A focus group made clear that few customers were requesting option ARMs and that "this is not a product that sells itself."29 The study found "the best selling point for the Option Arm" was to show consumers "how much lower their monthly payment would be by choosing the Option Arm versus a fixed-rate loan."30 The study also revealed that many WaMu brokers
-Despite these challenges, option ARM originations soared at Washington Mutual from \f653\f6460 billion in 200\f646 to \f65368 billion in 2004, when they were more than half of WaMu’s originations and had become the thrift’s signature adjustable-rate home loan product.\f646\f646 The average FICO score was around 700, well into the range considered
+"felt these loans were ‘bad’ for customers."31 One member of the focus group remarked, "A lot of (Loan) Consultants don’t believe in it . . . and don’t think [it’s] good for the customer. You’re going to have to change the mindset."32
-“prime,” and about two-thirds were jumbo loans—mortgage loans exceeding the maximum Fannie Mae and Freddie Mac were allowed to purchase or guarantee.\f6464
+Despite these challenges, option ARM originations soared at Washington Mutual from $30 billion in 2003 to $68 billion in 2004, when they were more than half of WaMu’s originations and had become the thrift’s signature adjustable-rate home loan product.33 The average FICO score was around 700, well into the range considered
-More than half were in California.\f6465
+"prime," and about two-thirds were jumbo loans—mortgage loans exceeding the maximum Fannie Mae and Freddie Mac were allowed to purchase or guarantee.34
-Countrywide’s option ARM business peaked at \f65314.5 billion in originations in the second quarter of 2005, about 25\f642 of all its loans originated that quarter.\f6466 But it had to relax underwriting standards to get there. In July 2004, Countrywide decided it would lend up to 90\f642 of a home’s appraised value, up from 80\f642, and reduced the minimum credit score to as low as 620.\f6467 In early 2005, Countrywide eased standards again, increasing the allowable combined loan-to-value ratio (including second liens) to 95\f642.\f6468
+More than half were in California.35
+Countrywide’s option ARM business peaked at $14.5 billion in originations in the second quarter of 2005, about 25% of all its loans originated that quarter.36 But it had to relax underwriting standards to get there. In July 2004, Countrywide decided it would lend up to 90% of a home’s appraised value, up from 80%, and reduced the minimum credit score to as low as 620.37 In early 2005, Countrywide eased standards again, increasing the allowable combined loan-to-value ratio (including second liens) to 95%.38 he risk in these loans was growing. From 2003 to 2005, the average loan-to-value ratio rose about 4%, the combined loan-to-value ratio rose about 6%, and debt-to-income ratios had risen from 34% to 38%: borrowers were pledging more of their income to their mortgage payments. Moreover, 68% of these two originators’ option ARMs had low documentation in 2005.39 The percentage of these loans made to investors and speculators—that is, borrowers with no plans to use the home as their primary residence—also rose.
+These changes worried the lenders even as they continued to make the loans. In September 2004 and August 2005, Mozilo emailed to senior management that these loans could bring "financial and reputational catastrophe."40 Countrywide should not market them to investors, he insisted. "Pay option loans being used by investors is a pure commercial spec[ulation] loan and not the traditional home loan that we have successfully managed throughout our history," Mozilo wrote to Carlos Garcia, CEO
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+of Countrywide Bank. Speculative investors "should go to Chase or Wells not us. It is also important for you and your team to understand from my point of view that there is nothing intrinsically wrong with pay options loans themselves, the problem is the quality of borrowers who are being offered the product and the abuse by third party originators. . . . [I]f you are unable to find sufficient product then slow down the growth of the Bank for the time being."41
-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
+However, Countrywide’s growth did not slow. Nor did the volume of option ARMs retained on its balance sheet, increasing from $5 billion in 2004 to $26 billion in 2005 and peaking in 2006 at $33 billion.42 Finding these loans very profitable, through 2006, WaMu also retained option ARMs—more than $60 billion with the bulk from California, followed by Florida.43 But in the end, these loans would cause significant losses during the crisis.
-The risk in these loans was growing. From 200\f646 to 2005, the average loan-to-value ratio rose about 4\f642, the combined loan-to-value ratio rose about 6\f642, and debt-to-income ratios had risen from \f6464\f642 to \f6468\f642: borrowers were pledging more of their income to their mortgage payments. Moreover, 68\f642 of these two originators’ option ARMs had low documentation in 2005.\f6469 The percentage of these loans made to investors and speculators—that is, borrowers with no plans to use the home as their primary residence—also rose.
+Mentioning Countrywide and WaMu as tough, "in our face" competitors, John Stumpf, the CEO, chairman, and president of Wells Fargo, recalled Wells’s decision not to write option ARMs, even as it originated many other high-risk mortgages.
-These changes worried the lenders even as they continued to make the loans. In September 2004 and August 2005, Mozilo emailed to senior management that these loans could bring “financial and reputational catastrophe.”40 Countrywide should not market them to investors, he insisted. “Pay option loans being used by investors is a pure commercial spec[ulation] loan and not the traditional home loan that we have successfully managed throughout our history,” Mozilo wrote to Carlos Garcia, CEO
-
-of Countrywide Bank. Speculative investors “should go to Chase or Wells not us. It is also important for you and your team to understand from my point of view that there is nothing intrinsically wrong with pay options loans themselves, the problem is the quality of borrowers who are being offered the product and the abuse by third party originators. . . . [I]f you are unable to find sufficient product then slow down the growth of the Bank for the time being.”41
-
-However, Countrywide’s growth did not slow. Nor did the volume of option ARMs retained on its balance sheet, increasing from \f6535 billion in 2004 to \f65326 billion in 2005 and peaking in 2006 at \f653\f646\f646 billion.42 Finding these loans very profitable, through 2006, WaMu also retained option ARMs—more than \f65360 billion with the bulk from California, followed by Florida.4\f646 But in the end, these loans would cause significant losses during the crisis.
-
-Mentioning Countrywide and WaMu as tough, “in our face” competitors, John Stumpf, the CEO, chairman, and president of Wells Fargo, recalled Wells’s decision not to write option ARMs, even as it originated many other high-risk mortgages.
-
-These were “hard decisions to make at the time,” he said, noting “we did lose revenue, and we did lose volume.”44
+These were "hard decisions to make at the time," he said, noting "we did lose revenue, and we did lose volume."44
Across the market, the volume of option ARMs had risen nearly fourfold from
-200\f646 to 2006, from approximately \f65365 billion to \f653255 billion. By then, WaMu and Countrywide had plenty of evidence that more borrowers were making only the minimum payments and that their mortgages were negatively amortizing—which meant their equity was being eaten away. The percentage of Countrywide’s option ARMs that were negatively amortizing grew from just 1\f642 in 2004 to 5\f646\f642 in 2005 and then to more than 90\f642 by 2007.45 At WaMu, it was 2\f642 in 200\f646, 28\f642 in 2004, and 82\f642
-
-in 2007.46 Declines in house prices added to borrowers’ problems: any equity remaining after the negative amortization would simply be eroded. Increasingly, borrowers would owe more on their mortgages than their homes were worth on the market, giving them an incentive to walk away from both home and mortgage.
+2003 to 2006, from approximately $65 billion to $255 billion. By then, WaMu and Countrywide had plenty of evidence that more borrowers were making only the minimum payments and that their mortgages were negatively amortizing—which meant their equity was being eaten away. The percentage of Countrywide’s option ARMs that were negatively amortizing grew from just 1% in 2004 to 53% in 2005 and then to more than 90% by 2007.45 At WaMu, it was 2% in 2003, 28% in 2004, and 82% in 2007.46 Declines in house prices added to borrowers’ problems: any equity remaining after the negative amortization would simply be eroded. Increasingly, borrowers would owe more on their mortgages than their homes were worth on the market, giving them an incentive to walk away from both home and mortgage.
Kevin Stein, from the California Reinvestment Coalition, testified to the FCIC
-that option ARMs were sold inappropriately: “Nowhere was this dynamic more clearly on display than in the summer of 2006 when the Federal Reserve convened THE MORTGAGE MACHINE 109
+that option ARMs were sold inappropriately: "Nowhere was this dynamic more clearly on display than in the summer of 2006 when the Federal Reserve convened HOEPA (Home Ownership and Equity Protection Act) hearings in San Francisco. At the hearing, consumers testified to being sold option ARM loans in their primary non-English language, only to be pressured to sign English-only documents with significantly worse terms. Some consumers testified to being unable to make even their initial payments because they had been lied to so completely by their brokers."47
-HOEPA (Home Ownership and Equity Protection Act) hearings in San Francisco. At the hearing, consumers testified to being sold option ARM loans in their primary non-English language, only to be pressured to sign English-only documents with significantly worse terms. Some consumers testified to being unable to make even their initial payments because they had been lied to so completely by their brokers.”47
+Mona Tawatao, a regional counsel with Legal Services of Northern California, described the borrowers she was assisting as "people who got steered or defrauded into entering option ARMs with teaser rates or pick-a-pay loans forcing them to pay into—pay loans that they could never pay off. Prevalent among these clients are seniors, people of color, people with disabilities, and limited English speakers and seniors who are African American and Latino."48
-Mona Tawatao, a regional counsel with Legal Services of Northern California, described the borrowers she was assisting as “people who got steered or defrauded into entering option ARMs with teaser rates or pick-a-pay loans forcing them to pay into—pay loans that they could never pay off. Prevalent among these clients are seniors, people of color, people with disabilities, and limited English speakers and seniors who are African American and Latino.”48
+Underwriting standards: "We’re going to have to hold our nose" Another shift would have serious consequences. For decades, the down payment for a prime mortgage had been 20% (in other words, the loan-to-value ratio (LTV) had been 80%). As prices continued to rise, finding the cash to put 20% down became harder, and from 2000 on, lenders began accepting smaller down payments.
-Underwriting standards: “We’re going to have to hold our nose” Another shift would have serious consequences. For decades, the down payment for a prime mortgage had been 20\f642 (in other words, the loan-to-value ratio (LTV) had been 80\f642). As prices continued to rise, finding the cash to put 20\f642 down became harder, and from 2000 on, lenders began accepting smaller down payments.
+There had always been a place for borrowers with down payments below 20%.
-There had always been a place for borrowers with down payments below 20\f642.
+Typically, lenders required such borrower to purchase private mortgage insurance for a monthly fee. If a mortgage ended in foreclosure, the mortgage insurance company would make the lender whole. Worried about defaults, the GSEs would not buy or guarantee mortgages with down payments below 20% unless the borrower bought the insurance. Unluckily for many homeowners, for the housing industry, and for the financial system, lenders devised a way to get rid of these monthly fees that had added to the cost of homeownership: lower down payments that did not require insurance.
-Typically, lenders required such borrower to purchase private mortgage insurance for a monthly fee. If a mortgage ended in foreclosure, the mortgage insurance company would make the lender whole. Worried about defaults, the GSEs would not buy or guarantee mortgages with down payments below 20\f642 unless the borrower bought the insurance. Unluckily for many homeowners, for the housing industry, and for the financial system, lenders devised a way to get rid of these monthly fees that had added to the cost of homeownership: lower down payments that did not require insurance.
+Lenders had latitude in setting down payments. In 1991, Congress ordered federal regulators to prescribe standards for real estate lending that would apply to banks and thrifts. The goal was to "curtail abusive real estate lending practices in order to reduce risk to the deposit insurance funds and enhance the safety and soundness of insured depository institutions."49 Congress had debated including explicit LTV standards, but chose not to, leaving that to the regulators. In the end, regulators declined to introduce standards for LTV ratios or for documentation for home mortgages.50
-Lenders had latitude in setting down payments. In 1991, Congress ordered federal regulators to prescribe standards for real estate lending that would apply to banks and thrifts. The goal was to “curtail abusive real estate lending practices in order to reduce risk to the deposit insurance funds and enhance the safety and soundness of insured depository institutions.”49 Congress had debated including explicit LTV standards, but chose not to, leaving that to the regulators. In the end, regulators declined to introduce standards for LTV ratios or for documentation for home mortgages.50
+The agencies explained: "A significant number of commenters expressed concern that rigid application of a regulation implementing LTV ratios would constrict credit, impose additional lending costs, reduce lending flexibility, impede economic growth, and cause other undesirable consequences."51
-The agencies explained: “A significant number of commenters expressed concern that rigid application of a regulation implementing LTV ratios would constrict credit, impose additional lending costs, reduce lending flexibility, impede economic growth, and cause other undesirable consequences.”51
+In 1999, regulators revisited the issue, as high LTV lending was increasing. They tightened reporting requirements and limited a bank’s total holdings of loans with LTVs above 90% that lacked mortgage insurance or some other protection; they also reminded the banks and thrifts that they should establish internal guidelines to manage the risk of these loans.52
-In 1999, regulators revisited the issue, as high LTV lending was increasing. They tightened reporting requirements and limited a bank’s total holdings of loans with LTVs above 90\f642 that lacked mortgage insurance or some other protection; they also reminded the banks and thrifts that they should establish internal guidelines to manage the risk of these loans.52
-
-High LTV lending soon became even more common, thanks to the so-called
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-piggyback mortgage. The lender offered a first mortgage for perhaps 80\f642 of the home’s value and a second mortgage for another 10\f642 or even 20\f642. Borrowers liked these because their monthly payments were often cheaper than a traditional mortgage plus the required mortgage insurance, and the interest payments were tax deductible. Lenders liked them because the smaller first mortgage—even without mortgage insurance—could potentially be sold to the GSEs.
+High LTV lending soon became even more common, thanks to the so-called iggyback mortgage. The lender offered a first mortgage for perhaps 80% of the home’s value and a second mortgage for another 10% or even 20%. Borrowers liked these because their monthly payments were often cheaper than a traditional mortgage plus the required mortgage insurance, and the interest payments were tax deductible. Lenders liked them because the smaller first mortgage—even without mortgage insurance—could potentially be sold to the GSEs.
At the same time, the piggybacks added risks. A borrower with a higher combined LTV had less equity in the home. In a rising market, should payments become unmanageable, the borrower could always sell the home and come out ahead. However, should the payments become unmanageable in a falling market, the borrower might owe more than the home was worth. Piggyback loans—which often required nothing down—guaranteed that many borrowers would end up with negative equity if house prices fell, especially if the appraisal had overstated the initial value.
-But piggyback lending helped address a significant challenge for companies like New Century, which were big players in the market for mortgages. Meeting investor demand required finding new borrowers, and homebuyers without down payments were a relatively untapped source. Yet among borrowers with mortgages originated in 2004, by September 2005 those with piggybacks were four times as likely as other mortgage holders to be 60 or more days delinquent. When senior management at New Century heard these numbers, the head of the Secondary Marketing Department asked for “thoughts on what to do with this . . . pretty compelling” information.
-
-Nonetheless, New Century increased mortgages with piggybacks to \f6465\f642 of loan production by the end of 2005, up from only 9\f642 in 200\f646.5\f646 They were not alone. Across securitized subprime mortgages, the average combined LTV rose from 79\f642 to 86\f642
-
-between 2001 and 2006.54
+But piggyback lending helped address a significant challenge for companies like New Century, which were big players in the market for mortgages. Meeting investor demand required finding new borrowers, and homebuyers without down payments were a relatively untapped source. Yet among borrowers with mortgages originated in 2004, by September 2005 those with piggybacks were four times as likely as other mortgage holders to be 60 or more days delinquent. When senior management at New Century heard these numbers, the head of the Secondary Marketing Department asked for "thoughts on what to do with this . . . pretty compelling" information.
-Another way to get people into mortgages—and quickly—was to require less information of the borrower. “Stated income” or “low-documentation” (or sometimes
+Nonetheless, New Century increased mortgages with piggybacks to 35% of loan production by the end of 2005, up from only 9% in 2003.53 They were not alone. Across securitized subprime mortgages, the average combined LTV rose from 79% to 86% between 2001 and 2006.54
-“no-documentation”) loans had emerged years earlier for people with fluctuating or hard-to-verify incomes, such as the self-employed, or to serve longtime customers with strong credit. Or lenders might waive information requirements if the loan looked safe in other respects. “If I’m making a 65\f642, 75\f642, 70\f642 loan-to-value, I’m not going to get all of the documentation,” Sandler of Golden West told the FCIC. The process was too cumbersome and unnecessary. He already had a good idea how much money teachers, accountants, and engineers made—and if he didn’t, he could easily find out. All he needed was to verify that his borrowers worked where they said they did. If he guessed wrong, the loan-to-value ratio still protected his investment.55
+Another way to get people into mortgages—and quickly—was to require less information of the borrower. "Stated income" or "low-documentation" (or sometimes
-Around 2005, however, low- and no-documentation loans took on an entirely different character. Nonprime lenders now boasted they could offer borrowers the convenience of quicker decisions and not having to provide tons of paperwork. In return, they charged a higher interest rate. The idea caught on: from 2000 to 2007, low- and no-doc loans skyrocketed from less than 2\f642 to roughly 9\f642 of all outstanding loans.56 Among Alt-A securitizations, 80\f642 of loans issued in 2006 had limited or no documentation.57 As William Black, a former banking regulator, testified before the FCIC, the mortgage industry’s own fraud specialists described stated income THE MORTGAGE MACHINE 111
+"no-documentation") loans had emerged years earlier for people with fluctuating or hard-to-verify incomes, such as the self-employed, or to serve longtime customers with strong credit. Or lenders might waive information requirements if the loan looked safe in other respects. "If I’m making a 65%, 75%, 70% loan-to-value, I’m not going to get all of the documentation," Sandler of Golden West told the FCIC. The process was too cumbersome and unnecessary. He already had a good idea how much money teachers, accountants, and engineers made—and if he didn’t, he could easily find out. All he needed was to verify that his borrowers worked where they said they did. If he guessed wrong, the loan-to-value ratio still protected his investment.55
-loans as “an open ‘invitation to fraud’ that justified the industry term ‘liar’s loans.’”58
+Around 2005, however, low- and no-documentation loans took on an entirely different character. Nonprime lenders now boasted they could offer borrowers the convenience of quicker decisions and not having to provide tons of paperwork. In return, they charged a higher interest rate. The idea caught on: from 2000 to 2007, low- and no-doc loans skyrocketed from less than 2% to roughly 9% of all outstanding loans.56 Among Alt-A securitizations, 80% of loans issued in 2006 had limited or no documentation.57 As William Black, a former banking regulator, testified before the FCIC, the mortgage industry’s own fraud specialists described stated income loans as "an open ‘invitation to fraud’ that justified the industry term ‘liar’s loans.’"58
-Speaking of lending up to 2005 at Citigroup, Richard Bowen, a veteran banker in the consumer lending group, told the FCIC, “A decision was made that ‘We’re going to have to hold our nose and start buying the stated product if we want to stay in business.’”59 Jamie Dimon, the CEO of JP Morgan, told the Commission, “In mortgage underwriting, somehow we just missed, you know, that home prices don’t go up forever and that it’s not sufficient to have stated income.”60
+Speaking of lending up to 2005 at Citigroup, Richard Bowen, a veteran banker in the consumer lending group, told the FCIC, "A decision was made that ‘We’re going to have to hold our nose and start buying the stated product if we want to stay in business.’"59 Jamie Dimon, the CEO of JP Morgan, told the Commission, "In mortgage underwriting, somehow we just missed, you know, that home prices don’t go up forever and that it’s not sufficient to have stated income."60
In the end, companies in subprime and Alt-A mortgages had, in essence, placed all their chips on black: they were betting that home prices would never stop rising.
The 4,499 loans bundled in this deal were adjustable-rate and fixed-rate residential mortgages originated by New Century. They had an average principal balance of
-\f653210,5\f6466—just under the median home price of \f653221,900 in 2006.61 The vast majority had a \f6460-year maturity, and more than 90\f642 were originated in May, June, and July
+$210,536—just under the median home price of $221,900 in 2006.61 The vast majority had a 30-year maturity, and more than 90% were originated in May, June, and July
-2006, just after national home prices had peaked. More than 90\f642 were reportedly for primary residences, with 4\f646\f642 for home purchases and 48\f642 for cash-out refinancings.
+2006, just after national home prices had peaked. More than 90% were reportedly for primary residences, with 43% for home purchases and 48% for cash-out refinancings.
The loans were from all 50 states and the District of Columbia, but more than a fifth came from California and more than a tenth from Florida.62
-About 80\f642 of the loans were ARMs, and most of these were 2/28s or \f646/27s. In a twist, many of these hybrid ARMs had other “affordability features” as well. For example, more than 20\f642 of the ARMs were interest-only—during the first two or three years, not only would borrowers pay a lower fixed rate, they would not have to pay any principal. In addition, more than 40\f642 of the ARMs were “2/28 hybrid balloon” loans, in which the principal would amortize over 40 years—lowering the monthly payments even further, but as a result leaving the borrower with a final principal payment at the end of the \f6460-year term.
-
-The great majority of the pool was secured by first mortgages; of these, \f646\f646\f642 had a piggyback mortgage on the same property. As a result, more than one-third of the mortgages in this deal had a combined loan-to-value ratio between 95\f642 and 100\f642.
-
-Raising the risk a bit more, 42\f642 of the mortgages were no-doc loans. The rest were
+About 80% of the loans were ARMs, and most of these were 2/28s or 3/27s. In a twist, many of these hybrid ARMs had other "affordability features" as well. For example, more than 20% of the ARMs were interest-only—during the first two or three years, not only would borrowers pay a lower fixed rate, they would not have to pay any principal. In addition, more than 40% of the ARMs were "2/28 hybrid balloon" loans, in which the principal would amortize over 40 years—lowering the monthly payments even further, but as a result leaving the borrower with a final principal payment at the end of the 30-year term.
-“full-doc,” although their documentation was fuller in some cases than in others.6\f646 In sum, the loans bundled in this deal mirrored the market: complex products with high LTVs and little documentation. And even as many warned of this toxic mix, the regulators were not on the same page.
+The great majority of the pool was secured by first mortgages; of these, 33% had a piggyback mortgage on the same property. As a result, more than one-third of the mortgages in this deal had a combined loan-to-value ratio between 95% and 100%.
-FEDERAL REGULATORS: “IMMUNITY FROM
+Raising the risk a bit more, 42% of the mortgages were no-doc loans. The rest were
-MANY STATE LAWS IS A SIGNIFICANT BENEFIT”
+"full-doc," although their documentation was fuller in some cases than in others.63 In sum, the loans bundled in this deal mirrored the market: complex products with high LTVs and little documentation. And even as many warned of this toxic mix, the regulators were not on the same page.
-For years, some states had tried to regulate the mortgage business, especially to clamp down on the predatory mortgages proliferating in the subprime market. The national thrifts and banks and their federal regulators—the Office of Thrift Supervision (OTS) and the Office of the Comptroller of the Currency (OCC), respectively—resisted the
+FEDERAL REGULATORS: "IMMUNITY FROM
+MANY STATE LAWS IS A SIGNIFICANT BENEFIT"
+For years, some states had tried to regulate the mortgage business, especially to clamp down on the predatory mortgages proliferating in the subprime market. The national thrifts and banks and their federal regulators—the Office of Thrift Supervision (OTS) and the Office of the Comptroller of the Currency (OCC), respectively—resisted the tates’ efforts to regulate those national banks and thrifts. The companies claimed that without one uniform set of rules, they could not easily do business across the country, and the regulators agreed. In August 2003, as the market for riskier subprime and AltA loans grew, and as lenders piled on more risk with smaller down payments, reduced documentation requirements, interest-only loans, and payment-option loans, the OCC fired a salvo. The OCC proposed strong preemption rules for national banks, nearly identical to earlier OTS rules that empowered nationally chartered thrifts to disregard state consumer laws.64
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-states’ efforts to regulate those national banks and thrifts. The companies claimed that without one uniform set of rules, they could not easily do business across the country, and the regulators agreed. In August 200\f646, as the market for riskier subprime and AltA loans grew, and as lenders piled on more risk with smaller down payments, reduced documentation requirements, interest-only loans, and payment-option loans, the OCC fired a salvo. The OCC proposed strong preemption rules for national banks, nearly identical to earlier OTS rules that empowered nationally chartered thrifts to disregard state consumer laws.64
-
-Back in 1996 the OTS had issued rules saying federal law preempted state predatory lending laws for federally regulated thrifts.65 In 200\f646, the OTS referred to these rules in issuing four opinion letters declaring that laws in Georgia, New York, New Jersey, and New Mexico did not apply to national thrifts. In the New Mexico opinion, the regulator pronounced invalid New Mexico’s bans on balloon payments, negative amortization, prepayment penalties, loan flipping, and lending without regard to the borrower’s ability to repay.
+Back in 1996 the OTS had issued rules saying federal law preempted state predatory lending laws for federally regulated thrifts.65 In 2003, the OTS referred to these rules in issuing four opinion letters declaring that laws in Georgia, New York, New Jersey, and New Mexico did not apply to national thrifts. In the New Mexico opinion, the regulator pronounced invalid New Mexico’s bans on balloon payments, negative amortization, prepayment penalties, loan flipping, and lending without regard to the borrower’s ability to repay.
The Comptroller of the Currency took the same line on the national banks that it regulated, offering preemption as an inducement to use a national bank charter. In a
2002 speech, before the final OCC rules were passed, Comptroller John D. Hawke Jr.
-pointed to “national banks’ immunity from many state laws” as “a significant benefit of the national charter—a benefit that the OCC has fought hard over the years to preserve.”66 In an interview that year, Hawke explained that the potential loss of regulatory market share for the OCC “was a matter of concern.”67
+pointed to "national banks’ immunity from many state laws" as "a significant benefit of the national charter—a benefit that the OCC has fought hard over the years to preserve."66 In an interview that year, Hawke explained that the potential loss of regulatory market share for the OCC "was a matter of concern."67
-In August 200\f646 the OCC issued its first preemptive order, aimed at Georgia’s mini-HOEPA statute, and in January 2004 the OCC adopted a sweeping preemption rule applying to all state laws that interfered with or placed conditions on national banks’ ability to lend. Shortly afterward, three large banks with combined assets of more than \f6531 trillion said they would convert from state charters to national charters, which increased OCC’s annual budget 15\f642.68
+In August 2003 the OCC issued its first preemptive order, aimed at Georgia’s mini-HOEPA statute, and in January 2004 the OCC adopted a sweeping preemption rule applying to all state laws that interfered with or placed conditions on national banks’ ability to lend. Shortly afterward, three large banks with combined assets of more than $1 trillion said they would convert from state charters to national charters, which increased OCC’s annual budget 15%.68
State-chartered operating subsidiaries were another point of contention in the preemption battle. In 2001 the OCC had adopted a regulation preempting state law regarding state-chartered operating subsidiaries of national banks. In response, several large national banks moved their mortgage-lending operations into subsidiaries and asserted that the subsidiaries were exempt from state mortgage lending laws.
2007.69
-Once OCC and OTS preemption was in place, the two federal agencies were the only regulators with the power to prohibit abusive lending practices by national banks and thrifts and their direct subsidiaries. Comptroller John Dugan, who succeeded Hawke, defended preemption, noting that “72\f642 of all nonprime mortgages were made by lenders that were subject to state law. Well over half were made by mortgage lenders that were exclusively subject to state law.”70 Lisa Madigan, the attorney general of Illinois, flipped the argument around, noting that national banks and thrifts, and their subsidiaries, were heavily involved in subprime lending. Using different data, she contended: “National banks and federal thrifts and . . . their sub-THE MORTGAGE MACHINE 11\f646
-
-sidiaries . . . were responsible for almost \f6462 percent of subprime mortgage loans, 40.1
-
-percent of the Alt-A loans, and 51 percent of the pay-option and interest-only ARMs that were sold.” Madigan told the FCIC:
+Once OCC and OTS preemption was in place, the two federal agencies were the only regulators with the power to prohibit abusive lending practices by national banks and thrifts and their direct subsidiaries. Comptroller John Dugan, who succeeded Hawke, defended preemption, noting that "72% of all nonprime mortgages were made by lenders that were subject to state law. Well over half were made by mortgage lenders that were exclusively subject to state law."70 Lisa Madigan, the attorney general of Illinois, flipped the argument around, noting that national banks and thrifts, and their subsidiaries, were heavily involved in subprime lending. Using different data, she contended: "National banks and federal thrifts and . . . their subsidiaries . . . were responsible for almost 32 percent of subprime mortgage loans, 40.1 percent of the Alt-A loans, and 51 percent of the pay-option and interest-only ARMs that were sold." Madigan told the FCIC:
Even as the Fed was doing little to protect consumers and our financial system from the effects of predatory lending, the OCC and OTS were actively engaged in a campaign to thwart state efforts to avert the coming crisis. . . . In the wake of the federal regulators’ push to curtail state authority, many of the largest mortgage-lenders shed their state licenses and sought shelter behind the shield of a national charter. And I think that it is no coincidence that the era of expanded federal preemption gave rise to the worst lending abuses in our nation’s history.71
-Comptroller Hawke offered the FCIC a different interpretation: “While some critics have suggested that the OCC’s actions on preemption have been a grab for power, the fact is that the agency has simply responded to increasingly aggressive initiatives at the state level to control the banking activities of federally chartered institutions.”72
+Comptroller Hawke offered the FCIC a different interpretation: "While some critics have suggested that the OCC’s actions on preemption have been a grab for power, the fact is that the agency has simply responded to increasingly aggressive initiatives at the state level to control the banking activities of federally chartered institutions."72
MORTGAGE SECURITIES PLAYERS:
-“WALL STREET WAS VERY HUNGRY FOR OUR PRODUCT”
+"WALL STREET WAS VERY HUNGRY FOR OUR PRODUCT"
Subprime and Alt-A mortgage–backed securities depended on a complex supply chain, largely funded through short-term lending in the commercial paper and repo market—which would become critical as the financial crisis began to unfold in 2007.
These loans were increasingly collateralized not by Treasuries and GSE securities but by highly rated mortgage securities backed by increasingly risky loans. Independent mortgage originators such as Ameriquest and New Century—without access to deposits—typically relied on financing to originate mortgages from warehouse lines of credit extended by banks, from their own commercial paper programs, or from money borrowed in the repo market.
-For commercial banks such as Citigroup, warehouse lending was a multibillion-dollar business. From 2000 to 2010, Citigroup made available at any one time as much as \f6537 billion in warehouse lines of credit to mortgage originators, including \f653950 million to New Century and more than \f653\f646.5 billion to Ameriquest.7\f646 Citigroup CEO
-
-Chuck Prince told the FCIC he would not have approved, had he known. “I found out at the end of my tenure, I did not know it before, that we had some warehouse lines out to some originators. And I think getting that close to the origination function—
+For commercial banks such as Citigroup, warehouse lending was a multibillion-dollar business. From 2000 to 2010, Citigroup made available at any one time as much as $7 billion in warehouse lines of credit to mortgage originators, including $950 million to New Century and more than $3.5 billion to Ameriquest.73 Citigroup CEO
-being that involved in the origination of some of these products—is something that I wasn’t comfortable with and that I did not view as consistent with the prescription I had laid down for the company not to be involved in originating these products.”74
+Chuck Prince told the FCIC he would not have approved, had he known. "I found out at the end of my tenure, I did not know it before, that we had some warehouse lines out to some originators. And I think getting that close to the origination function—
-As early as 1998, Moody’s called the new asset-backed commercial paper (ABCP) programs “a whole new ball game.”75 As asset-backed commercial paper became a popular method to fund the mortgage business, it grew from about one-quarter to about one-half of commercial paper sold between 1997 and 2001.
+being that involved in the origination of some of these products—is something that I wasn’t comfortable with and that I did not view as consistent with the prescription I had laid down for the company not to be involved in originating these products."74
+As early as 1998, Moody’s called the new asset-backed commercial paper (ABCP) programs "a whole new ball game."75 As asset-backed commercial paper became a popular method to fund the mortgage business, it grew from about one-quarter to about one-half of commercial paper sold between 1997 and 2001.
+n 2001, only five mortgage companies borrowed a total of $4 billion through asset-backed commercial paper; in 2006, 19 entities borrowed $43 billion.76 For instance, Countrywide launched the commercial paper programs Park Granada in
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-In 2001, only five mortgage companies borrowed a total of \f6534 billion through asset-backed commercial paper; in 2006, 19 entities borrowed \f6534\f646 billion.76 For instance, Countrywide launched the commercial paper programs Park Granada in
-
-200\f646 and Park Sienna in 2004.77 By May 2007, it was borrowing \f6531\f646 billion through Park Granada and \f6535.\f646 billion through Park Sienna. These programs would house subprime and other mortgages until they were sold.78
+2003 and Park Sienna in 2004.77 By May 2007, it was borrowing $13 billion through Park Granada and $5.3 billion through Park Sienna. These programs would house subprime and other mortgages until they were sold.78
Commercial banks used commercial paper, in part, for regulatory arbitrage.
-When banks kept mortgages on their balance sheets, regulators required them to hold 4\f642 in capital to protect against loss. When banks put mortgages into off-balance-sheet entities such as commercial paper programs, there was no capital charge (in 2004, a small charge was imposed). But to make the deals work for investors, banks had to provide liquidity support to these programs, for which they earned a fee. This liquidity support meant that the bank would purchase, at a previously set price, any commercial paper that investors were unwilling to buy when it came up for renewal. During the financial crisis these promises had to be kept, eventually putting substantial pressure on banks’ balance sheets.
-
-When the Financial Accounting Standards Board, the private group that establishes standards for financial reports, responded to the Enron scandal by making it harder for companies to get off-balance-sheet treatment for these programs, the favorable capital rules were in jeopardy. The asset-backed commercial paper market stalled. Banks protested that their programs differed from the practices at Enron and should be excluded from the new standards. In 200\f646, bank regulators responded by proposing to let banks remove these assets from their balance sheets when calculating regulatory capital. The proposal would have also introduced for the first time a capital charge amounting to at most 1.6\f642 of the liquidity support banks provided to the ABCP programs. However, after strong pushback—the American Securitization Forum, an industry association, called that charge “arbitrary,” and State Street Bank complained it was “too conservative”79—regulators in 2004 announced a final rule setting the charge at up to 0.8\f642, or half the amount of the first proposal. Growth in this market resumed.
-
-Regulatory changes—in this case, changes in the bankruptcy laws—also boosted growth in the repo market by transforming the types of repo collateral. Prior to 2005, repo lenders had clear and immediate rights to their collateral following the borrower’s bankruptcy only if that collateral was Treasury or GSE securities. In the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Congress expanded that provision to include many other assets, including mortgage loans, mortgage-backed securities, collateralized debt obligations, and certain derivatives. The result was a short-term repo market increasingly reliant on highly rated non-agency mortgage-backed securities; but beginning in mid-2007, when banks and investors became skittish about the mortgage market, they would prove to be an unstable funding source (see figure 7.1). Once the crisis hit, these “illiquid, hard-to-value securities made up a greater share of the tri-party repo market than most people would have wanted,” Darryll Hendricks, a UBS executive and chair of a New York Fed task force examining the repo market after the crisis, told the Commission.80
-
-
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-THE MORTGAGE MACHINE 115
-
-Repo Borrowing
-
-Broker-dealers’ use of repo borrowing rose sharply before the crisis.
-
-IN BILLIONS OF DOLLARS
-
-$1,500
-
-1,200
-
-900
-
-600
-
-300
-
-$396
+When banks kept mortgages on their balance sheets, regulators required them to hold 4% in capital to protect against loss. When banks put mortgages into off-balance-sheet entities such as commercial paper programs, there was no capital charge (in 2004, a small charge was imposed). But to make the deals work for investors, banks had to provide liquidity support to these programs, for which they earned a fee. This liquidity support meant that the bank would purchase, at a previously set price, any commercial paper that investors were unwilling to buy when it came up for renewal. During the financial crisis these promises had to be kept, eventually putting substantial pressure on banks’ balance sheets.
-0
-
-–300
+When the Financial Accounting Standards Board, the private group that establishes standards for financial reports, responded to the Enron scandal by making it harder for companies to get off-balance-sheet treatment for these programs, the favorable capital rules were in jeopardy. The asset-backed commercial paper market stalled. Banks protested that their programs differed from the practices at Enron and should be excluded from the new standards. In 2003, bank regulators responded by proposing to let banks remove these assets from their balance sheets when calculating regulatory capital. The proposal would have also introduced for the first time a capital charge amounting to at most 1.6% of the liquidity support banks provided to the ABCP programs. However, after strong pushback—the American Securitization Forum, an industry association, called that charge "arbitrary," and State Street Bank complained it was "too conservative"79—regulators in 2004 announced a final rule setting the charge at up to 0.8%, or half the amount of the first proposal. Growth in this market resumed.
-1980
-
-1985
-
-1990
-
-1995
-
-2000
-
-2005
-
-2010
-
-NOTE: Net borrowing by broker-dealers.
-
-SOURCE: Federal Reserve Flow of Funds Report
-
-Figure 7.1
+Regulatory changes—in this case, changes in the bankruptcy laws—also boosted growth in the repo market by transforming the types of repo collateral. Prior to 2005, repo lenders had clear and immediate rights to their collateral following the borrower’s bankruptcy only if that collateral was Treasury or GSE securities. In the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Congress expanded that provision to include many other assets, including mortgage loans, mortgage-backed securities, collateralized debt obligations, and certain derivatives. The result was a short-term repo market increasingly reliant on highly rated non-agency mortgage-backed securities; but beginning in mid-2007, when banks and investors became skittish about the mortgage market, they would prove to be an unstable funding source (see figure 7.1). Once the crisis hit, these "illiquid, hard-to-value securities made up a greater share of the tri-party repo market than most people would have wanted," Darryll Hendricks, a UBS executive and chair of a New York Fed task force examining the repo market after the crisis, told the Commission.80
Our sample deal, CMLTI 2006-NC2, shows how these funding and securitization markets worked in practice. Eight banks and securities firms provided most of the money New Century needed to make the 4,499 mortgages it would sell to Citigroup.
-Most of the funds came through repo agreements from a set of banks—including Morgan Stanley (\f653424 million); Barclays Capital, a division of a U.K.-based bank (\f653221 million); Bank of America (\f653147 million); and Bear Stearns (\f65364 million).81 The financing was provided when New Century originated these mortgages; so for about two months, New Century owed these banks approximately \f653940 million secured by the mortgages. Another \f65312 million in funding came from New Century itself, including\f653\f646 million through its own commercial paper program. On August 29, 2006, Citigroup paid New Century \f653979 million for the mortgages (and accrued interest), and New Century repaid the repo lenders after keeping a \f65324 million (2.5\f642) premium.82
+Most of the funds came through repo agreements from a set of banks—including Morgan Stanley ($424 million); Barclays Capital, a division of a U.K.-based bank ($221 million); Bank of America ($147 million); and Bear Stearns ($64 million).81 The financing was provided when New Century originated these mortgages; so for about two months, New Century owed these banks approximately $940 million secured by the mortgages. Another $12 million in funding came from New Century itself, including$3 million through its own commercial paper program. On August 29, 2006, Citigroup paid New Century $979 million for the mortgages (and accrued interest), and New Century repaid the repo lenders after keeping a $24 million (2.5%) premium.82
The investors in the deal
Investors for mortgage-backed securities came from all over the globe; what made securitization work were the customized tranches catering to every one of them.
-CMLTI 2006-NC2 had 19 tranches, whose investors are shown in figure 7.2. Fannie Mae bought the entire \f653155 million triple-A-rated A1 tranche, which paid a better return than super-safe U.S. Treasuries.8\f646 The other triple-A-rated tranches, worth
-
-
-
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-
-Selected Investors in CMLTI 2006-NC2
-
-A wide variety of investors throughout the world purchased the securities in this deal, including Fannie Mae, many international banks, SIVs and many CDOs.
-
-Tranche
-
-Original Balance
-
-Original
-
-Spread2
-
-Selected Investors
-
-(MILLIONS)
-
-Rating1
-
-A1
-
-$154.6 AAA
-
-0.14%
-
-Fannie
-
-Mae
-
-A2-A
-
-$281.7
-
-AAA
-
-0.04%
-
-Chase Security Lendings Asset
-
-Management; 1 investment fund
-
-in China; 6 investment funds
-
-78%
-
-A2-B
-
-$282.4
-
-AAA
-
-0.06%
-
-Federal Home Loan Bank of
-
-SENIOR
-
-Chicago; 3 banks in Germany,
-
-Italy and France; 11 investment
-
-funds; 3 retail investors
-
-A2-C
-
-$18.3 AAA
-
-0.24%
-
-2 banks in the U.S. and Germany
-
-M-1
-
-$39.3
-
-AA+
-
-0.29%
-
-1 investment fund and 2
-
-banks in Italy; Cheyne Finance
-
-Limited; 3 asset managers
-
-M-2
-
-$44 .0
-
-AA
-
-0.31%
-
-Parvest ABS Euribor; 4 asset
-
-managers; 1 bank in China;
-
-1 CDO
-
-M-3
-
-$14.2
-
-AA-
-
-0.34%
-
-2 CDOs; 1 asset manager
-
-M-4
-
-$16.1
-
-A+
-
-0.39%
-
-1 CDO; 1 hedge fund
+CMLTI 2006-NC2 had 19 tranches, whose investors are shown in figure 7.2. Fannie Mae bought the entire $155 million triple-A-rated A1 tranche, which paid a better return than super-safe U.S. Treasuries.83 The other triple-A-rated tranches, worth $582 million, went to more than 20 institutional investors around the world, spreading the risk globally.84 These triple-A tranches represented 78% of the deal. Among the buyers were foreign banks and funds in China, Italy, France, and Germany; the Federal Home Loan Bank of Chicago; the Kentucky Retirement Systems; a hospital; and JP Morgan, which purchased part of the tranche using cash from its securities-lending operation.85 (In other words, JP Morgan lent securities held by its clients to other financial institutions in exchange for cash collateral, and then put that cash to work investing in this deal. Securities lending was a large, but ultimately unstable, source of cash that flowed into this market.)
-21%
-
-M-5
-
-$16.6
-
-A
-
-0.40%
-
-2 CDOs
-
-MEZZANINE
-
-M-6
-
-$10.9
-
-A-
-
-0.46%
-
-3 CDOs
-
-M-7
-
-$9.9
-
-BBB+
-
-0.70%
-
-3 CDOs
-
-M-8
-
-$8.5
-
-BBB
-
-0.80%
-
-2 CDOs; 1 bank
-
-M-9
-
-$11.8
-
-BBB-
-
-1.50%
-
-5 CDOs; 2 asset managers
-
-M-10
-
-$13.7
-
-BB+
-
-2.50%
-
-3 CDOs; 1 asset manager
-
-M-11
-
-$10.9 BB
-
-2.50%
-
-NA
-
-CE
-
-$13.3
-
-NR
+The middle, mezzanine tranches in this deal constituted about 21% of the total value of the security. If losses rose above 1% to 3% (by design the threshold would increase over time), investors in the residual tranches would be wiped out, and the mezzanine investors would start to lose money. Creators of collateralized debt obligations, or CDOs—discussed in the next chapter—bought most of the mezzanine tranches rated below triple-A and nearly all those rated below AA. Only a few of the highest-rated mezzanine tranches were not put into CDOs. For example, Cheyne Finance Limited purchased $7 million of the top mezzanine tranche. Cheyne—a structured investment vehicle (SIV)—would be one of the first casualties of the crisis, sparking panic during the summer of 2007. Parvest ABS Euribor, which purchased
-Citi and Capmark Fin Grp
+$20 million of the second mezzanine tranche,86 would be one of the BNP Paribas funds which helped ignite the financial crisis that summer.87
-UITY
+Typically, investors seeking high returns, such as hedge funds, would buy the equity tranches of mortgage-backed securities; they would be the first to lose if there were problems. These investors anticipated returns of 15%, 20%, or even 30%. Citigroup retained part of the residual or "first-loss" tranches, sharing the rest with Capmark Financial Group.88
-1%
-
-Q
-
-P, R, Rx: Additional tranches entitled to specific payments E
-
-1 Standard & Poor’s.
-
-2 The yield is the rate on the one-month London Interbank Offered Rate (LIBOR), an interbank lending interest rate, plus the spread listed. For example, when the deal was issued, Fannie Mae would have received the LIBOR rate of 5.32% plus 0.14% to give a total yield of 5.46%.
-
-SOURCES: Citigroup; Standard & Poor’s; FCIC calculations Figure 7.2
-
-
-
-THE MORTGAGE MACHINE 117
-
-\f653582 million, went to more than 20 institutional investors around the world, spreading the risk globally.84 These triple-A tranches represented 78\f642 of the deal. Among the buyers were foreign banks and funds in China, Italy, France, and Germany; the Federal Home Loan Bank of Chicago; the Kentucky Retirement Systems; a hospital; and JP Morgan, which purchased part of the tranche using cash from its securities-lending operation.85 (In other words, JP Morgan lent securities held by its clients to other financial institutions in exchange for cash collateral, and then put that cash to work investing in this deal. Securities lending was a large, but ultimately unstable, source of cash that flowed into this market.)
-
-The middle, mezzanine tranches in this deal constituted about 21\f642 of the total value of the security. If losses rose above 1\f642 to \f646\f642 (by design the threshold would increase over time), investors in the residual tranches would be wiped out, and the mezzanine investors would start to lose money. Creators of collateralized debt obligations, or CDOs—discussed in the next chapter—bought most of the mezzanine tranches rated below triple-A and nearly all those rated below AA. Only a few of the highest-rated mezzanine tranches were not put into CDOs. For example, Cheyne Finance Limited purchased \f6537 million of the top mezzanine tranche. Cheyne—a structured investment vehicle (SIV)—would be one of the first casualties of the crisis, sparking panic during the summer of 2007. Parvest ABS Euribor, which purchased
-
-\f65320 million of the second mezzanine tranche,86 would be one of the BNP Paribas funds which helped ignite the financial crisis that summer.87
-
-Typically, investors seeking high returns, such as hedge funds, would buy the equity tranches of mortgage-backed securities; they would be the first to lose if there were problems. These investors anticipated returns of 15\f642, 20\f642, or even \f6460\f642. Citigroup retained part of the residual or “first-loss” tranches, sharing the rest with Capmark Financial Group.88
-
-“Compensated very well”
+"Compensated very well"
The business of structuring, selling, and distributing this deal, and the thousands like it, was lucrative for the banks. The mortgage originators profited when they sold loans for securitization.89 Some of this profit flowed down to employees—particularly those generating mortgage volume.
-Part of the \f65324 million premium received by New Century for the deal we analyzed went to pay the many employees who participated. “The originators, the loan officers, account executives, basically the salespeople [who] were the reason our loans came in . . . were compensated very well,” New Century’s Patricia Lindsay told the FCIC. And volume mattered more than quality. She noted, “Wall Street was very hungry for our product. We had our loans sold three months in advance, before they were even made at one point.”90
-
-Similar incentives were at work at Long Beach Mortgage, the subprime division of Washington Mutual, which organized its 2004 Incentive Plan by volume. As WaMu showed in a 2007 plan, “Home Loans Product Strategy,” the goals were also product-specific: to drive “growth in higher margin products (Option ARM, Alt A, Home Equity,
-
-
+Part of the $24 million premium received by New Century for the deal we analyzed went to pay the many employees who participated. "The originators, the loan officers, account executives, basically the salespeople [who] were the reason our loans came in . . . were compensated very well," New Century’s Patricia Lindsay told the FCIC. And volume mattered more than quality. She noted, "Wall Street was very hungry for our product. We had our loans sold three months in advance, before they were even made at one point."90
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+Similar incentives were at work at Long Beach Mortgage, the subprime division of Washington Mutual, which organized its 2004 Incentive Plan by volume. As WaMu showed in a 2007 plan, "Home Loans Product Strategy," the goals were also product-specific: to drive "growth in higher margin products (Option ARM, Alt A, Home Equity,
-Subprime),” “recruit and leverage seasoned Option ARM sales force,” and “maintain a compensation structure that supports the high margin product strategy.”91
+ubprime)," "recruit and leverage seasoned Option ARM sales force," and "maintain a compensation structure that supports the high margin product strategy."91
-After structuring a security, an underwriter, often an investment bank, marketed and sold it to investors. The bank collected a percentage of the sale (generally between 0.2\f642 and 1.5\f642) as discounts, concessions, or commissions.92 For a \f6531 billion deal like CMLTI 2006-NC2, a 1\f642 fee would earn Citigroup \f65310 million. In this case, though, Citigroup instead kept parts of the residual tranches. Doing so could yield large profits as long as the deal performed as expected.
+After structuring a security, an underwriter, often an investment bank, marketed and sold it to investors. The bank collected a percentage of the sale (generally between 0.2% and 1.5%) as discounts, concessions, or commissions.92 For a $1 billion deal like CMLTI 2006-NC2, a 1% fee would earn Citigroup $10 million. In this case, though, Citigroup instead kept parts of the residual tranches. Doing so could yield large profits as long as the deal performed as expected.
-Options Group, which compiles compensation figures for investment banks, examined the mortgage-backed securities sales and trading desks at 11 commercial and investment banks from 2005 to 2007.9\f646 It found that associates had average annual base salaries of \f65365,000 to \f65390,000 from 2005 through 2007, but received bonuses that could well exceed their salaries. On the next rung, vice presidents averaged base salaries and bonuses from \f653200,000 to \f6531,150,000. Directors averaged \f653625,000 to \f6531,625,000.94 At the top was the head of the unit. For example, in 2006, Dow Kim, the head of Merrill’s Global Markets and Investment Banking segment, received a base salary of \f653\f64650,000
+Options Group, which compiles compensation figures for investment banks, examined the mortgage-backed securities sales and trading desks at 11 commercial and investment banks from 2005 to 2007.93 It found that associates had average annual base salaries of $65,000 to $90,000 from 2005 through 2007, but received bonuses that could well exceed their salaries. On the next rung, vice presidents averaged base salaries and bonuses from $200,000 to $1,150,000. Directors averaged $625,000 to $1,625,000.94 At the top was the head of the unit. For example, in 2006, Dow Kim, the head of Merrill’s Global Markets and Investment Banking segment, received a base salary of $350,000
-plus a \f653\f6465 million bonus, a package second only to Merrill Lynch’s CEO.95
+plus a $35 million bonus, a package second only to Merrill Lynch’s CEO.95
-MOODY’S: “GIVEN A BLANK CHECK”
+MOODY’S: "GIVEN A BLANK CHECK"
The rating agencies were essential to the smooth functioning of the mortgage-backed securities market. Issuers needed them to approve the structure of their deals; banks needed their ratings to determine the amount of capital to hold; repo markets needed their ratings to determine loan terms; some investors could buy only securities with a triple-A rating; and the rating agencies’ judgment was baked into collateral agreements and other financial contracts. To examine the rating process, the Commission focused on Moody’s Investors Service, the largest and oldest of the three rating agencies.
To do its work, Moody’s rated mortgage-backed securities using models based, in part, on periods of relatively strong credit performance. Moody’s did not sufficiently account for the deterioration in underwriting standards or a dramatic decline in home prices. And Moody’s did not even develop a model specifically to take into account the layered risks of subprime securities until late 2006, after it had already rated nearly 19,000 subprime securities.98
-“In the business forevermore”
-
-Credit ratings have been linked to government regulations for three-quarters of a century.99 In 19\f6461, the Office of the Comptroller of the Currency let banks report publicly traded bonds with a rating of BBB or better at book value (that is, the price THE MORTGAGE MACHINE 119
+"In the business forevermore"
-they paid for the bonds); lower-rated bonds had to be reported at current market prices, which might be lower. In 1951, the National Association of Insurance Commissioners adopted higher capital requirements on lower-rated bonds held by insurers.100 But the watershed event in federal regulation occurred in 1975, when the Securities and Exchange Commission modified its minimum capital requirements for broker-dealers to base them on credit ratings by a “nationally recognized statistical rating organization” (NRSRO); at the time, that was Moody’s, S&P, or Fitch. Ratings are also built into banking capital regulations under the Recourse Rule, which, since 2001, has permitted banks to hold less capital for higher-rated securities. For example, BBB rated securities require five times as much capital as AAA and AA rated securities, and BB securities require ten times more capital. Banks in some countries were subject to similar requirements under the Basel II international capital agreement, signed in June 2004, although U.S. banks had not fully implemented the advanced approaches allowed under those rules.
+Credit ratings have been linked to government regulations for three-quarters of a century.99 In 1931, the Office of the Comptroller of the Currency let banks report publicly traded bonds with a rating of BBB or better at book value (that is, the price they paid for the bonds); lower-rated bonds had to be reported at current market prices, which might be lower. In 1951, the National Association of Insurance Commissioners adopted higher capital requirements on lower-rated bonds held by insurers.100 But the watershed event in federal regulation occurred in 1975, when the Securities and Exchange Commission modified its minimum capital requirements for broker-dealers to base them on credit ratings by a "nationally recognized statistical rating organization" (NRSRO); at the time, that was Moody’s, S&P, or Fitch. Ratings are also built into banking capital regulations under the Recourse Rule, which, since 2001, has permitted banks to hold less capital for higher-rated securities. For example, BBB rated securities require five times as much capital as AAA and AA rated securities, and BB securities require ten times more capital. Banks in some countries were subject to similar requirements under the Basel II international capital agreement, signed in June 2004, although U.S. banks had not fully implemented the advanced approaches allowed under those rules.
-Credit ratings also determined whether investors could buy certain investments at all. The SEC restricts money market funds to purchasing “securities that have received credit ratings from any two NRSROs . . . in one of the two highest short-term rating categories or comparable unrated securities.”101 The Department of Labor restricts pension fund investments to securities rated A or higher. Credit ratings affect even private transactions: contracts may contain triggers that require the posting of collateral or immediate repayment, should a security or entity be downgraded. Triggers played an important role in the financial crisis and helped cripple AIG.
+Credit ratings also determined whether investors could buy certain investments at all. The SEC restricts money market funds to purchasing "securities that have received credit ratings from any two NRSROs . . . in one of the two highest short-term rating categories or comparable unrated securities."101 The Department of Labor restricts pension fund investments to securities rated A or higher. Credit ratings affect even private transactions: contracts may contain triggers that require the posting of collateral or immediate repayment, should a security or entity be downgraded. Triggers played an important role in the financial crisis and helped cripple AIG.
-Importantly for the mortgage market, the Secondary Mortgage Market Enhancement Act of 1984 permitted federal- and state-chartered financial institutions to invest in mortgage-related securities if the securities had high ratings from at least one rating agency. “Look at the language of the original bill,” Lewis Ranieri told the FCIC.
+Importantly for the mortgage market, the Secondary Mortgage Market Enhancement Act of 1984 permitted federal- and state-chartered financial institutions to invest in mortgage-related securities if the securities had high ratings from at least one rating agency. "Look at the language of the original bill," Lewis Ranieri told the FCIC.
-“It requires a rating. . . . It put them in the business forevermore. It became one of the biggest, if not the biggest, business.”102 As Eric Kolchinsky, a former Moody’s managing director, would summarize the situation, “the rating agencies were given a blank check.”10\f646
+"It requires a rating. . . . It put them in the business forevermore. It became one of the biggest, if not the biggest, business."102 As Eric Kolchinsky, a former Moody’s managing director, would summarize the situation, "the rating agencies were given a blank check."103
The agencies themselves were able to avoid regulation for decades. Beginning in
-1975, the SEC had to approve a company’s application to become an NRSRO—but if approved, a company faced no further regulation. More than \f6460 years later, the SEC
+1975, the SEC had to approve a company’s application to become an NRSRO—but if approved, a company faced no further regulation. More than 30 years later, the SEC
got limited authority to oversee NRSROs in the Credit Rating Agency Reform Act of
-2006. That law, taking effect in June 2007, focused on mandatory disclosure of the rating agencies’ methodologies; however, the law barred the SEC from regulating “the substance of the credit ratings or the procedures and methodologies.”104
+2006. That law, taking effect in June 2007, focused on mandatory disclosure of the rating agencies’ methodologies; however, the law barred the SEC from regulating "the substance of the credit ratings or the procedures and methodologies."104
Many investors, such as some pension funds and university endowments, relied on credit ratings because they had neither access to the same data as the rating agencies nor the capacity or analytical ability to assess the securities they were purchasing.
-As Moody’s former managing director Jerome Fons has acknowledged, “Subprime
-
-[residential mortgage–backed securities] and their offshoots offer little transparency around composition and characteristics of the loan collateral. . . . Loan-by-loan data, the highest level of detail, is generally not available to investors.”105 Others, even large
-
+As Moody’s former managing director Jerome Fons has acknowledged, "Subprime
-
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-
-financial institutions, relied on the ratings. Still, some investors who did their home-work were skeptical of these products despite their ratings. Arnold Cattani, chairman of Mission Bank in Bakersfield, California, described deciding to sell the bank’s holdings of mortgage-backed securities and CDOs:
+[residential mortgage–backed securities] and their offshoots offer little transparency around composition and characteristics of the loan collateral. . . . Loan-by-loan data, the highest level of detail, is generally not available to investors."105 Others, even large inancial institutions, relied on the ratings. Still, some investors who did their home-work were skeptical of these products despite their ratings. Arnold Cattani, chairman of Mission Bank in Bakersfield, California, described deciding to sell the bank’s holdings of mortgage-backed securities and CDOs:
At one meeting, when things started getting difficult, maybe in 2006, I asked the CFO what the mechanical steps were in . . . mortgage-backed securities, if a borrower in Des Moines, Iowa, defaulted. I know what it is if a borrower in Bakersfield defaults, and somebody has that mortgage. But as a package security, what happens1 And he couldn’t answer the question. And I told him to sell them, sell all of them, then, because we didn’t understand it, and I don’t know that we had the capability to understand the financial complexities; didn’t want any part of it.106
-Notably, rating agencies were not liable for misstatements in securities registra-tions because courts ruled that their ratings were opinions, protected by the First Amendment. Moody’s standard disclaimer reads “The ratings . . . are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell, or hold any securities.” Gary Witt, a former team managing director at Moody’s, told the FCIC, “People expect too much from ratings . . . investment decisions should always be based on much more than just a rating.”107
+Notably, rating agencies were not liable for misstatements in securities registra-tions because courts ruled that their ratings were opinions, protected by the First Amendment. Moody’s standard disclaimer reads "The ratings . . . are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell, or hold any securities." Gary Witt, a former team managing director at Moody’s, told the FCIC, "People expect too much from ratings . . . investment decisions should always be based on much more than just a rating."107
-“Everything but the elephant sitting on the table” The ratings were intended to provide a means of comparing risks across asset classes and time. In other words, the risk of a triple-A rated mortgage security was supposed to be similar to the risk of a triple-A rated corporate bond.
+"Everything but the elephant sitting on the table" The ratings were intended to provide a means of comparing risks across asset classes and time. In other words, the risk of a triple-A rated mortgage security was supposed to be similar to the risk of a triple-A rated corporate bond.
-Since the mid-1990s, Moody’s has rated tranches of mortgage-backed securities using three models. The first, developed in 1996, rated residential mortgage–backed securities. In 200\f646, Moody’s created a new model, M\f646 Prime, to rate prime, jumbo, and Alt-A deals. Only in the fall of 2006, when the housing market had already peaked, did it develop its model for rating subprime deals, called M\f646 Subprime.108
+Since the mid-1990s, Moody’s has rated tranches of mortgage-backed securities using three models. The first, developed in 1996, rated residential mortgage–backed securities. In 2003, Moody’s created a new model, M3 Prime, to rate prime, jumbo, and Alt-A deals. Only in the fall of 2006, when the housing market had already peaked, did it develop its model for rating subprime deals, called M3 Subprime.108
-The models incorporated firm- and security-specific factors, market factors, regulatory and legal factors, and macroeconomic trends. The M\f646 Prime model let Moody’s automate more of the process. Although Moody’s did not sample or review individual loans, the company used loan-level information from the issuer. Relying on loan-to-value ratios, borrower credit scores, originator quality, and loan terms and other information, the model simulated the performance of each loan in 1,250
+The models incorporated firm- and security-specific factors, market factors, regulatory and legal factors, and macroeconomic trends. The M3 Prime model let Moody’s automate more of the process. Although Moody’s did not sample or review individual loans, the company used loan-level information from the issuer. Relying on loan-to-value ratios, borrower credit scores, originator quality, and loan terms and other information, the model simulated the performance of each loan in 1,250
-scenarios, including variations in interest rates and state-level unemployment as well as home price changes. On average, across the scenarios, home prices trended upward at approximately 4\f642 per year.109 The model put little weight on the possibility prices would fall sharply nationwide. Jay Siegel, a former Moody’s team managing director involved in developing the model, told the FCIC, “There may have been [state-level] components of this real estate drop that the statistics would have covered, but THE MORTGAGE MACHINE 121
+scenarios, including variations in interest rates and state-level unemployment as well as home price changes. On average, across the scenarios, home prices trended upward at approximately 4% per year.109 The model put little weight on the possibility prices would fall sharply nationwide. Jay Siegel, a former Moody’s team managing director involved in developing the model, told the FCIC, "There may have been [state-level] components of this real estate drop that the statistics would have covered, but the 38% national drop, staying down over this short but multiple-year period, is more stressful than the statistics call for." Even as housing prices rose to unprecedented levels, Moody’s never adjusted the scenarios to put greater weight on the possibility of a decline. According to Siegel, in 2005, "Moody’s position was that there was not a . . .
-the \f6468\f642 national drop, staying down over this short but multiple-year period, is more stressful than the statistics call for.” Even as housing prices rose to unprecedented levels, Moody’s never adjusted the scenarios to put greater weight on the possibility of a decline. According to Siegel, in 2005, “Moody’s position was that there was not a . . .
+national housing bubble."110
-national housing bubble.”110
+When the initial quantitative analysis was complete, the lead analyst on the deal convened a rating committee of other analysts and managers to assess it and determine the overall ratings for the securities.111 Siegel told the FCIC that qualitative analysis was also integral: "One common misperception is that Moody’s credit ratings are derived solely from the application of a mathematical process or model. This is not the case. . . . The credit rating process involves much more—most importantly, the exercise of independent judgment by members of the rating committee. Ultimately, ratings are subjective opinions that reflect the majority view of the committee’s members."112 As Roger Stein, a Moody’s managing director, noted, "Overall, the model has to contemplate events for which there is no data."113
-When the initial quantitative analysis was complete, the lead analyst on the deal convened a rating committee of other analysts and managers to assess it and determine the overall ratings for the securities.111 Siegel told the FCIC that qualitative analysis was also integral: “One common misperception is that Moody’s credit ratings are derived solely from the application of a mathematical process or model. This is not the case. . . . The credit rating process involves much more—most importantly, the exercise of independent judgment by members of the rating committee. Ultimately, ratings are subjective opinions that reflect the majority view of the committee’s members.”112 As Roger Stein, a Moody’s managing director, noted, “Overall, the model has to contemplate events for which there is no data.”11\f646
+After rating subprime deals with the 1996 model for years, in 2006 Moody’s introduced a parallel model for rating subprime mortgage–backed securities. Like M3
-After rating subprime deals with the 1996 model for years, in 2006 Moody’s introduced a parallel model for rating subprime mortgage–backed securities. Like M\f646
+Prime, the subprime model ran the mortgages through 1,250 scenarios.114 Moody’s officials told the FCIC they recognized that stress scenarios were not sufficiently severe, so they applied additional weight to the most stressful scenario, which reduced the portion of each deal rated triple-A. Stein, who helped develop the subprime model, said the output was manually "calibrated" to be more conservative to ensure predicted losses were consistent with analysts’ "expert views." Stein also noted Moody’s concern about a suitably negative stress scenario; for example, as one step, analysts took the "single worst case" from the M3 Subprime model simulations and multiplied it by a factor in order to add deterioration.115
-Prime, the subprime model ran the mortgages through 1,250 scenarios.114 Moody’s officials told the FCIC they recognized that stress scenarios were not sufficiently severe, so they applied additional weight to the most stressful scenario, which reduced the portion of each deal rated triple-A. Stein, who helped develop the subprime model, said the output was manually “calibrated” to be more conservative to ensure predicted losses were consistent with analysts’ “expert views.” Stein also noted Moody’s concern about a suitably negative stress scenario; for example, as one step, analysts took the “single worst case” from the M\f646 Subprime model simulations and multiplied it by a factor in order to add deterioration.115
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-Moody’s did not, however, sufficiently account for the deteriorating quality of the loans being securitized. Fons described this problem to the FCIC: “I sat on this high-level Structured Credit committee, which you’d think would be dealing with such issues [of declining mortgage-underwriting standards], and never once was it raised to this group or put on our agenda that the decline in quality that was going into pools, the impact possibly on ratings, other things. . . . We talked about everything but, you know, the elephant sitting on the table.”116
+Moody’s did not, however, sufficiently account for the deteriorating quality of the loans being securitized. Fons described this problem to the FCIC: "I sat on this high-level Structured Credit committee, which you’d think would be dealing with such issues [of declining mortgage-underwriting standards], and never once was it raised to this group or put on our agenda that the decline in quality that was going into pools, the impact possibly on ratings, other things. . . . We talked about everything but, you know, the elephant sitting on the table."116
To rate CMLTI 2006-NC2, our sample deal, Moody’s first used its model to simulate losses in the mortgage pool. Those estimates, in turn, determined how big the junior tranches of the deal would have to be in order to protect the senior tranches from losses. In analyzing the deal, the lead analyst noted it was similar to another Citigroup deal of New Century loans that Moody’s had rated earlier and recommended the same amount.117 Then the deal was tweaked to account for certain riskier types of loans, including interest-only mortgages.118 For its efforts, Moody’s was paid an estimated
-\f653208,000.119 (S&P also rated this deal and received \f6531\f6465,000.)120
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-As we will describe later, three tranches of this deal would be downgraded less than a year after issuance—part of Moody’s mass downgrade on July 10, 2007, when housing prices had declined by only 4\f642. In October 2007, the M4–M11 tranches
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+$208,000.119 (S&P also rated this deal and received $135,000.)120
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-122
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-FINANCIAL CRISIS INQUIRY COMMISSION REPORT
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-were downgraded and by 2008, all the tranches had been downgraded. Of all mortgage-backed securities it had rated triple-A in 2006, Moody’s downgraded 7\f646\f642 to junk.121 The consequences would reverberate throughout the financial system.
+As we will describe later, three tranches of this deal would be downgraded less than a year after issuance—part of Moody’s mass downgrade on July 10, 2007, when housing prices had declined by only 4%. In October 2007, the M4–M11 tranches ere downgraded and by 2008, all the tranches had been downgraded. Of all mortgage-backed securities it had rated triple-A in 2006, Moody’s downgraded 73% to junk.121 The consequences would reverberate throughout the financial system.
FANNIE MAE AND FREDDIE MAC:
-“LESS COMPETITIVE IN THE MARKETPLACE”
+"LESS COMPETITIVE IN THE MARKETPLACE"
-In 2004, Fannie and Freddie faced problems on multiple fronts. They had violated accounting rules and now faced corrections and fines.122 They were losing market share to Wall Street, which was beginning to dominate the securitization market. Struggling to remain dominant, they loosened their underwriting standards, purchasing and guaranteeing riskier loans, and increasing their securities purchases.12\f646 Yet their regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), focused more on accounting and other operational issues than on Fannie’s and Freddie’s increasing investments in risky mortgages and securities.
+In 2004, Fannie and Freddie faced problems on multiple fronts. They had violated accounting rules and now faced corrections and fines.122 They were losing market share to Wall Street, which was beginning to dominate the securitization market. Struggling to remain dominant, they loosened their underwriting standards, purchasing and guaranteeing riskier loans, and increasing their securities purchases.123 Yet their regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), focused more on accounting and other operational issues than on Fannie’s and Freddie’s increasing investments
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