From: dsc Date: Thu, 22 Dec 2011 03:12:39 +0000 (-0800) Subject: Haikus. X-Git-Url: http://git.less.ly:3516/?a=commitdiff_plain;h=654c0e15965bb48c60a58260c3cd7568977194a3;p=crisishaiku.git Haikus. --- diff --git a/data/haikus/haikus-fav.txt b/data/haikus/haikus-fav.txt new file mode 100644 index 0000000..19b6d72 --- /dev/null +++ b/data/haikus/haikus-fav.txt @@ -0,0 +1,279 @@ +On line 24: + Commission’s public + hearings, testimony, and + supporting research—that + + can be studied for + years to come. Much of what is + footnoted in this + + can be found on the + website. In addition, more + materials that + + cannot be released + yet for various reasons + will eventually + + made public through the + National Archives and Records + Administration. + + + +On line 26: + extraordinary + commitment and knowledge of + the members of the + + Commission who were + accorded the honor of + this public service. + + + +On line 40: + American people. + We are keenly aware of the + significance of + + +On line 46: + financial upheaval, + if you will—that wreaked havoc in + communities and + + neighborhoods across this + country. As this report goes + to print, there are more + + million Americans + who are out of work, cannot + find full-time work, + + up looking for work. + About four million families + have lost their homes to + + their mortgage payments. + Nearly trillion in household + wealth has vanished, with + + and life savings swept + away. Businesses, large and small, + have felt the sting of + + 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 + + about their future prospects. + The collateral damage + of this crisis has + + been real people + and real communities. + The impacts of this + + are likely to be + felt for a generation. + And the nation faces + + so many Americans, + we began our exploration + with our own views and + + how the world’s strongest + financial system came to + the brink of collapse. + + + +On line 50: + 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. + + + +On line 52: + the total collapse + of our financial system + and economy or + + +On line 20: + what caused the crisis. + In that sense, the Commission + has functioned somewhat + + + +On line 20: + the federal law + (the Troubled Asset Relief + Program, known as TARP) + + + +On line 467: + U.S. Congress that "the + apparent froth in housing + markets may have spilled + + + +On line 467: + Still, he reassured + legislators that the U.S. + economy was on + + + +On line 4799: + you get to the end + of the week, you go out and + you refinance that + + And then you get to + the end of another week + and you refinance + + + +On line 4815: + did not indicate + substantial deficiencies. + He wasn’t looking + + + +On line 4817: + a former senior + managing director at + Bear Stearns, said, "I guess + + + +On line 7855: + Firms and families + are still deleveraging and are + uncertain about both + + + +On line 4053: + the head of credit + trading at AIG Financial + Products, told Alan Frost, + + "every f***ing rating + agency we’ve spoken to [came] + out with more downgrades" + + + +On line 4053: + mark it. It’s, it’s, uh, + we’re [unintelligible] + f***ed basically." + + + +On line 4073: + that "[AIG] would be in + fine shape if Goldman wasn’t + hanging its head out + + + +On line 4073: + f***ing number that’s well + bigger than we ever planned + for." He acknowledged + + + +On line 5235: + referred to it as + "bullsh*t capital." Still, the + GSEs kept buying more + + + +On line 5949: + I think that was sort + of pie in the sky dreaming." + Geithner agreed, + + and told Reich so + bluntly. Reich told the FCIC + about a phone call from + + after the rescue. + "About all I can remember + is the foul language + + + +On line 5951: + Geithner telling + him. "‘You guys have handed me + a bag of sh*t.’ I + + + +On line 5957: + selecting a weak + federal regulator, + the Office of Thrift + + + +On line 4209: + Central Bank infused + billions of Euros into + overnight lending markets. + + + +On line 4243: + known as "breaking the + buck" and generally leads + to a fund’s collapse. + + + +On line 4245: + including large banks + such as Bank of America, + US Bancorp, and SunTrust, + + + +On line 4245: + US Bancorp, and SunTrust, + purchased SIV assets from their + money market funds. + + + +On line 4249: + which may include wealthy + investors who invest million + or more. Enhanced cash + + + diff --git a/data/haikus/haikus-longest_chains.txt b/data/haikus/haikus-longest_chains.txt new file mode 100644 index 0000000..49574eb --- /dev/null +++ b/data/haikus/haikus-longest_chains.txt @@ -0,0 +1,258 @@ +Longest Chains of Haikus + +- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - + + loans. Nevertheless, + subprime loans were necessary + for PMBS, because they + + generally bore + higher interest rates and + thus could support the + + yields that investors were + expecting. As subprime loans + were originated, + + Fannie and Freddie + were willing consumers of those + that might meet the AH + + goals; moreover, because + of their lower cost of funds, + they were able to buy + + the "best of the worst," + the highest quality among + the NTMs on off er. + + Th ese factors—the + need for higher yielding loans + and the ability + +- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - + + 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 + +- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - + + 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 + +- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - + + former senior vice + president, testified to + the FCIC. "When I left + + Moody’s, an analyst’s + worst fear was that he would do + something, or she, that + + would allow him or + her to be singled out for + jeopardizing Moody’s + + market share."123 Clarkson + denied having a "forceful" + management style, and + + his supervisor, + Raymond McDaniel, told the FCIC that + Clarkson was a "good + + manager."124 Former + team managing director + Gary Witt recalled that + +- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - + + billion) to billion) + without engendering the + substantial increase + + in delinquencies that + would ordinarily have + alarmed investors and brought + + the bubble to a + halt.46 Indeed, the absence of + delinquencies had the + + opposite eff ect. + As investors around the world saw + housing prices rise in + + the U.S. without any + signifi cant losses even among + subprime and other + + high-yielding loans, they + were encouraged to buy PMBS + that—although rated AAA—still off + +- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - + + at the Financial + Services Roundtable in early + "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 + +- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - + + an Industrial + Loan Company," November + pp. To approve such + + a proposal, the + Bank Holding Company Act + requires the Fed to + + determine that a + transaction "can reasonably + be expected to + + produce benefits + to the public, such as greater + convenience, increased + + competition, or + gains in efficiency, that + outweigh possible + + adverse effects, such + as undue concentration + of resources, decreased + +- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - + + PMBS. Losses of this + magnitude would certainly + be enough—when combined + + with other losses + on securities and loans + not related to + + mortgages—to call into + question the stability + of a large number + + of banks, investment + banks and other fi nancial + institutions in + + the U.S. and around the + world. However, there was one + other factor that + + exacerbated + the adverse eff ect of the + loss of a market + +- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - + + were generally + prime mortgages, did not suff er + substantial losses + + at the outset of + the mortgage meltdown, although + as the fi nancial + + crisis turned into + a recession and housing + prices continued to + + fall, losses among prime + mortgages began to approach + the level of prime + + mortgage losses that + had occurred in past housing + crises. However, those + +- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - + + true, in part, because + CRA loans are generally + loans to low income + + individuals; + as such, they are more likely + than loans to middle + + income borrowers + to be subprime and Alt-A loans + and thus sought aft er + + by FHA, Fannie and + Freddie and subprime lenders such + as Countrywide; this + + competition is + another reason why their + rates are likely to + diff --git a/data/haikus/haikus-no_overlap.txt b/data/haikus/haikus-no_overlap.txt new file mode 100644 index 0000000..947f07b --- /dev/null +++ b/data/haikus/haikus-no_overlap.txt @@ -0,0 +1,96309 @@ +Found 19940 haiku... + +On line 4: + current financial + and economic crisis in + the United States." In + +On line 4: + 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 + +On line 6: + financial crisis, + our economy, as well as + communities and + +On line 6: + the after-shocks. Millions + of Americans have lost their + jobs and their homes, and + +On line 6: + rebound. This report + is intended to provide + a historical + + accounting of what + brought our financial system + and economy to + +On line 8: + better understand + how this calamity came to be. + The Commission was + +On line 8: + as part of the Fraud + Enforcement and Recovery + Act (Public Law 111-21) + +On line 10: + by Congress and signed + by the President in May + This independent, + +On line 10: + panel was composed + of private citizens with + experience in + +On line 10: + banking, and consumer + protection. Six members of + the Commission were + +On line 10: + by the Democratic + leadership of Congress and + four members by the + +On line 12: + specific topics + for inquiry and called for the + examination + +On line 12: + collapse of major + financial institutions + that failed or would have + +On line 12: + the government. This + report fulfills these mandates. + In addition, the + +On line 12: + was instructed to + refer to the attorney + general of the + +On line 12: + any appropriate + state attorney general + any person that the + + Commission found may + have violated the laws + of the United States + +On line 12: + relation to the + crisis. Where the Commission + found such potential + +On line 12: + The Commission used + the authority it was + given to issue + +On line 12: + and the production + of documents, but in the + vast majority + +On line 14: + voluntarily + cooperated with this + inquiry. In the course + +On line 14: + millions of pages of + documents, interviewed more + than witnesses, and + +On line 14: + of public hearings + in New York, Washington, D.C., + and communities + +On line 14: + the country that were + hard hit by the crisis. The + Commission also + + drew from a large body + of existing work about the + crisis developed + +On line 14: + government agencies, + academics, journalists, legal + investigators, + +On line 16: + We have tried in this + report to explain in clear, + understandable terms + +On line 16: + complex financial + system worked, how the pieces fit + together, and how + +On line 16: + occurred. Doing so + required research into broad + and sometimes arcane + +On line 16: + risk management. To + bring these subjects out of the + realm of the abstract, + +On line 16: + Financial, Fannie + Mae, Goldman Sachs, Lehman Brothers, + Merrill Lynch, Moody’s, and + + Wachovia. We looked more + generally at the roles + and actions of scores + +On line 18: + We also studied + relevant policies put in + place by successive + +On line 18: + And importantly, + we examined the roles of + policy makers + +On line 18: + Corporation, the + Federal Reserve Board, the + Federal Reserve + +On line 18: + Housing and Urban + Development, the Office + of the Comptroller + + of the Currency, + the Office of Federal + Housing Enterprise + +On line 18: + its successor, the + Federal Housing Finance + Agency), the Office + +On line 18: + Supervision, the + Securities and Exchange + Commission, and the + + Treasury Department. + Of course, there is much work the + Commission did not + +On line 20: + it to delve into + what caused the crisis. In that + sense, the Commission + +On line 20: + other transportation + accidents so that knowledge + of the probable + +On line 20: + can help avoid future + accidents. Nor were we tasked + with evaluating + + the federal law + (the Troubled Asset Relief + Program, known as TARP) + +On line 20: + major financial + institutions. That duty + was assigned to the + +On line 22: + General for TARP. + This report is not the sole + repository of + + what the panel found. + A website will host a wealth + of information + +On line 24: + contain a stockpile + of materials—including + documents and emails, + +On line 24: + Commission’s public + hearings, testimony, and + supporting research—that + + can be studied for + years to come. Much of what is + footnoted in this + +On line 24: + can be found on the + website. In addition, more + materials that + + cannot be released + yet for various reasons + will eventually + +On line 24: + made public through the + National Archives and Records + Administration. + +On line 26: + extraordinary + commitment and knowledge of + the members of the + + Commission who were + accorded the honor of + this public service. + +On line 26: + from the perspectives + shared with commissioners by + thousands of concerned + +On line 26: + and emails. And we are + grateful to the hundreds of + individuals + +On line 26: + personal accounts + in extensive interviews, + testimony, and + + discussions with the + Commission. We want to thank + the Commission staff, + +On line 30: + particular, Wendy + Edelberg, our executive + director, for the + + professionalism, + passion, and long hours they brought + to this mission in + +On line 30: + 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 + +On line 32: + this report to reach + their own conclusions, even as + the comprehensive + +On line 38: + record of this crisis + continues to be written. + CONCLUSIONS OF THE + +On line 40: + Commission has been + called upon to examine + the financial and + + economic crisis + that has gripped our country and + explain its causes + +On line 40: + American people. + We are keenly aware of the + significance of + +On line 40: + economic damage + that America has suffered + in the wake of the + +On line 42: + crisis since the Great + Depression. Our task was first + to determine what + +On line 42: + and how it happened + so that we could understand + why it happened. Here + +On line 42: + our conclusions. We + encourage the American + people to join us + +On line 42: + own assessments based + on the evidence gathered + in our inquiry. If + +On line 42: + from history, we + are unlikely to fully + recover from it. + + Some on Wall Street and + in Washington with a stake + in the status quo + + may be tempted to + wipe from memory the events + of this crisis, or + +On line 42: + unravel myths, and + help us understand how the + crisis could have been + + avoided. It is an + attempt to record history, + not to rewrite it, + +On line 44: + allow it to be + rewritten. To help our fellow + citizens better + +On line 44: + conclusions at the + end of chapters in Parts III, + IV, and V of this + + report. The subject + of this report is of no + small consequence to + +On line 46: + nation. The profound + events of and were neither bumps + in the road nor an + + accentuated + dip in the financial and + business cycles we + +On line 46: + come to expect in + a free market economic + system. This was a + +On line 46: + financial upheaval, + if you will—that wreaked havoc in + communities and + + neighborhoods across this + country. As this report goes + to print, there are more + +On line 48: + million Americans + who are out of work, cannot + find full-time work, + +On line 48: + up looking for work. + About four million families + have lost their homes to + +On line 48: + their mortgage payments. + Nearly trillion in household + wealth has vanished, with + +On line 48: + and life savings swept + away. Businesses, large and small, + have felt the sting of + +On line 48: + 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 + +On line 48: + about their future prospects. + The collateral damage + of this crisis has + + been real people + and real communities. + The impacts of this + +On line 48: + are likely to be + felt for a generation. + And the nation faces + +On line 50: + so many Americans, + we began our exploration + with our own views and + +On line 50: + how the world’s strongest + financial system came to + the brink of collapse. + +On line 50: + our appointment to + this independent panel, + much had already been + +On line 50: + 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. + +On line 52: + revelation. Much + attention over the past two + years has been focused + +On line 52: + the decisions by + the federal government + to provide massive + +On line 52: + financial system + and rescue large financial + institutions that + +On line 52: + important to fail. + Those decisions—and the deep + emotions surrounding + + them—will be debated + long into the future. But + our mission was to + + ask and answer this + central question: how did it + come to pass that in + +On line 52: + the total collapse + of our financial system + and economy or + +On line 52: + and an array of + companies, as millions of + Americans still lost + + their jobs, their savings, + and their homes1 In this report, + we detail the events + +On line 54: + the crisis. But a + simple summary, as we + see it, is useful + + at the outset. While + the vulnerabilities + that created the + +On line 54: + the making, it was + the collapse of the housing + bubble—fueled by + + low interest rates, + easy and available credit, scant + regulation, and + + toxic mortgages— that + was the spark that ignited + a string of events, which + +On line 56: + fall of Trillions of + dollars in risky mortgages had + become embedded + +On line 56: + as mortgage-related + securities were packaged, + repackaged, and sold to + +On line 56: + world. When the bubble + burst, hundreds of billions of + dollars in losses + +On line 56: + to those mortgages and + had borrowed heavily against + them. This happened not + +On line 56: + in the United States + but around the world. The losses + were magnified by + +On line 58: + crisis reached seismic + proportions in September + with the failure of + + Lehman Brothers and the + impending collapse of the + insurance giant + +On line 58: + International + Group (AIG). Panic fanned by a + lack of transparency + +On line 58: + interconnections + among institutions perceived + to be "too big to + + fail," caused the credit + markets to seize up. Trading + ground to a halt. The + +On line 58: + market plummeted. + The economy plunged into + a deep recession. + +On line 60: + financial system + we examined bears little + resemblance to that + +On line 60: + generation. The + changes in the past three decades alone + have been remarkable. + +On line 60: + markets have become + increasingly globalized. + Technology has + +On line 60: + and complexity + of financial instruments + and transactions. There + +On line 60: + costs of financing + than ever before. And the + financial sector + + itself has become + a much more dominant force + in our economy. + +On line 64: + the amount of debt held + by the financial sector + soared from trillion to + +On line 66: + doubling as a share + of gross domestic product. + The very nature of + +On line 66: + to publicly traded + corporations taking greater + and more diverse kinds + +On line 66: + risks. By the largest U.S. + commercial banks held of the + industry’s assets, + +On line 66: + more than double the + level held in On the eve + of the crisis in + +On line 66: + constituted of + all corporate profits in + the United States, up + +On line 66: + in Understanding + this transformation has been + critical to the + +On line 68: + Now to our major + findings and conclusions, which + are based on the facts + +On line 68: + in this report: they + are offered with the hope that + lessons may be learned to + +On line 70: + future catastrophe. + We conclude this financial + crisis was avoidable. + + The crisis was the + result of human action + and inaction, not + + of Mother Nature + or computer models gone + haywire. The captains + +On line 70: + the public stewards + of our financial system + ignored warnings and + +On line 70: + evolving risks within + a system essential to + the well-being of the + +On line 72: + public. Theirs was a + big miss, not a stumble. While + the business cycle + +On line 72: + 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 + +On line 74: + in Washington that + the crisis could not have been + foreseen or avoided, + +On line 74: + were warning signs. The + tragedy was that they were ignored + or discounted. There + +On line 74: + risky subprime lending + and securitization, + an unsustainable + +On line 74: + in household mortgage + debt, and exponential growth + in financial firms’ + +On line 74: + red flags. Yet there was + pervasive permissiveness; + little meaningful + +On line 76: + taken to quell the + threats in a timely manner. + The prime example + +On line 76: + failure to stem the + flow of toxic mortgages, which + it could have done by + +On line 78: + mortgage-lending standards. + The Federal Reserve was + the one entity + +On line 78: + examination + is replete with evidence + of other failures: + +On line 78: + 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 + +On line 78: + blindly relied on + credit rating agencies as + their arbiters of risk. + +On line 78: + else could one expect + on a highway where there were + neither speed limits + +On line 80: + widespread failures in + financial regulation + and supervision + +On line 80: + devastating to + the stability of the + nation’s financial + + markets. The sentries + were not at their posts, in no + small part due to the + +On line 80: + self-correcting + nature of the markets and + the ability of + +On line 80: + to effectively + police themselves. More than years + of deregulation + +On line 80: + former Federal + Reserve chairman Alan Greenspan and + others, supported + +On line 80: + 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 + +On line 82: + race to the weakest + supervisor. Yet we do + not accept the view + +On line 82: + regulators lacked + the power to protect the + financial system. + +On line 84: + had ample power + in many arenas and they chose + not to use it. To + +On line 84: + three examples: the + Securities and Exchange + Commission could have + +On line 84: + more capital and + halted risky practices at the + big investment banks. + +On line 86: + Federal Reserve + Bank of New York and other + regulators could + +On line 86: + down on Citigroup’s + excesses in the run-up to + the crisis. They did + +On line 86: + the runaway mortgage + securitization train. + They did not. In case + +On line 86: + the institutions + they oversaw as safe and sound + even in the face of + +On line 86: + downgrading them just + before their collapse. And where + regulators lacked + +On line 86: + Too often, they lacked + the political will—in + a political + +On line 86: + as the fortitude + to critically challenge + the institutions + +On line 88: + 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, + +On line 88: + and products. It did + not surprise the Commission + that an industry + +On line 88: + would exert pressure + on policy makers and + regulators. From + +On line 88: + individuals + and political action + committees in the + +On line 88: + made more than billion + in campaign contributions. + What troubled us was + + the extent to which + the nation was deprived of + the necessary strength + +On line 88: + independence of + the oversight necessary to + safeguard financial + +On line 90: + dramatic failures + of corporate governance + and risk management + +On line 90: + institutions were + a key cause of this crisis. + There was a view that + +On line 90: + self-preservation + inside major financial + firms would shield them from + + fatal risk-taking + without the need for a steady + regulatory + +On line 90: + argued, would stifle + innovation. Too many of + these institutions + +On line 90: + too much risk, with too + little capital, and with + too much dependence + +On line 90: + In many respects, this + reflected a funda-CONCLUSIONS OF THE + FINANCIAL CRISIS + +On line 90: + these institutions, + particularly the large + investment banks and + +On line 90: + lenders and creating, + packaging, repackaging, and + selling trillions of + +On line 92: + products. Like Icarus, they + never feared flying ever + closer to the sun. + +On line 94: + grew aggressively + through poorly executed + acquisition and + +On line 94: + more challenging. The + CEO of Citigroup told the + Commission that a + +On line 94: + billion position + in highly rated mortgage + securities would + + "not in any way have + excited my attention," + and the co-head of + +On line 94: + investment bank said + he spent "a small fraction of + of his time on those + +On line 96: + In this instance, too + big to fail meant too big to + manage. Financial + +On line 96: + instances. Too often, + risk management became risk + justification. + +On line 98: + 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 line 100: + examination + revealed stunning instances of + governance breakdowns + +On line 100: + read, among other things, + about AIG senior management’s + ignorance of the + +On line 100: + company’s billion + derivatives exposure + to mortgage-related + +On line 100: + 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 + +On line 100: + that the company + held billion in "super-senior" + and supposedly + +On line 102: + securities that + resulted in billions of + dollars in losses. + +On line 104: + a combination + of excessive borrowing, + risky investments, and + + lack of transparency + put the financial system + on a collision + +On line 104: + with crisis. Clearly, + this vulnerability + was related to + +On line 104: + and regulation, + but it is significant + enough by itself to + +On line 106: + our attention here. + In the years leading up to + the crisis, too many + +On line 106: + as too many households, + borrowed to the hilt, leaving + them vulnerable + +On line 106: + financial distress + or ruin if the value + of their investments + +On line 108: + even modestly. For + example, as of the five + major investment + + banks—Bear Stearns, Goldman Sachs, + Lehman Brothers, Merrill Lynch, and + Morgan Stanley—were + + operating with + extraordinarily thin + capital. By one + +On line 108: + measure, their leverage + ratios were as high as to + meaning for every + +On line 108: + in assets, there was + only in capital to + cover losses. Less + +On line 108: + a drop in asset + values could wipe out a firm. + To make matters worse, + +On line 108: + borrowing had to + be renewed each and every + day. For example, + +On line 108: + Stearns had billion in + equity and billion in + liabilities + +On line 108: + and was borrowing + as much as billion in the + overnight market. It was + +On line 108: + a small business with + in equity borrowing + million, with 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. + And the leverage was + +On line 110: + "window dressing" of + financial reports available + to the investing + + public. The kings of + leverage were Fannie Mae and + Freddie Mac, the two + +On line 112: + the end of Fannie’s + and Freddie’s combined leverage + ratio, including + +On line 114: + owned and guaranteed, + stood at to But financial + firms were not alone in + +On line 114: + the borrowing spree: + from to national mortgage + debt almost doubled, + +On line 114: + the amount of mortgage + debt per household rose more than + from to even while wages + +On line 114: + the housing downturn + hit, heavily indebted + financial firms and + +On line 116: + institutions was + exacerbated by the + risky assets they were + +On line 116: + debt. As the mortgage + and real estate markets + churned out riskier and + +On line 116: + securities, many + financial institutions + loaded up on them. + +On line 116: + the end of Lehman had + amassed billion in commercial + and residential + +On line 116: + 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 + +On line 116: + taken on just by + the big financial firms, but + by families, too. + +On line 116: + mortgage borrowers + in and took out "option ARM" + loans, which meant they could + +On line 118: + make payments so low + that their mortgage balances rose + every month. Within + +On line 118: + financial system, + the dangers of this debt were + magnified because + + transparency was not + required or desired. Massive, + short-term borrowing, + +On line 118: + obligations unseen + by others in the market, + heightened the chances the + +On line 118: + rapidly unravel. + In the early part of the + 20th century, we + +On line 118: + protections—the + Federal Reserve as a + lender of last resort, + +On line 118: + deposit insurance, + ample regulations—to + provide a bulwark + +On line 118: + had regularly + plagued America’s banking + system in the 19th + +On line 118: + over the past 30-plus years, + we permitted the growth of + a shadow banking + +On line 118: + and laden with short-term + debt—that rivaled the size of + the traditional + +On line 118: + of over-the-counter derivatives—were + hidden from view, without the + protections we had + +On line 118: + financial meltdowns. + We had a 21st-century + financial system + + with 19th-century + safeguards. When the housing and + mortgage markets cratered, + +On line 120: + lack of transparency, + the extraordinary debt + loads, the short-term loans, + +On line 120: + risky assets all came + home to roost. What resulted + was panic. We had + +On line 122: + reaped what we had sown. + We conclude the government + was ill prepared for + +On line 122: + response added to the + uncertainty and panic + in the financial + +On line 122: + As part of our charge, + it was appropriate to + review government + +On line 122: + in response to the + developing crisis, not + just those policies or + +On line 122: + it, to determine + if any of those responses + contributed to or + + exacerbated + the crisis. As our report + shows, key policy + +On line 124: + Treasury Department, + the Federal Reserve Board, + and the Federal + +On line 124: + Bank of New York—who + were best positioned to watch + over our markets were + +On line 126: + ill prepared for the + events of and Other agencies + were also behind + +On line 126: + were hampered because + they did not have a clear grasp + of the financial + +On line 126: + 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 + +On line 126: + 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 + +On line 126: + an ad hoc basis + with specific programs to + put fingers in the + +On line 126: + comprehensive and + strategic plan for containment, + because they lacked a + +On line 126: + 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 + +On line 128: + least a debate about, + the housing bubble, the record + reflects that senior + +On line 128: + officials did not + recognize that a bursting + of the bubble could + +On line 128: + threaten the entire + financial system. Throughout + the summer of both + + Federal Reserve + Chairman Ben Bernanke and Treasury + Secretary Henry + +On line 128: + that the turmoil in + the subprime mortgage markets + would be contained. When + + Bear Stearns’s hedge funds, which + were heavily invested + in mortgage-related + +On line 128: + 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 + +On line 128: + be "relatively + unique." Days before the collapse + of Bear Stearns in March + +On line 130: + SEC Chairman Christopher + Cox expressed "comfort about the + capital cushions" + +On line 130: + big investment banks. + It was not until August + just weeks before the + +On line 130: + Mae and Freddie Mac, + that the Treasury Department + understood the full + +On line 130: + conditions of those + two institutions. And just + a month before Lehman’s + +On line 130: + Bank of New York was + still seeking information + on the exposures + +On line 132: + In addition, the + government’s inconsistent + handling of major + +On line 132: + rescue Bear Stearns and + then to place Fannie Mae and + Freddie Mac into + +On line 132: + Lehman Brothers and then + to save AIG—increased uncertainty + and panic in the + +On line 134: + we deeply respect and + appreciate the efforts + made by Secretary + +On line 134: + Bernanke, and Timothy + Geithner, formerly + president of the + +On line 134: + Bank of New York and + now treasury secretary, and + so many others who + +On line 134: + to stabilize our + financial system and our + economy in the + +On line 136: + a systemic breakdown + in accountability and + ethics. The integrity + +On line 136: + and the public’s trust in + those markets are essential + to the economic + +On line 136: + financial system + and our economy rely + on the notions of + +On line 136: + In our economy, + we expect businesses and + individuals + +On line 136: + pursue profits, at + the same time that they produce + products and services + +On line 138: + been the case in past + speculative booms and busts—we + witnessed an erosion + +On line 138: + exacerbated + the financial crisis. This + was not universal, + + but these breaches stretched + from the ground level to the + corporate suites. They + +On line 138: + in significant + financial consequences but + also in damage + +On line 138: + the trust of investors, + businesses, and the public + in the financial + +On line 140: + according to one + measure, that the percentage + of borrowers who + +On line 140: + just a matter of + months after taking a loan + nearly doubled from + +On line 140: + the summer of to + late This data indicates + they likely took out + +On line 140: + 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 + +On line 140: + mortgage fraud grew 20-fold + between and and then more than + doubled again between + +On line 142: + and One study places the + losses resulting from fraud + on mortgage loans made + +On line 144: + at billion. Lenders made + loans that they knew borrowers + could not afford and + +On line 144: + of the loans they were + originating could result + in "catastrophic + + consequences." Less than + a year later, they noted + that certain high-risk + +On line 144: + result not only + in foreclosures but also + in "financial and + + reputational + catastrophe" for the firm. But + they did not stop. And + +On line 146: + sampled loans they were + purchasing to package and + sell to investors. They + +On line 146: + a significant + percentage of the sampled + loans did not meet their + +On line 146: + of many prospectuses + provided to investors found + that this critical + + information was + not disclosed. THESE CONCLUSIONS + must be viewed in the + +On line 148: + to pin this crisis + on mortal flaws like greed and + CONCLUSIONS OF THE + +On line 148: + COMMISSION xxiii + hubris would be simplistic. It + was the failure to + +On line 150: + for human weakness + that is relevant to this + crisis. Second, we + +On line 150: + believe the crisis + was a result of human + mistakes, misjudgments, + +On line 150: + in systemic failures + for which our nation has paid + dearly. As you read + + this report, you will + see that specific firms and + individuals + +On line 150: + 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 + +On line 150: + is at fault"; many firms + and individuals did + not participate + +On line 152: + We do place special + responsibility with + the public leaders + + charged with protecting + our financial system, those + entrusted to run + +On line 152: + chief executives + of companies whose failures + drove us to crisis. + +On line 152: + of significant + responsibility and + obligation. Tone at + + the top does matter + and, in this instance, we were + let down. No one said + +On line 152: + must also accept + responsibility for + what we permitted + +On line 154: + unanimously, we + acquiesced to or embraced + a system, a set + +On line 160: + and actions, that gave + rise to our present predicament. THIS + REPORT DESCRIBES THE + +On line 160: + and the system that + propelled our nation toward + crisis. The complex + + machinery of our + financial markets has many + essential gears—some + +On line 160: + a critical role + as the crisis developed + and deepened. Here we + +On line 160: + our conclusions about + specific components of + the system that we + + believe contributed + significantly to the + financial meltdown. + +On line 162: + pipeline lit and spread + the flame of contagion and + crisis. When housing + + prices fell and mortgage + borrowers defaulted, the + lights began to dim + +On line 164: + toxic mortgages from + neighborhoods across America + to investors around the + + globe. Many mortgage lenders + set the bar so low that lenders + simply took eager + +On line 166: + disregard for a + borrower’s ability to + pay. Nearly one-quarter + +On line 166: + made in the first half + of were interest-only loans. + During the same year, + +On line 166: + originated by + Countrywide and Washington + Mutual had low- + +On line 168: + lending, including + predatory and fraudulent + practices, became more + +On line 168: + Federal Reserve + and other regulators + and authorities + + heard warnings from many + quarters. Yet the Federal + Reserve neglected + +On line 168: + mission "to ensure + the safety and soundness of + the nation’s banking + +On line 168: + financial system + and to protect the credit + rights of consumers." It + +On line 168: + build the retaining + wall before it was too late. + And the Office of + +On line 168: + 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 + +On line 170: + cash into newly + created mortgage-related + securities. It + +On line 170: + regulators alike + that risk had been conquered: the + investors held highly + +On line 170: + they thought were sure to + perform; the banks thought they had + taken the riskiest + +On line 170: + firms making profits + and borrowing costs reduced. + But each step in the + +On line 170: + 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 + +On line 170: + firms that created + the mortgage-backed securities, + collateralized + +On line 170: + 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. + +On line 170: + wrong. When borrowers + stopped making mortgage payments, + the losses—amplified + +On line 170: + through the pipeline. As + it turned out, these losses were + concentrated in + +On line 172: + millions of mortgages + so efficiently has proven + to be difficult + +On line 172: + erected barriers + to modifying mortgages + so families can + +On line 174: + housing market and + financial institutions. + We conclude over-the-counter + +On line 174: + The enactment of + legislation in to ban + the regulation + +On line 174: + the federal and + state governments of over-the-counter + (OTC) derivatives + + was a key turning + point in the march toward the + financial crisis. + +On line 176: + 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 + +On line 176: + rapidly spiraled out + of control and out of sight, + growing to trillion + +On line 176: + and collateral + requirements; speculation; + interconnections + +On line 178: + in this market. OTC + derivatives contributed + to the crisis in + +On line 178: + sold to investors to + protect against the default or + decline in value + + of mortgage-related + securities backed by risky + loans. Companies sold + +On line 178: + tune of billion, in + AIG’s case—to investors in these + newfangled mortgage + +On line 178: + to launch and expand + the market and, in turn, to + further fuel the + +On line 180: + were essential to + the creation of synthetic + CDOs. These synthetic + +On line 180: + on the performance + of real mortgage-related + securities. They + +On line 180: + multiple bets on + the same securities and + helped spread them throughout + +On line 182: + system. Goldman Sachs + alone packaged and sold billion + in synthetic CDOs + +On line 182: + July CONCLUSIONS + OF THE FINANCIAL CRISIS + INQUIRY COMMISSION + +On line 184: + to May Synthetic + CDOs created by Goldman + referenced more than + +On line 186: + securities, and + of them were referenced at + least twice. This is apart + +On line 188: + in synthetic CDOs + created by other firms. + Finally, when the + +On line 188: + and crisis followed, + derivatives were in the + center of the storm. + +On line 188: + 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 + +On line 188: + committed more than + billion because of concerns + that AIG’s collapse would + + trigger cascading + losses throughout the global + financial system. + +On line 188: + the existence of + millions of derivatives + contracts of all types + +On line 188: + panic, helping to + precipitate government + assistance to those + +On line 190: + conclude the failures + of credit rating agencies + were essential cogs + +On line 190: + wheel of financial + destruction. The three credit + rating agencies were + +On line 190: + of the financial + meltdown. The mortgage-related + securities at + +On line 190: + heart of the crisis + could not have been marketed + and sold without their + +On line 190: + regulatory + capital standards were hinged + on them. This crisis + + could not have happened + without the rating agencies. + Their ratings helped the + +On line 190: + market soar and their + downgrades through and wreaked havoc + across markets and firms. + + In our report, you + will read about the breakdowns at + Moody’s, examined by + +On line 192: + This compares with six + private-sector companies + in the United States + +On line 192: + early In alone, Moody’s + put its triple-A stamp of approval + on mortgage-related + +On line 192: + were disastrous: of + the mortgage securities + rated triple-A that year + + ultimately were + downgraded. You will also + read about the forces at + +On line 194: + behind the breakdowns + at Moody’s, including the flawed + computer models, + +On line 194: + 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 + +On line 194: + for mortgage-related + securities could not have + been what it became. + +On line 200: + ARE MANY COMPETING + VIEWS as to the causes of + this crisis. In this + +On line 200: + the Commission has + endeavored to address key + questions posed to us. + +On line 200: + availability and + excess liquidity, the + role of Fannie Mae + + and Freddie Mac (the + GSEs), and government housing + policy. First, as + +On line 200: + in our report, we + outline monetary policies + and capital flows + +On line 200: + years leading up to + the crisis. Low interest + rates, widely available + +On line 200: + international + investors seeking to put their + money in real + +On line 202: + a credit bubble. + Those conditions created + increased risks, which should + + have been recognized + by market participants, + policy makers, + +On line 202: + liquidity did + not need to cause a crisis. + It was the failures + +On line 202: + in excesses in + the mortgage and financial + markets—that were the + + principal causes + of this crisis. Indeed, the + availability of + +On line 204: + directions. Second, + we examined the role of + the GSEs, with Fannie + +On line 204: + government-sponsored + enterprises had a deeply + flawed business model + +On line 204: + corporations with + the implicit backing of + and subsidies from + +On line 206: + mortgage exposure + and market position were + significant. In + +On line 208: + and they decided + to ramp up their purchase and + guarantee of risky + +On line 208: + just as the housing + market was peaking. They used + their political + +On line 208: + for decades to ward off + effective regulation + and oversight—spending + +On line 210: + on lobbying from + to They suffered from many of + the same failures of + +On line 210: + management as the + Commission discovered in + other financial + +On line 212: + the third quarter of + the Treasury Department had + provided billion + +On line 214: + We conclude that these + two entities contributed + to the crisis, but + +On line 214: + 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 + +On line 216: + subprime and other + risky mortgages, but they followed + rather than led Wall Street + +On line 216: + other lenders in the + rush for fool’s gold. They purchased + the highest rated + +On line 216: + added helium to + the housing balloon, but their + purchases never + +On line 216: + majority of + the market. Those purchases + represented of + +On line 218: + non-GSE subprime mortgage-backed + securities in with the + share rising to in + +On line 218: + loans and related + securities in order + to meet stock market + +On line 218: + regain market share, + and to ensure generous + compensation for + + their executives + and employees—justifying + their activities + +On line 218: + the broad and sustained + public policy support + for homeownership. + +On line 220: + of the loans purchased + or guaranteed by Fannie + and Freddie. While they + +On line 220: + substantial losses, + delinquency rates for GSE loans + were substantially + +On line 220: + securitized by + other financial firms. For + example, data + +On line 220: + Commission for a + subset of borrowers with + similar credit + +On line 220: + below 660—show that by + the end of GSE mortgages were + far less likely to + +On line 222: + non-GSE securitized + mortgages: versus We also + studied at length how + +On line 222: + Development’s (HUD’s) + affordable housing goals for + the GSEs affected + +On line 222: + CONCLUSIONS OF THE + FINANCIAL CRISIS INQUIRY + COMMISSION xxvii risky + +On line 222: + on the evidence + and interviews with dozens of + individuals + +On line 222: + this subject area, we + determined these goals only + contributed marginally + +On line 224: + Fannie’s and Freddie’s + participation in those + mortgages. Finally, + +On line 224: + the matter of whether + government housing policies + were a primary + +On line 224: + for decades, government + policy has encouraged + homeownership through + +On line 224: + programs, and mandates. + These policies were put in place + and promoted by + +On line 224: + and Congresses—indeed, + both Presidents Bill Clinton + and George W. Bush set + +On line 226: + homeownership. In + conducting our inquiry, we + took a careful look + +On line 226: + noted above, and the + Community Reinvestment + Act (CRA). The CRA was + +On line 226: + enacted in to + combat "redlining" by banks—the + practice of denying + +On line 226: + individuals + and businesses in certain + neighborhoods without + +On line 226: + The CRA requires banks + and savings and loans to lend, + invest, and provide + +On line 228: + the CRA was not a + significant factor in + subprime lending or + +On line 228: + subprime lenders were not + subject to the CRA. Research + indicates only + +On line 228: + 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 + +On line 228: + were half as likely + to default as similar + loans made in the same + +On line 228: + by independent + mortgage originators not + subject to the law. + +On line 230: + this respect: As a + nation, we set aggressive + homeownership goals + +On line 230: + extend credit to + families previously + denied access to + +On line 230: + the philosophy + of opportunity was + being matched by the + +On line 230: + ground. Witness again the + failure of the Federal + Reserve and other + +On line 230: + irresponsible + lending. Homeownership peaked + in the spring of and + +On line 230: + began to decline. + From that point on, the talk of + opportunity + +On line 230: + tragically at + odds with the reality + of a financial + +On line 236: + disaster in the + making. WHEN THIS COMMISSION + began its work months + +On line 236: + some imagined that the + events of and their consequences + would be well behind + + us by the time we + issued this report. Yet more + than two years after + +On line 236: + an unprecedented + manner in our financial + markets, our country + +On line 236: + aftereffects of + the calamity. Our financial + system is, in many + + respects, still unchanged + from what existed on the + eve of the crisis. + +On line 236: + in the wake of the + crisis, the U.S. financial + sector is now more + +On line 236: + While we have not been + charged with making policy + recommendations, + + the very purpose of + our report has been to take + stock of what happened + +On line 236: + we can plot a new + course. In our inquiry, we found + dramatic breakdowns + +On line 236: + profound lapses in + regulatory oversight, + and near fatal flaws + +On line 238: + series of choices + and actions led us toward + a catastrophe for + +On line 238: + we were ill prepared. + These are serious matters + that must be addressed + +On line 238: + to restore faith in + our financial markets, to + avoid the next crisis, + +On line 238: + rebuild a system + of capital that provides + the foundation for + +On line 240: + shared prosperity. + The greatest tragedy would be to + accept the refrain + +On line 240: + no one could have seen + this coming and thus nothing + could have been done. If + +On line 242: + this notion, it will + happen again. This report should + not be viewed as the + + end of the nation’s + examination of this + crisis. There is still + +On line 244: + is our collective + responsibility. It + falls to us to make + +On line 261: + we want different + results. PART I Crisis on + the Horizon BEFORE + +On line 263: + examining the + worst financial meltdown since + the Great Depression, + +On line 263: + Financial Crisis + Inquiry Commission reviewed + millions of pages of + +On line 265: + people from all walks + of life—to find out how and + why it happened. In + +On line 265: + 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 + +On line 267: + the magnitude of + the crisis that would ensue. + Charles Prince, the former + +On line 267: + chief executive + officer of Citigroup + Inc., called the collapse + +On line 267: + housing prices "wholly + unanticipated."1 Warren + Buffett, the chairman + +On line 267: + of Berkshire Hathaway + Inc., which until was the largest + single shareholder + +On line 267: + Moody’s Corporation, + told the Commission that "very, + very few people could + +On line 267: + the bubble," which he + called a "mass delusion" shared by + million Americans."2 + +On line 267: + the chairman and chief + executive officer + of Goldman Sachs Group, + +On line 269: + likened the financial + crisis to a hurricane.3 + Regulators echoed + +On line 269: + similar refrain. + Ben Bernanke, the chairman of the + Federal Reserve + +On line 269: + told the Commission + a "perfect storm" had occurred + that regulators + +On line 269: + when asked about whether the + Fed’s lack of aggressiveness + in regulating + +On line 269: + market during the + housing boom was a failure, + Bernanke responded, "It + +On line 269: + indeed. I think it + was the most severe failure + of the Fed in this + +On line 269: + episode."4 Alan Greenspan, the Fed + chairman during the two decades + leading up to the + +On line 269: + Commission that it + was beyond the ability + of regulators + +On line 271: + 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 + +On line 273: + 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 + +On line 273: + were clanging inside + financial institutions, + regulatory + +On line 273: + organizations, + state law enforcement agencies, + and corporations + + throughout America, + as well as in neighborhoods + across the country. Many + +On line 273: + to avoid the train wreck. + While countless Americans joined + in the financial + +On line 273: + others were shouting + to government officials + in Washington and + +On line 273: + to what would become + a human disaster, not + just an economic + +On line 275: + "Everybody in the + whole world knew that the mortgage + bubble was there," said + +On line 275: + the former chairman + of the Securities and + Exchange Commission + +On line 275: + President George H. + W. Bush. "I mean, it wasn’t + hidden. You cannot + +On line 275: + at any of this and + say that the regulators + did their job. This was + +On line 275: + some hidden problem. + It wasn’t out on Mars or + Pluto or somewhere. + +On line 275: + It was right here. You + can’t make trillions of dollars’ + worth of mortgages and + +On line 277: + notice."6 Paul McCulley, a + managing director at + PIMCO, one of the + +On line 277: + money management + firms, told the Commission that + he and his colleagues + +On line 277: + to get worried about + "serious signs of bubbles" + in they therefore sent + +On line 279: + cities to do what he + called "old-fashioned shoe-leather research," + talking to real + +On line 279: + brokers, and local + investors about the housing and + mortgage markets. They + +On line 279: + outright degradation + of underwriting standards," + McCulley asserted, and + +On line 279: + shared what they had learned + when they got back home to the + company’s Newport + +On line 279: + when our group came back, + they reported what they saw, + and we adjusted + +On line 281: + those who remembered + the savings and loan crisis, + knew that age-old rules of + +On line 281: + cast aside. Arnold Cattani, + the chairman of Bakersfield, + California–based + +On line 281: + the Commission that + he grew uncomfortable with + the "pure lunacy" + +On line 281: + saw in the local + home-building market, fueled + by "voracious" Wall + +On line 281: + investment banks; he + thus opted out of certain + kinds of investments + +On line 283: + 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 + +On line 283: + bright flash wipes clean the + memories of everyone + who has witnessed an + +On line 285: + event," he said.9 Unlike + so many other bubbles—tulip bulbs + in Holland in the + +On line 285: + South Sea stocks in the + 1700s, Internet stocks in the + late 1990s—this one involved + +On line 285: + the economy: the + family home. Homes are the + foundation upon + +On line 285: + economic structures + rest. Children usually go + to schools linked to their + +On line 285: + 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 + +On line 289: + cause ripple effects + almost everywhere. When the + Federal Reserve + +On line 289: + mortgage rates fell, home + refinancing surged, climbing + from billion in to + +On line 289: + allowing people + to withdraw equity built + up over previous + + decades and to consume + more, despite stagnant wages. Home + sales volume started + +On line 289: + and average home + prices nationwide climbed, rising + in eight years by one + +On line 289: + measure and hitting + a national high of in + early Home prices in + +On line 289: + skyrocketed: prices + increased nearly two and one-half + times in Sacramento, + +On line 289: + example, in just + five years,12 and shot up by about + the same percentage + +On line 289: + Prices about doubled in + more than metropolitan + areas, including + +On line 289: + Poughkeepsie, San Diego, + and West Palm Beach.13 Housing starts + nationwide climbed from + +On line 291: + reached a record in the + spring of although it wouldn’t + rise an inch further + +On line 291: + machine kept churning + for another three years. By + refinancing their + +On line 293: + equity between + and including billion in + alone, more than seven + +On line 293: + speculators and + potential homeowners stood + in line outside new + +On line 293: + for a chance to buy + houses before the ground had + even been broken. By + +On line 293: + the first half of more + than one out of every ten + home sales was to an + +On line 293: + or someone buying + a second home.15 Bigger was + better, and even the + +On line 293: + ballooned in size; the + floor area of an average + new home grew by to + +On line 295: + decade from to Money + washed through the economy like + water rushing through + +On line 297: + Low interest rates + and then foreign capital + helped fuel the boom. + +On line 297: + 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 + +On line 297: + 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 + +On line 297: + vacations, or launch + new businesses. They also + paid off credit cards, + +On line 297: + as personal debt + rose nationally. Survey + evidence shows that + +On line 297: + homeowners pulled out + cash to buy a vehicle + and over spent the cash + +On line 297: + tax payments, clothing, + gifts, and living expenses.17 + Renters used new forms of + +On line 297: + homes and to move to + suburban subdivisions, + erect-ing swing sets in + +On line 299: + backyards and enrolling + their children in local schools. + In an interview + +On line 299: + the longtime CEO of + Countrywide Financial—a lender + brought down by its risky + +On line 301: + rush" mentality + overtook the country during + these years, and that he + +On line 301: + swept up in it as + well: "Housing prices were rising + so rapidly—at a rate + +On line 301: + that I’d never seen + in my 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 + +On line 303: + house, make 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 + +On line 305: + the culture. It was + sudden, unexpected."18 On + the surface, it looked + +On line 305: + 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. + +On line 307: + going wrong. Like a + science fiction movie in which + ordinary household + +On line 307: + were being transformed. + The time-tested 30-year fixed-rate mortgage, + with a down payment, + +On line 307: + of style. There was a + burgeoning global demand + for residential + +On line 307: + securities that + offered seemingly solid + and secure returns. + +On line 307: + around the world clamored + to purchase securities + built on American + +On line 309: + estate, seemingly + one of the safest bets in the + world. Wall Street labored + +On line 309: + 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 + +On line 309: + changes—these financial + innovations, they said, had + lowered borrowing + +On line 309: + consumers and moved risks + away from the biggest and most + systemically + +On line 309: + in ways that were not + understood by either the + captains of finance + +On line 309: + the system’s public + stewards. In fact, some of the + largest institutions + +On line 309: + 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. + +On line 309: + loans had been bundled + into investment products + in ways that seemed to + +On line 309: + 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 + +On line 311: + Mayo, a managing + director and financial + services analyst + +On line 311: + 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 + +On line 313: + really inside."19 + The securitization + machine began to + +On line 313: + these once-rare mortgage + products with their strange-sounding + names: Alt-A, subprime, I-O + +On line 313: + low-doc, no-doc, or + ninja (no income, no job, + no assets) loans; 2–28s + +On line 313: + piggyback second + mortgages; payment-option or + pick-a-pay adjustable + +On line 313: + variants on adjustable-rate + mortgages, called "exploding" ARMs, + featured low monthly + +On line 313: + at first, but payments + could suddenly double or + triple, if borrowers + +On line 313: + of different kinds + of mortgages available on the + market, confounding + +On line 313: + examine the fine + print, baffling conscientious + borrowers who tried + + to puzzle out their + implications, and opening + the door for those who + +On line 315: + 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 + +On line 315: + them to defer the + payment of principal.20 Some + borrowers opted + +On line 315: + nontraditional + mortgages because that was the + only way they could + +On line 315: + foothold in areas such + as the sky-high California + housing market.21 Some + +On line 315: + and Georgia became + a particular target + for investors who used + +On line 315: + to acquire real + estate.22 Some were misled by + salespeople who came + +On line 315: + homes and persuaded + them to sign loan documents + on their kitchen tables. + +On line 315: + 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 + +On line 315: + if they didn’t have + enough income to qualify + for traditional + +On line 317: + these exotic loans + had existed in the past, + used by high-income, + +On line 317: + secure people as + a cash-management tool. Some + had been targeted + +On line 317: + they refinanced. But + the instruments began to + deluge the larger + +On line 317: + and The changed occurred + "almost overnight," Faith Schwartz, then an + executive at + +On line 317: + lender Option One and + later the executive + director of Hope + +On line 317: + "I would suggest most + every lender in the country + is in it, one way + +On line 319: + 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 + +On line 319: + the United States climbed + from trillion in to trillion + in The mortgage debt + +On line 319: + American households + rose almost as much in the + six years from to as + + it had over the course + of the country’s more than 200-year + history. The amount + +On line 319: + per household rose from + in to in 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 + +On line 321: + 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 + +On line 321: + clear anymore who the + lender was. The mortgages would be + packaged, sliced, repackaged, + +On line 321: + securities to + an assortment of hungry + investors. Now even the + +On line 323: + find a buyer. More + loan sales meant higher profits + for everyone in + +On line 323: + that were expanding + mortgage originations. He + crisscrossed the nation, + +On line 325: + 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 + +On line 327: + "flipping burgers," he + told the FCIC. Given the right + training, however, + +On line 329: + 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 + +On line 329: + and unsuspecting + borrowers," he said. He taught + them the new playbook: + +On line 329: + 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 + +On line 329: + 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. + +On line 329: + 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 + +On line 331: + 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 + +On line 331: + the future. And, for + a long time, IBGYBG worked + at every level. + +On line 333: + 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 + +On line 333: + 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 + +On line 333: + mostly be stamped with + triple-A ratings by the credit + rating agencies, and + +On line 333: + riskier portions of + these securities—which would then + be sold to other + +On line 333: + 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 + +On line 333: + For every buyer + of a credit default swap, + there was a seller: + + as these investors made + opposing bets, the layers + of entanglement + +On line 335: + The instruments grew + more and more complex; CDOs were + constructed out of + +On line 335: + creating CDOs squared. + When firms ran out of real + product, they started + +On line 335: + but just of bets on + other mortgage products. Each + new permutation + +On line 335: + to extract more fees + and trading profits. And each + new layer brought in + +On line 335: + 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 line 335: + in south Florida + might become part of dozens of + securities owned + +On line 335: + Treasury Secretary + Timothy Geithner, + the president of + +On line 335: + crisis, described the + resulting product as "cooked + spaghetti" that became + + hard to "untangle."29 + Ralph Cioffi spent several + years creating CDOs + +On line 337: + and a couple of + more years on the repurchase + or "repo" desk, which + +On line 337: + responsible for + borrowing money every + night to finance Bear + +On line 337: + Cioffi created + a hedge fund within Bear Stearns + with a minimum + +On line 337: + money—up to borrowed + for every from investors—to buy + CDOs. Cioffi’s first fund + +On line 337: + for investors in and + in 2005—after the annual + management fee and + +On line 337: + profit for Cioffi + and his Bear Stearns team—and grew + to almost billion + +On line 337: + of In the fall of + he created another, + more aggressive fund. + +On line 337: + This one would shoot for + leverage of up to to By + the end of the two + +On line 337: + in securities + issued by CDOs centered on + housing. As a CDO + +On line 339: + mortgage-related CDOs + for other investors. Cioffi’s + investors and others + +On line 341: + high-yielding mortgage + securities. That, in turn, + required high-yielding + +On line 341: + borrowers, urging + them to buy or refinance + homes. Direct-mail + +On line 341: + people’s mailboxes.30 + Dancing figures, depicting + happy homeowners, + +On line 341: + hook with calls from loan + officers offering the + latest loan products: + + One percent loan! (But + only for the first year.) No + money down! (Leaving + +On line 341: + if home prices fell.) No + income documentation + needed! (Mortgages soon + +On line 341: + industry itself.) + Borrowers answered the call, + many believing that + + with ever-rising prices, + housing was the investment + that couldn’t lose. In + +On line 343: + four intermingled + issues came into play that + made it difficult + + to acknowledge the + looming threats. First, efforts to + boost homeownership + +On line 343: + broad political + support—from Presidents Bill + Clinton and George W. + + Bush and successive + Congresses—even though in + reality the + +On line 343: + the spring of Second, + the real estate boom was + generating a + +On line 343: + of cash on Wall Street + and creating a lot of + jobs in the housing + +On line 343: + believed that even if + the housing market tanked, the + broader financial + +On line 345: + would hold up. As the + mortgage market began its + transformation in + + the late 1990s, consumer + advocates and front-line + local government + +On line 345: + 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 + +On line 345: + began raising the + issue with the Federal + Reserve and other + +On line 345: + general counsel + and policy director + of the Greenlining + +On line 345: + California-based + nonprofit housing group, told + the Commission that + +On line 345: + he began meeting + with Greenspan at least once a year + starting in each time + +On line 345: + to him the growth of + predatory lending practices + and discussing with him + +On line 347: + economic problems + they were creating.32 One of + the first places to see + +On line 347: + an entire market + was Cleveland, Ohio. From to home + prices in Cleveland rose + +On line 349: + median of to + while home prices nationally + rose about in those same + +On line 349: + years; at the same time, + the city’s unemployment rate, + ranging rom in to + +On line 351: + more or less tracked the + broader U.S. pattern. James Rokakis, + the longtime county + +On line 351: + of Cuyahoga County, + where Cleveland is located, + told the Commission + +On line 351: + the region’s housing + market was juiced by "flipping + on mega-steroids," with rings + +On line 351: + appraisers, and loan + originators earning fees + on each transaction + +On line 353: + Street. City officials + began to hear reports that + these activities + +On line 353: + propelled by new kinds + of nontraditional loans + that enabled investors + +On line 353: + buy properties with + little or no money down + and gave homeowners + +On line 353: + to refinance their + houses, regardless of whether + they could afford to + +On line 353: + the loans. Foreclosures + shot up in Cuyahoga County + from a year in to + +On line 353: + a year in Rokakis and + other public officials + watched as families + + who had lived for years + in modest residences lost + their homes. After they + +On line 353: + were ultimately + abandoned, vandalized, and then + stripped bare, as scavengers + +On line 355: + siding to sell for + scrap. "Securitization + was one of the most + + brilliant financial + innovations of the 20th + century," Rokakis told + +On line 355: + Commission. "It freed + up a lot of capital. + If it had been done + + responsibly, it + would have been a wondrous thing + because nothing is + +On line 357: + nothing safer, than the + American mortgage market. + It worked for years. But + +On line 359: + scam it."34 Officials + in Cleveland and other Ohio + cities reached out to the + +On line 359: + for help. They asked the + Federal Reserve, the one + entity with the + +On line 359: + risky lending practices + by all mortgage lenders, to use + the power it had + +On line 359: + in under the Home + Ownership and Equity + Protection Act (HOEPA) + +On line 359: + new mortgage lending + rules. In March Fed Governor + Edward Gramlich, an + +On line 359: + access to credit + but only with safeguards in + place, attended a + + conference on the + topic in Cleveland. He spoke + about the Fed’s power + +On line 359: + HOEPA, declared some of + the lending practices to be + "clearly illegal," + +On line 363: + enforcement measures."35 + 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 + +On line 363: + rules. I thought it would + result in action being + taken. It was kind + +On line 365: + Cleveland was looking + for help from the federal + government, other + +On line 365: + around the country were + doing the same. John Taylor, + the president of + +On line 365: + of community + leaders from Nevada, Michigan, + Maryland, Delaware, + +On line 365: + New Jersey, and Ohio, + went to the Office of Thrift + Supervision (OTS), + +On line 365: + loan institutions, + asking the agency to crack + down on what they called + +On line 367: + believed were putting both + borrowers and lenders at risk.37 + The California + +On line 367: + group based in Northern + California, also begged + regulators to + +On line 367: + officials told the + Commission. The nonprofit + group had reviewed the + +On line 367: + 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 There were + government reports, + +On line 371: + Treasury Department + issued a joint report on + predatory lending + +On line 371: + that made a number + of recommendations for + reducing the risks + +On line 371: + to borrowers.39 In + December the Federal + Reserve Board used the + + HOEPA law to amend some + regulations; among the changes + were new rules aimed at + +On line 371: + 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 + +On line 371: + only of subprime + loans. FDIC Chairman Sheila C. Bair, + then an assistant + + treasury secretary + in the administration + of President George + +On line 371: + Bush, characterized + the action to the FCIC as + addressing only + +On line 371: + a "narrow range of + predatory lending issues."41 + In Gramlich noted + +On line 371: + "increasing reports + of abusive, unethical + and in some cases, + +On line 373: + lending practices."42 Bair + told the Commission that this + was when "really + +On line 373: + 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 + +On line 375: + but that effort fell + by the wayside as well.44 In + an environment + +On line 375: + standards declined. The + companies issuing these + loans made profits that + +On line 377: + rose sharply. In the top + nonprime lenders originated + billion in loans. Their + +On line 379: + billion in and then + billion in California, + with its high housing + +On line 379: + kind of lending. In + nearly billion, or of all + nontraditional + +On line 379: + nationwide, were made + in that state; California’s + share rose to by with + +On line 379: + growing to billion + or by in California + in just two years.46 In + +On line 379: + director of the + California Reinvestment + Coalition, testified + +On line 379: + the Commission. "We + estimated at that time + that the average + +On line 379: + California was + paying over more per month on + their mortgage payment + +On line 381: + result of having + received the subprime loan."47 Gail + Burks, president and + +On line 381: + Nevada Fair Housing, + Inc., a Las Vegas–based + housing clinic, told + +On line 381: + Commission she and + other groups took their concerns + directly to Greenspan + +On line 383: + time, describing to + him in person what she called + the "metamorphosis" + +On line 383: + industry. She told + him that besides predatory + lending practices such + + as flipping loans or + misinforming seniors about + reverse mortgages, she + +On line 385: + accounts.48 Lisa Madigan, + the attorney general + in Illinois, also + +On line 385: + Consumers complained that + they had been deceived into + taking out loans with + +On line 387: + fees. The company + was then packaging the loans + and selling them as + + securities to + Lehman Brothers, Madigan said. The + case was settled in + +On line 387: + received million. First + Alliance went out of business. + But other firms stepped + +On line 389: + to investigate + another fast-growing lender, + California-based + +On line 389: + nation’s largest subprime + lender, originating billion + in subprime loans in + + 2003—mostly refinances + that let borrowers take cash + out of their homes, but + +On line 391: + hefty fees that ate away + at their equity.50 Madigan + testified to the + +On line 391: + Ameriquest revealed that the + company engaged in the + kinds of fraudulent + +On line 391: + lenders subsequently + emulated on a wide + scale: inflating home + +On line 391: + interest rates on + borrowers’ loans or switching + their loans from fixed to + + adjustable interest + rates at closing; and promising + borrowers that they + + could refinance their + costly loans into loans with + better terms in just + + a few months or a + year, even when borrowers had + no equity to + + absorb another + refinance."51 Ed Parker, the + former head of Ameriquest’s + +On line 393: + the Commission that + he detected fraud at the + company within + +On line 393: + month of starting his + job there in January but + senior management + + did nothing with the + reports he sent. He heard that + other departments + +On line 395: + were complaining he + "looked too much" into the loans. + In November he + +On line 399: + from "manager" to + "supervisor," and was laid + off in May In late + +On line 399: + its loans. He received + about 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 + +On line 399: + he recalled in an + interview with the FCIC, a + disabled borrower + +On line 399: + his 80s who used a + walker was described in the + loan application + +On line 403: + being employed in + "light construction."53 "It didn’t + take Sherlock Holmes to + +On line 403: + out this was bogus," + Cox told the Commission. As + he tried to figure + +On line 403: + suggested that he + "look upstream." Cox suddenly + realized that the + +On line 405: + product to ship to + Wall Street to sell to investors. + "I got that it had + +On line 407: + "The lending pattern + had shifted."54 Ultimately, + states and the District + + of Columbia joined + in the lawsuit against Ameriquest, on + behalf of "more than + +On line 407: + million settlement. + But during the years when the + investigation + +On line 409: + way, between and Ameriquest + originated another + billion in loans,55 which + +On line 411: + investigation, + some federal officials + said they had followed + +On line 411: + Housing and Urban + Development, "we began + to get rumors" that + +On line 411: + firms were "running wild, + taking applications over + the Internet, not + +On line 411: + peoples’ income or + their ability to have a + job," recalled Alphonso + +On line 413: + the HUD secretary + from to in an interview + with the Commission. + +On line 413: + great deal of money + and there wasn’t a great deal + of oversight going + +On line 413: + he was the nation’s + top housing official at + the time, he placed much + +On line 415: + the blame on Congress.56 + Cox, the former Minnesota + prosecutor, and + + Madigan, the Illinois + attorney general, told + the Commission that + +On line 415: + the single biggest + obstacles to effective + state regulation + +On line 415: + chartered banks—including + Bank of America, Citibank, and + Wachovia—and the OTS, + +On line 415: + thrifts. The OCC and OTS + issued rules preempting states + from enforcing rules + +On line 417: + national banks and + thrifts.57 Cox recalled that in Julie + Williams, the chief counsel + +On line 419: + OCC, had delivered + what he called a "lecture" to + the states’ attorneys + +On line 419: + in a meeting in + Washington, warning them that + the OCC would "quash" them + + if they persisted + in attempting to control + the consumer practices + +On line 421: + institutions.58 Two + former OCC comptrollers, John + Hawke and John Dugan, told + +On line 421: + Commission that they + were defending the agency’s + constitutional + +On line 421: + entities. Because + state-chartered lenders had more lending + problems, they said, the + +On line 421: + to involve themselves + in federally chartered + institutions, an + +On line 421: + told the Commission + that national banks funded + of the largest subprime + +On line 421: + operating with + state charters, and that those banks + were the end market + +On line 421: + by the state-chartered firms. + She noted that the OCC was + "particularly + +On line 421: + in its efforts to + thwart state authority over + national lenders, and + + lax in its efforts + to protect consumers from the + coming crisis."60 Many + +On line 423: + in enforcing their + own lending regulations, + as did some cities. In + +On line 423: + 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 + +On line 423: + Wachovia’s announcement, + and Wachovia sued Michigan. The + OCC, the American + +On line 423: + and the Mortgage Bankers + Association entered + the fray on Wachovia’s + +On line 423: + and the District of + Columbia aligned themselves with + Michigan. The legal + +On line 423: + four years. The Supreme Court + ruled in Wachovia’s favor on + April leaving the OCC + +On line 423: + were they negligent, + they were aggressive players + attempting to stop + +On line 425: + enforcement action[s]. + Those guys should have been on our + side."61 Nonprime lending + +On line 425: + surged to billion in + and then trillion in 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 + +On line 425: + financed the mortgages—who + prepared the paperwork for + loans and earned fees from + +On line 425: + lenders for doing it. + More than new mortgage brokers + egan their jobs during + +On line 425: + than honorable in + their dealings with borrowers.63 + According to an + +On line 425: + investigative news + report published in between + and at least people + +On line 425: + entered the field in + Florida, for example, + including who had + +On line 425: + been convicted of + such crimes as fraud, bank robbery, + racketeering, and + + extortion.64 J. Thomas + Cardwell, the commissioner + of the Florida + +On line 425: + accountability + created a condition + in which fraud flourished."65 + +On line 425: + Association + of Mortgage Brokers, told the + Commission that while + + most mortgage brokers + looked out for borrowers’ best + interests and steered + +On line 425: + them away from risky loans, + about of the newcomers to + the field nationwide + +On line 425: + to do whatever + it took to maximize the + number of loans they + +On line 427: + home values grew even + faster between and the real + estate appraiser + +On line 427: + initially felt pride + that his birthplace, miles north of + Los Angeles, "had + +On line 427: + been discovered" by + other Californians. + The city, a farming + +On line 427: + industry center + in the San Joaquin Valley, was + drawing national + + attention for the + pace of its development. + Wide-open farm fields were plowed + +On line 429: + into thousands of + building lots. Home prices jumped in + Bakersfield in in + +On line 431: + more in Crabtree, an + appraiser for years, started + in and to think that + +On line 431: + 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 + +On line 433: + the new suburban + subdivisions. The Cleveland + phenomenon had + +On line 433: + Bakersfield, a place + far from the Rust Belt. Crabtree + watched as foreclosures + +On line 433: + Houses fell into + disrepair and neighborhoods + disintegrated. + +On line 435: + began studying the + market. In he ended up + identifying what + +On line 435: + in Bakersfield; some, + for instance, were allowing + insiders to siphon + +On line 435: + property transfer. + The transactions involved many + of the nation’s largest + +On line 435: + for example, was + listed for sale for and was + recorded as selling + +On line 435: + for with financing, + though the real estate agent + told Crabtree that it + +On line 435: + actually sold + for Crabtree realized that + the gap between the + +On line 435: + sales price and loan amount + allowed these insiders to + pocket The terms of + +On line 435: + The house went into + foreclosure and was sold in + a distress sale for + +On line 437: + began calling lenders + to tell them what he had found; + but to his shock, they + +On line 437: + reached one quality + assurance officer at + Fremont Investment + +On line 437: + nation’s eighth-largest subprime + lender. "Don’t put your nose where it + doesn’t belong," he + +On line 439: + story to state law + enforcement officials and + to the Federal + +On line 439: + Investigation. + "I was screaming at the top + of my lungs," he said. + +On line 439: + pace of enforcement + and at prosecutors’ lack + of response to a + +On line 441: + wreaking economic + havoc in Bakersfield.69 At + the Washington, D.C., + +On line 441: + the FBI, Chris Swecker, + an assistant director, + was also trying + +On line 441: + to pay attention + to mortgage fraud. "It has the + potential to be + + an epidemic," he + said at a news conference + in Washington in + +On line 441: + think we can prevent + a problem that could have as + much impact as the + +On line 443: + crisis."70 Swecker called + another news conference + in December to + +On line 443: + 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 + +On line 443: + Internal Revenue + Service. The officials told + reporters that real + +On line 443: + executives were + not doing enough to root out + mortgage fraud and that + +On line 445: + do more to "police + their own organizations."71 + Meanwhile, the number + +On line 447: + continued to swell. + Suspicious activity + reports, also known + +On line 447: + are reports filed by + banks to the Financial Crimes + Enforcement Network + +On line 447: + within the Treasury + Department. In November + the network published + +On line 447: + analysis that found + a 20-fold increase in mortgage + fraud reports between + +On line 447: + underreporting, + because two-thirds of all the loans + being created + + were originated + by mortgage brokers who were + not subject to any + +On line 447: + 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. Black, an + expert on white-collar crime + and a former staff + +On line 451: + Reform, Recovery + and Enforcement, created + by Congress in as + +On line 455: + served from February + to told the FCIC he could not + remember the press + + conferences or news + reports about mortgage fraud. Both + Gonzales and his + +On line 455: + Michael Mukasey, who served as + attorney general in + and told the FCIC that + +On line 455: + to them as a top + priority. "National + security was + +On line 457: + overriding" concern, + Mukasey said.75 To community + activists and local + +On line 457: + lending practices were + a matter of national + economic concern. + +On line 457: + the Empire Justice + Center in Rochester, New York, told + Fed Governors Bernanke, + +On line 457: + Susan Bies, and Roger + Ferguson in October + that she suspected + +On line 457: + 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 + +On line 457: + Fed officials, who + were gathered at the public + hearing period + +On line 457: + 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 + +On line 459: + from a confluence + of financial events: flat or + declining incomes, + +On line 461: + and fraudulent loans + with overstated values.77 In + an interview with + +On line 461: + Fed officials seemed + impervious to what the + consumer advocates + +On line 461: + The Fed governors + politely listened and said + little, she recalled. + +On line 461: + 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 + +On line 463: + out interest-only + loans, and the trend was far more + pronounced on the West + +On line 463: + of their easy credit + terms, nontraditional loans + enabled borrowers + +On line 463: + buy more expensive + homes and ratchet up the prices + in bidding wars. The + +On line 463: + pattern of higher + foreclosure rates frequently + appeared soon after. + + As home prices shot up + in much of the country, many + observers began to + +On line 465: + June the Economist + magazine’s cover story + posited that the day + + of reckoning was + at hand, with the headline "House + Prices: After the Fall." + +On line 465: + depicted a brick + plummeting out of the sky. + "It is not going + + to be pretty," the + article declared. "How the + current housing boom + +On line 465: + decide the course of + the entire world economy + over the next few years."80 + +On line 467: + month, Fed Chairman Greenspan + acknowledged the issue, telling + the Joint Economic + +On line 467: + of the U.S. Congress + that "the apparent froth in + housing markets may + +On line 467: + spilled over into the + mortgage markets."81 For years, he + had warned that Fannie + +On line 467: + Freddie Mac, bolstered + by investors’ belief that these + institutions had + +On line 467: + backing of the U.S. + government, were growing so + large, with so little + +On line 467: + for the financial + system. Still, he reassured + legislators that + + the U.S. economy + was on a "reasonably firm + footing" and that the + +On line 469: + be resilient if the + housing market turned sour. "The + dramatic increase + +On line 469: + the introduction + of other relatively + exotic forms of + +On line 469: + 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 + +On line 471: + that would otherwise + be unaffordable, their use + is beginning to + +On line 473: + to the pressures in + the marketplace. Although we + certainly cannot + +On line 473: + local markets, these + declines, were they to occur, + likely would not have + +On line 473: + banking and widespread + securitization of + mortgages makes it less + +On line 473: + would be impaired than + was the case in prior episodes + of regional house + +On line 475: + corrections.82 Indeed, + Greenspan would not be the only + one confident that + +On line 475: + downturn would leave the + broader financial system + largely unscathed. As + +On line 475: + after housing prices + had been declining for a + year, Bernanke testified + +On line 477: + "the problems in the + subprime market were likely + to be contained"—that is, + +On line 479: + economy.83 Some were + less sanguine. For example, + the consumer lawyer Sheila + +On line 481: + interest-only, a + proportion that was more than + twice the national + +On line 481: + "That’s insanity," + she told the Fed governors. + "That means we’re facing + + something down the road + that we haven’t faced before and + we are going to + + be looking at a + safety and soundness crisis."84 + On another front, + + some academics offered + pointed analyses as they raised + alarms. For example, + +On line 485: + the Yale professor + Robert Shiller, who along with Karl Case + developed the Case-Shiller + +On line 487: + the market appeared + in historical terms. Shiller + warned that the housing + +On line 489: + would likely burst.85 In + that same month, a conclave of + economists gathered + + at Jackson Lake Lodge + in Wyoming, in a conference + center nestled in + + Grand Teton National + Park. It was a "who’s who of + central bankers," recalled + +On line 491: + who was then on leave + from the University of + Chicago’s business school + +On line 491: + 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 + +On line 495: + dignitaries.86 Rajan + presented a paper with + a provocative title: + +On line 495: + Development Made + the World Riskier1" He posited + that executives + +On line 495: + let off the hook for + any eventual losses—the + IBGYBG syn-drome. + +On line 495: + investment strategies + such as credit default swaps + could have disastrous + +On line 495: + 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 + +On line 497: + then president of + Harvard University, called + Rajan a "Luddite," + +On line 497: + simply opposed to + technological change.88 "I + felt like an early + +On line 497: + had wandered into + a convention of half-starved + lions," Rajan wrote + +On line 499: + University of + Pennsylvania’s Wharton School, + prepared a research + +On line 499: + that the United States + could have a real estate + crisis similar + +On line 501: + suffered in Asia in + the 1990s. When she discussed her + work at another + +On line 501: + Hole gathering two + years later, it received a + chilly reception, she + +On line 501: + Commission. "It was + universally panned," she said, + and an economist + +On line 505: + were beginning to + highlight indications that + the real estate + +On line 505: + was weakening. Home + sales began to drop, and Fitch + Ratings reported + +On line 505: + mortgage delinquencies + were rising. That year, the hedge + fund manager Mark + +On line 505: + securities trade + group, that investors had become + "over optimistic" about + +On line 505: + market. "I see a + lot of irrationality," + he added. He said he + +On line 505: + different this time"—a + rationale commonly heard + before previous + +On line 507: + Some real estate + appraisers had also been + expressing concerns + +On line 509: + to a coalition of + appraisal organizations + circulated and + +On line 509: + petition; signed by + appraisers and including + the name and address + +On line 509: + assigning business + only to appraisers who + would hit the desired + +On line 509: + "The powers that be + cannot claim ignorance," the + appraiser Dennis + +On line 511: + Black of Port Charlotte, + Florida, testified to + the Commission.92 The + +On line 511: + veteran, told the + Commission that lenders had opened + subsidiaries to perform + +On line 511: + consumers and making + it easier to inflate + home values. The steep + +On line 511: + the un-merited and + inflated appraisals she was + seeing in Northern + +On line 511: + was headed for a + cataclysmic downturn. In she + laid off some of her + +On line 511: + in order to cut + her overhead expenses, in + anticipation + +On line 511: + 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 + +On line 513: + slowing, Wall Street just + kept going and going—ordering + up loans, packaging + +On line 513: + By the third quarter + of home prices were falling and + mortgage delinquencies + +On line 513: + a combination + that spelled trouble for mortgage-backed + securities. But + +On line 513: + from the third quarter + of on, banks created and + sold some trillion in + +On line 515: + and more than billion + in mortgage-related CDOs.94 Not + everyone on Wall + +On line 515: + were urging caution, + as corporate governance + and risk management + +On line 517: + down. Reflecting on + the causes of the crisis, + Jamie Dimon, CEO of + +On line 517: + testified to the + FCIC, "I blame the management + teams and no one else."95 + +On line 519: + too many financial + firms, management brushed aside the + growing risks to their + +On line 519: + At Lehman Brothers, for + example, Michael Gelband, the + head of fixed income, + +On line 519: + his colleague Madelyn + Antoncic warned against taking + on too much risk in + +On line 519: + growing pressure to + compete aggressively against + other investment + +On line 519: + Antoncic, who was + the firm’s chief risk officer + from to 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 + +On line 523: + on "philosophical + differences."97 At Citigroup, + meanwhile, Richard Bowen, a + +On line 523: + the consumer lending + group, received a promotion + in early when he + + was named business chief + under writer. He would go + on to oversee loan + +On line 523: + quality for over + billion a year of mortgages + underwritten and + + purchased by CitiFinancial. These + mortgages were sold to Fannie + Mae, Freddie Mac, and + +On line 523: + others. In June Bowen + discovered that as much as + of the loans that Citi + +On line 525: + meet Citi - group’s loan + guidelines and thus endangered + the company—if the + +On line 525: + were to default on + their loans, the investors could force + Citi to buy them back. + +On line 525: + the Commission that + he tried to alert top managers + at the firm by "email, + +On line 527: + and discussions"; but + though they expressed concern, it + "never translated + + into any action." + Instead, he said, "there was a + considerable push + +On line 527: + to increase market + share." Indeed, Bowen recalled, Citi + began to loosen its + +On line 527: + started to purchase + stated-income loans. "So we joined + the other lemmings + +On line 529: + for the cliff," he said + in an interview with the + FCIC.98 He finally + +On line 529: + his warnings to the + highest level he could reach—Robert + Rubin, the chairman + +On line 529: + 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 + +On line 531: + the words "URGENT—READ + IMMEDIATELY" in the + subject line. Sharing + + his concerns, he stressed + to top managers that Citi faced + billions of dollars + +On line 531: + if investors were to + demand that Citi repurchase + the defective loans.99 + +On line 533: + told the Commission + in a public hearing in + April that Citibank handled + +On line 533: + 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 + +On line 533: + that that was acted + on promptly and actions were + taken in response + +On line 533: + the bank undertook + an investigation in + response to Bowen’s claims + + and the system of + underwriting reviews was + revised.101 Bowen told the + +On line 535: + sending emails, he went + from supervising0 people + to supervising + +On line 535: + bonus was reduced, and + he was downgraded in his + performance review.102 + +On line 539: + a former Bear Stearns + executive, testified + to the FCIC that he + +On line 539: + to be on a shaky + foundation. "Their answer at + the time was, and this + +On line 539: + the thought that was—that was + homogeneous throughout Wall + Street’s analysts—was home + +On line 539: + always track income + growth and jobs growth. And they showed + me income growth on + +On line 539: + 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 + +On line 539: + you obviously + don’t realize where the dog + is and where the tail + +On line 541: + what."103 ven those who had + profited from the growth of + nontraditional + + lending practices said + they became disturbed by what + was happening. Herb + +On line 541: + Corporation, which + was heavily loaded with + option ARM loans, wrote + +On line 541: + to officials at + the Federal Reserve, the + FDIC, the OTS, and the + +On line 541: + regulators were + "too dependent" on ratings + agencies and "there is + +On line 541: + high potential for + gaming when virtually + any asset can be + +On line 541: + and transformed into + a AAA-rated asset, and when a + multi-billion + +On line 543: + all too eager to + facilitate this alchemy."104 + Similarly, Lewis + +On line 545: + machine in the 1980s, + said he didn’t like what he + called "the madness" that + +On line 545: + descended on the + real estate market. Ranieri + told the Commission, + +On line 545: + was not the only + guy. I’m not telling you I was + John the Baptist. There + +On line 545: + of us, analysts + and others, wandering around + going ‘look at this + +On line 545: + it would be hard to + miss it."105 Ranieri’s own Houston-based Franklin + Bank Corporation + +On line 547: + under the weight of + the financial crisis in + November Other + +On line 547: + inside the business + also acknowledged that the + rules of the game were + +On line 547: + 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 + +On line 547: + 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 + +On line 547: + of ours."108 Still, Mozilo + was nervous. "There was a time + when savings and loans + +On line 551: + doing it," he told + the other executives. + "They all went broke."109 In + +On line 553: + to take a look at + the changing mortgage market. + Sabeth Siddique, the + +On line 553: + for credit risk in + the Division of Banking + Supervision and + +On line 553: + Reserve Board, was charged + with investigating how + broadly loan patterns + +On line 553: + were changing. He took + the questions directly to + large banks in and asked + +On line 555: + of which kinds of loans + they were making. Siddique found + the information + +On line 555: + told the Commission.110 + In fact, nontraditional + loans made up percent + +On line 555: + at National City, + at Washington Mutual, + at CitiFinancial, and at Bank + +On line 555: + America. Moreover, + the banks expected that their + originations of + +On line 557: + would rise by in to + billion. The review also + noted the "slowly + +On line 557: + due to loosening + underwriting standards." In + addition, it found + +On line 557: + banks in had been of + the stated-income, minimal + documentation + +On line 557: + known as liar loans, which + had a particularly + great likelihood of + +On line 559: + sour.111 The reaction + to Siddique’s briefing was mixed. + Federal Reserve + +On line 559: + response by the Fed + governors and regional + board directors as + +On line 559: + people on the board + and regional presidents + just wanted to come + + to a different + answer. So they did ignore + it, or the full thrust + +On line 563: + the Commission.112 The + OCC was also pondering + the situation. + +On line 563: + comptroller of the + currency John C. Dugan told + the Commission that + +On line 563: + had come from below, + from bank examiners who + had become concerned + +On line 565: + The agency began + to consider issuing + "guidance," a kind of + +On line 565: + warning to banks, that + nontraditional loans could + jeopardize safety + +On line 565: + bank examiners. + Siddique said the OCC led the + effort, which became + +On line 567: + deliberations + over the potential guidance + also stirred debate + +On line 567: + critics feared it both + would stifle the financial + innovation that + +On line 567: + record profits to Wall + Street and the banks and would make + homes less affordable. + +On line 567: + the agencies—the + Fed, the OCC, the OTS, the FDIC, + and the National + +On line 567: + work together on + it, or it would unfairly + block one group of lenders + +On line 569: + regulatory + overreach. "The bankers pushed back," Bies + told the Commission. + +On line 569: + Congress pushed back. Some + of our internal people + at the Fed pushed back."115 + +On line 571: + represents mortgage + insurance companies, weighed + in on the other + +On line 571: + underwritten or + unsuitable mortgages and home + equity loans," the + +On line 571: + to regulators + in "The most recent market + trends show alarming signs + +On line 573: + risk-taking that puts + both lenders and consumers at risk."116 + In congressional + +On line 573: + downturns. "We take a + conservative position + on risk because of + +On line 573: + first loss position," + Simpson informed the Senate + Subcommittee on + +On line 573: + we also have a + historical perspective. + We were there when the + +On line 573: + turned sharply down during + the mid-1980s especially in + the oil patch and the + +On line 575: + in California + and the Northeast."117 Within the + Fed, the debate grew + +On line 575: + Siddique recalled. "It + got very personal," he told + the Commission. The + + ideological + turf war lasted more than a + year, while the number + +On line 577: + nontraditional + loans kept growing and growing.118 + Consumer advocates + +On line 577: + up the heat. In a + Fed Consumer Advisory + Council meeting in + +On line 577: + March Fed Governors + Bernanke, Mark Olson, and Kevin Warsh + were specifically + +On line 577: + warned of dangers that + nontraditional loans posed + to the economy. + +On line 577: + director of the + North Carolina Fair Housing + Center, raised concerns + +On line 577: + nontraditional + lending "may precipitate + a downward spiral + + that starts on the coast + and then creates panic in + the east that could have + +On line 579: + total economy + as well."119 At the next meeting + of the Fed’s Consumer + +On line 579: + June and attended + by Bernanke, Bies, Olson, and Warsh, + several consumer + +On line 579: + the Fed governors + alarming incidents that were + now occurring all + +On line 581: + and evaluation + at the Enterprise Corp. of + the Delta, in Jackson, + +On line 581: + by mortgage brokers + that property values were + being inflated + +On line 581: + profit for real + estate appraisers and loan + originators. Alan + +On line 581: + in Philadelphia, + reported a "huge surge in + foreclosures," noting + +On line 581: + up to half of the + borrowers he was seeing + with troubled loans had + +On line 581: + overcharged and given + high-interest rate mortgages + when their credit had + + qualified them for + lower-cost loans. Hattie B. + Dorsey, the president + +On line 583: + Development, said + she worried that houses were + being flipped back and + + forth so much that the + result would be neighborhood + "decay." Carolyn Carter + +On line 585: + authority to + "prohibit abuses in the + mortgage market."120 The + +On line 585: + Siddique, before Greenspan + left his post as Fed chairman + in January he + +On line 585: + indicated his + willingness to accept the + guidance. Ferguson + +On line 585: + the Fed board and the + regional Fed presidents + to get it done. Bies + + supported it, and + Bernanke did as well.121 More than a + year after the OCC + + had began discussing + the guidance, and after the + housing market had + +On line 587: + September as an + interagency warning + that affected banks, + +On line 587: + unions nationwide. Dozens + of states followed, directing + their versions of the + + guidance to tens of + thousands of state-chartered lenders and + mortgage brokers. Then, + +On line 589: + July long after + the risky, nontraditional + mortgage market had + +On line 589: + halt, the Federal + Reserve finally adopted + new rules under HOEPA + +On line 589: + curb the abuses about + which consumer groups had raised red + flags for years—including + +On line 591: + that borrowers have + the ability to repay + loans made to them. By + + that time, however, + the damage had been done. The + total value of + +On line 591: + 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 + +On line 593: + firms and markets had + become to the potential + contagion from these + +On line 593: + instruments. As the + housing market began to + turn, they scrambled to + +On line 593: + respond as losses + in one part of that system + would ricochet to + +On line 595: + end of most of the + subprime lenders had failed or been + acquired, including + +On line 595: + Financial, Ameriquest, and + American Home Mortgage. In + January Bank of + + America announced + it would acquire the ailing + lender Countrywide. It + +On line 595: + became clear that risk—rather + than being diversified + across the financial + + system, as had been + thought—was concentrated at + the largest financial + +On line 595: + risky mortgage assets + and dependent on fickle + short-term lending, was + + bought by JP Morgan + with government assistance + in the spring. Before + + the summer was over, + Fannie Mae and Freddie Mac + would be put into + +On line 599: + Brothers failed and the + remaining investment banks, + Merrill Lynch, Goldman + +On line 599: + confidence. AIG, with + its massive credit default + swap portfolio and + +On line 599: + 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 + +On line 599: + bank failure in U.S. + history. In October, + Wachovia struck a deal + + to be acquired by + Wells Fargo. Citigroup and + Bank of America + +On line 599: + to stay afloat. Before + it was over, taxpayers had + committed trillions + +On line 599: + through more than two dozen + extraordinary programs + to stabilize the + +On line 601: + crisis that befell + the country in had been years + in the making. In + +On line 601: + Commission, former + Fed chairman Greenspan defended + his record and said most + +On line 601: + of his judgments had + been correct. "I was right of + the time but I was + +On line 601: + wrong of the time," he + told the Commission.123 Yet the + consequences of what + +On line 603: + in the run-up to the + crisis would be enormous. The + economic impact + +On line 603: + devastating. And + the human devasta-tion + is continuing. + +On line 603: + in November but + the underemployment rate, + which includes those who + +On line 603: + given up looking + for work and part-time workers + who would prefer to + +On line 603: + full-time, was above + And the share of unemployed + workers who have been + +On line 603: + of work for more than + six months was just above Of large + metropolitan + +On line 605: + were as lethal as many + had predicted, and it has + been estimated + +On line 605: + that ultimately + as many as million households + in the United States + +On line 605: + foreclosure. As of + foreclosure rates were highest + in Florida and + +On line 605: + Florida, nearly + of loans were in foreclosure, + and Nevada was not + +On line 605: + American mortgage + borrowers owed more on their + mortgages than their home + +On line 609: + was nearly Households + have lost trillion in wealth since + As Mark Zandi, the + +On line 609: + economist of Moody’s + Economy.com, testified + to the Commission, + +On line 611: + crisis has dealt a + very serious blow to the + U.S. economy. The + +On line 611: + the Great Recession: + the longest, broadest and most + severe downturn since + +On line 611: + the Great Depression + of the 1930s. The longer-term fallout + from the economic + +On line 611: + crisis is also + very substantial. It will take + years for employment + +On line 613: + on the years before + the crisis, the economist + Dean Baker said: "So + +On line 613: + absolute public + knowledge in the sense that we + knew the number of + + loans that were being + issued with zero down. Now, + do we suddenly + +On line 613: + 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 + +On line 613: + off—than was true years ago1 + I mean, what’s changed in the world1 + There were a lot of + +On line 613: + didn’t require any + investigation at all; + these were totally + +On line 615: + the data."127 Warren + Peterson, a home builder in + Bakersfield, felt that + +On line 615: + world changed to the day. + Peterson built homes in an + upscale neighborhood, + +On line 615: + Monday morning, he + would arrive at the office + to find a bevy of + +On line 615: + 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 + +On line 615: + in November he + was at the sales office and + noticed that not a + + single purchaser + had entered the building. He + called a friend, also + +On line 617: + home-building business, + who said he had noticed the + same thing, and asked him + +On line 628: + he thought about it. "It’s + over," his friend told Peterson.128 + PART II Setting the + +On line 642: + repos: "Unfettered + markets"............................................29 The savings and loan + crisis: "They put a + +On line 646: + regulators" The + financial crisis of and + was not a single + + event but a series + of crises that rippled through the + financial system + +On line 646: + Distress in one area + of the financial markets + led to failures in + +On line 646: + interconnections + and vulnerabilities + that bankers, government + +On line 646: + had missed or dismissed. + When subprime and other risky + mortgages—issued + + during a housing + bubble that many experts failed + to identify, and + +On line 648: + began to default + at unexpected rates, a + once-obscure market + +On line 648: + complex investment + securities backed by those + mortgages abruptly failed. + +On line 648: + the contagion spread, + investors panicked—and the danger + inherent in the + +On line 648: + became manifest. + Financial markets teetered on + the edge, and brand-name + +On line 648: + institutions were + left bankrupt or dependent + on the taxpayers + +On line 650: + survival. Federal + Reserve Chairman Ben Bernanke now + acknowledges that he + + missed the systemic risks. + "Prospective subprime losses were + clearly not large enough + +On line 650: + their own to account + for the magnitude of the + crisis," Bernanke told the + +On line 654: + economy."1 This part + of our report explores the + origins of risks as + + they developed in + the financial system over + recent decades. It is + +On line 654: + complex history + that could yield its own report. + Instead, we focus + +On line 654: + developments that + helped shape the events that shook our + financial markets + +On line 654: + economy. Detailed + books could be written about each + of them; we stick to + +On line 654: + understanding our + specific concern, which is + the recent crisis. + +On line 656: + the phenomenal + growth of the shadow banking + system—the investment + +On line 656: + most prominently, but + also other financial + institutions—that + +On line 656: + regulatory + apparatus that had been + put in place in the + +On line 657: + wake of the crash of + and the Great Depression. This + new system threatened + +On line 657: + once-dominant + traditional commercial + banks, and they took their + +On line 657: + their regulators + and to Congress, which slowly + but steadily removed + +On line 657: + and helped banks break out + of their traditional mold + and join the feverish + + growth. As a result, + two parallel financial + systems of enormous + +On line 657: + new competition + not only benefited + Wall Street but also + +On line 657: + help all Americans, + lowering the costs of their + mortgages and boosting + +On line 657: + returns on their 401(k)s. + Shadow banks and commercial + banks were codependent + +On line 659: + new activities + were very profitable—and, it turned + out, very risky. Second, + +On line 659: + the evolution of + financial regulation. + To the Federal + +On line 659: + granted greater license + to market participants + appeared to provide + +On line 659: + and more dynamic + alternative to the era + of traditional + +On line 659: + Former Fed chairman + Alan Greenspan put it this way: "The + market-stabilizing + +On line 659: + government structures."2 + In the Fed’s view, if problems + emerged in the shadow + +On line 659: + the large commercial + banks—which were believed to be well-run, + well-capitalized, + + and well-regulated + despite the loosening of + their restraints—could provide + +On line 659: + restore financial + stability. It did so + again and again in the + +On line 659: + 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 + +On line 661: + 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, + +On line 661: + 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 + +On line 663: + dominant forces in + providing financing to + support the mortgage + +On line 665: + for investors. Fourth, we + introduce some of the most + arcane subjects in + +On line 665: + national vocabu-lary + as the financial markets + unraveled through and + +On line 665: + rating agencies whose + own motives were conflicted. + This entire market + +On line 665: + to be divorced from + reality—and on ever-rising + housing prices. When that + +On line 665: + bubble also burst: + the securities almost + no one understood, + +On line 665: + by mortgages no lender + would have signed years earlier, + were the first dominoes + +On line 669: + sector. A basic + understanding of these four + developments will + +On line 669: + reader up to speed + in grasping where matters stood + for the financial + +On line 669: + system in the year + at the dawn of a decade of + promise and peril. + +On line 675: + REPOS: "UNFETTERED + MARKETS" For most of the 20th + century, banks and + +On line 675: + deposits and loaned that + money to home buyers or + businesses. Before + +On line 675: + institutions were + vulnerable to runs, when + reports or merely + +On line 675: + that a bank was in + trouble spurred depositors + to demand their cash. + +On line 675: + widespread, the bank might + not have enough cash on hand to + meet depositors’ + +On line 675: + Reserve System in + which acted as the lender of + last resort to banks. + +On line 677: + creation of the Fed + was not enough to avert bank runs + and sharp contrac-tions + +On line 677: + in the financial + markets in the 1920s and 1930s. + So in Congress passed + + the Glass-Steagall Act, which, among + other changes, established the + Federal Deposit + +On line 677: + bank deposits up to + $2,500—an amount that covered the vast + majority of + +On line 679: + deposits at the time; + that limit would climb to by + where it stayed until + +On line 681: + was raised to during + the crisis in October + Depositors no + +On line 681: + 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 + +On line 681: + ensure that banks would + not fail simply from a lack + of liquidity. + + With these backstops in + place, Congress restricted banks’ + activities to + +On line 683: + move intended to + help prevent bank failures, with + taxpayer dollars + +On line 683: + Furthermore, Congress + let the Federal Reserve + cap interest rates + +On line 685: + thrifts—also known as + savings and loans, or S&Ls— could + pay depositors. + +On line 685: + Regulation Q, + was also intended to + keep institutions + +On line 685: + by ensuring that + competition for deposits + did not get out of + +On line 687: + was stable as long + as interest rates remained + relatively steady, + + which they did during + the first two decades after World + War II. Beginning + +On line 687: + started to increase, + pushing up interest rates. + For example, the + +On line 687: + paid other banks for + overnight loans had rarely exceeded + in the decades before + +On line 687: + it reached However, + thanks to Regulation Q, + banks and thrifts were stuck + +On line 687: + roughly less than on + most deposits. Clearly, this was + an untenable bind + +On line 687: + depository + institutions, which could not + compete on the most + +On line 689: + of the interest + rate offered on a deposit. + Compete with whom1 In + +On line 689: + others persuaded + consumers and businesses to + abandon banks and thrifts + +On line 691: + find new businesses, + particularly after + the Securities + +On line 693: + commissions on stock + trades in created money + market mutual + +On line 693: + securities such + as Treasury bonds and highly + rated corporate + +On line 693: + the funds paid higher + interest rates than banks and + thrifts were allowed to + +On line 695: + with a different + mechanism: customers bought shares + redeemable daily at + +On line 695: + a stable value. + In Merrill Lynch introduced + something even more like + + a bank account: "cash + management accounts" allowed + customers to write checks. + +On line 697: + market mutual + funds quickly followed.5 These funds + differed from bank and + + thrift deposits in one + important respect: they were + not protected by + +On line 697: + higher interest + rates, and the stature of the funds’ + sponsors reassured + +On line 697: + promised to maintain the + full net asset value of + a share. The funds would + +On line 697: + 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 + +On line 697: + growing up beside + the traditional banking + system. Assets in + +On line 699: + market mutual + funds jumped from billion in to + more than billion in + +On line 701: + To maintain their edge + over the insured banks and thrifts, + the money market + +On line 701: + in, and they quickly + developed an appetite for + two booming markets: + +On line 703: + "commercial paper" + and "repo" markets. Through these + instruments, Merrill + +On line 703: + Morgan Stanley, and + other Wall Street investment + banks could broker and + +On line 703: + Commercial paper + was unsecured corporate + debt—meaning that it + +On line 705: + the corporation’s + promise to pay. These loans were + cheaper because they + +On line 705: + sometimes as short as + two weeks and, eventually, + as short as one day; + +On line 705: + "rolled them over" when the + loan came due, and then again and + again. Because only + +On line 705: + were able to issue + commercial paper, it was + considered a very + +On line 705: + companies such as + General Electric and IBM, + investors believed, would + + always be good for + the money. Corporations + had been issuing + +On line 705: + since the beginning + of the century, but the + practice grew much more + +On line 707: + the 1960s. This market, + though, underwent a crisis + that demonstrated that + + capital markets, + too, were vulnerable to + runs. Yet that crisis + +On line 707: + in the U.S., filed for + bankruptcy with million in + commercial paper + +On line 707: + railroad’s default caused + investors to worry about the + broader commercial + +On line 707: + market; holders of + that paper—the lenders—refused to + roll over their loans to + +On line 707: + commercial paper + market virtually shut + down. In response, the + +On line 707: + with almost million + in emergency loans and with + interest rate cuts.7 + +On line 707: + Fed’s actions enabled + the banks, in turn, to lend to + corporations so + +On line 707: + commercial paper—the + borrowers—typically + set up standby lines + +On line 707: + credit with major + banks to enable them to pay + off their debts should there + +On line 707: + another shock. These + moves reassured investors that + commercial paper + +On line 709: + a safe investment. + In the 1960s, the commercial + paper market jumped + +On line 709: + than sevenfold. Then + in the 1970s, it grew almost + fourfold. Among the largest + +On line 709: + market mutual + funds. It seemed a win-win-win deal: the + mutual funds could + +On line 709: + stable companies + could borrow more cheaply, and + Wall Street firms could earn + +On line 709: + fees for putting the deals + together. By commercial + paper had risen to + +On line 711: + less than billion in + The second major shadow + banking market that + +On line 711: + market for repos, + or repurchase agreements. Like + commercial paper, + +On line 711: + a long history, + but they proliferated + quickly in the 1970s. + +On line 711: + often sold Treasury + bonds with their relatively + low returns to banks + +On line 711: + while then investing + the cash proceeds of these sales + in securities + +On line 711: + The dealers agreed to + repurchase the Treasuries—often + within a day—at + +On line 711: + for which they sold them. + This repo transaction—in + essence a loan—made it + + inexpensive and + convenient for Wall Street firms + to borrow. Because + +On line 711: + the securities + dealers borrowed nearly the + full value of the + +On line 711: + a small "haircut." Like + commercial paper, repos + were renewed, or "rolled + +On line 711: + could be considered + "hot money"—because lenders could + quickly move in and + +On line 711: + these investments in + search of the highest returns, + they could be a risky + +On line 713: + repo market, too, + had vulnerabilities, + but it, too, had emerged + +On line 713: + stronger than ever. In + two major borrowers, the + securities firms + +On line 713: + losses for lenders. In + the ensuing fallout, the + Federal Reserve + +On line 713: + resort to support + a shadow banking market. + The Fed loosened the + + terms on which it lent + Treasuries to securities + firms, leading to a + +On line 715: + to a tri-party + arrangement in which a large + clearing bank acted + +On line 715: + borrower and lender, + essentially protecting + the collateral + +On line 715: + them in escrow.9 This + mechanism would have severe + consequences in and + +On line 715: + 1980s, however, these + new procedures stabilized + the repo market. + + The new parallel + banking system—with commercial + paper and repo + +On line 717: + a crucial catch: its + popularity came at + the expense of the + +On line 719: + this development + with growing alarm. According + to Alan Blinder, the + +On line 721: + vice chairman of the + Federal Reserve from to + "We were concerned as + +On line 721: + regulators with + the eroding competitive + position of banks, + +On line 721: + of course would threaten + ultimately their safety + and soundness, due to + +On line 721: + they were getting from + a variety of nonbanks—and + these were mainly Wall + +On line 721: + 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 + +On line 725: + financial assets."10 + raditional and Shadow + Banking Systems The + + funding available through + the shadow banking system + grew sharply in the 2000s, + +On line 725: + the traditional + banking system in the years + before the crisis. + +On line 727: + that during the 1990s + the shadow banking system + steadily gained ground on + +On line 729: + sector for a brief + time after Banks argued that + their problems stemmed from + +On line 729: + Glass-Steagall Act. Glass-Steagall strictly + limited commercial banks’ + participation + +On line 729: + the securities + markets, in part to end the + practices of the 1920s, + +On line 729: + securities to + depositors. In Congress + also imposed new + + regulatory + requirements on banks owned by + holding companies, + +On line 729: + order to prevent + a holding company from + endangering any + +On line 731: + Bank supervisors + monitored banks’ leverage—their + assets relative + +On line 733: + by nearly every + financial institution, + amplifies returns. + +On line 733: + example, if an + investor uses of his own + money to purchase + +On line 733: + security that + increases in value by + he earns However, + +On line 733: + invests times as much + the same increase in value + yields a profit of + +On line 733: + investment. If the + investment sours, though, leverage + magnifies the loss + +On line 733: + much. A decline of + costs the unleveraged investor + leaving him with but + +On line 733: + wipes out the leveraged + investor’s An investor buying + assets worth times his + +On line 733: + of with the numbers + representing the total + money invested + +On line 735: + committed to the + deal. In bank supervisors + established the first + +On line 735: + liabilities—should + be at least of assets for + most banks. Capital, + +On line 735: + general, reflects + the value of shareholders’ + investment in the + +On line 737: + which bears the first risk + of any potential losses. + By comparison, + +On line 737: + leverage, unhindered + by oversight of their safety + and soundness or by + +On line 737: + 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 + +On line 739: + from federally + insured depositors but + principally from + + investors (in the case + of money market funds) or + commercial paper + +On line 741: + repo markets (in + the case of investment banks). + Both money market + +On line 741: + and securities + firms were regulated by + the Securities + +On line 741: + SEC, created in + was supposed to supervise + the securities + +On line 741: + investors. It was charged + with ensuring that issuers + of securities + + disclosed sufficient + information for investors, + and it required firms + +On line 741: + securities to + comply with procedural + restrictions such as + +On line 741: + separate accounts. + Historically, the SEC + did not focus on + +On line 741: + impose capital + requirements on broker-dealers + designed to protect + +On line 743: + Meanwhile, since deposit + insurance did not cover + such instruments as + +On line 743: + market mutual + funds, the government was not + on the hook. There was + +On line 743: + concern about a run. + In theory, the investors + had knowingly risked + + their money. If an + investment lost value, it + lost value. If a + +On line 743: + failed, it failed. As a + result, money market funds + had no capital + + or leverage standards. + "There was no regulation," + former Fed chairman + +On line 743: + Volcker told the + Financial Crisis Inquiry + Commission. "It was + +On line 743: + restricting the type + of securities in which + they could invest, the + +On line 743: + securities, and + the diversification + of their portfolios. + +On line 743: + ensure that investors’ + shares would not diminish in + value and would be + +On line 743: + against losses was the + implicit guarantee of + sponsors like Merrill + +On line 745: + with reputations + to protect. Increasingly, + the traditional + + world of banks and thrifts + was ill-equipped to keep up + with the parallel + +On line 745: + of the Wall Street firms. + The new shadow banks had few + constraints on raising + +On line 745: + investing money. + Commercial banks were at a + disadvantage and + +On line 745: + danger of losing + their dominant position. + Their bind was labeled + +On line 745: + system concluded + that policy makers, all + the way back to the + +On line 745: + only by capping + the interest rates they could + pay depositors + +On line 745: + critics argued, the + regulatory constraints + on industries across + +On line 745: + competition and + restricted innovation, + and the financial + +On line 747: + example of such + a hampered industry. Years + later, Fed Chairman + +On line 749: + the argument for + deregulation: "Those of us + who support market + +On line 749: + competitive forms + might argue that unfettered + markets create a + + degree of wealth that + fosters a more civilized + existence. I have + +On line 753: + that insight compelling."12 + THE SAVINGS AND LOAN CRISIS: + "THEY PUT A LOT OF + +On line 755: + continued to chafe + against the regulations still + in place. The playing + + field wasn’t level, + which "put a lot of pressure + on institutions + +On line 755: + higher-rate performing + assets," former SEC Chairman + Richard Breeden told the + +On line 757: + of pressure on their + regulators to allow + this to happen."13 The + +On line 757: + banks and the S&Ls went + to Congress for help. In the + Depository + +On line 757: + Monetary Control + Act repealed the limits on + the interest rates + +On line 757: + a significant + regulatory constraint + on banks and thrifts, it + +On line 757: + their competitive + advantage. Depositors + wanted a higher + +On line 757: + 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 + +On line 757: + faced an interest + rate squeeze. In the difference + in interest earned + + on the banks’ and thrifts’ + safest investments (one-year Treasury + notes) over interest + +On line 757: + deposits was almost + percentage points; by it was + only percentage + +On line 757: + The institutions + lost almost percentage points + of the advantage + +On line 757: + enjoyed when the rates + were capped.14 The legislation + had not done enough to + +On line 759: + facing the banks and + thrifts. That legislation was + followed in 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 + +On line 759: + 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 + +On line 759: + and adjustable-rate mortgages + (ARMs), even in states where state laws + forbade these loans. For + +On line 759: + 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 + +On line 759: + by inflation, but + it effectively transferred + the risk of rising + +On line 761: + interest rates to + borrowers. Then, beginning + in the Federal + +On line 761: + banks to undertake + activities forbidden + under Glass-Steagall and its + +On line 761: + in "bank-ineligible" + activities, including + selling or holding + +On line 761: + of securities + that were not permissible + for national banks + + to invest in or + underwrite. At first, the Fed + strictly limited + +On line 761: + activities to + no more than of the assets + or revenue of any + +On line 761: + time, however, the + Fed relaxed these restrictions. + By bank-ineligible + +On line 761: + represent up to + of assets or revenues of + a securities + +On line 763: + Meanwhile, the OCC, the + regulator of banks with + national charters, + +On line 763: + equivalent to, or + a logical outgrowth of, + a recognized bank + +On line 763: + new activities + were underwriting as well + as trading bets and + +On line 763: + derivatives, on + the prices of certain assets. + Between and the OCC + +On line 763: + derivatives in + which banks might deal to include + those related to + +On line 765: + metals such as gold + and silver and equity + stocks Fed Chairman Greenspan + +On line 765: + regulators and + legislators supported + and encouraged this + +On line 765: + financial markets. + They argued that financial + institutions had + +On line 765: + regulate themselves + through improved risk management. + Likewise, financial + +On line 765: + would exert strong and + effective discipline through + analysts, credit + + rating agencies, and + investors. Greenspan argued that the + urgent question about + +On line 767: + the issue this way: + financial "modern-ization" was + needed to "remove + +On line 767: + limit choices and + options for the consumer of + financial services." + +On line 767: + more effectively + in their natural markets. + The result would be + +On line 769: + better services to + the public."17 During the 1980s + and early 1990s, banks + +On line 769: + higher interest + payments. They made loans to oil + and gas producers, + +On line 769: + leveraged buyouts of + corporations, and funded + developers of + + residential and + commercial real estate. + The largest commercial + +On line 769: + advanced money to + companies and governments + in "emerging markets," + +On line 769: + riskier than the banks’ + traditional lending. The + consequences appeared + +On line 769: + the real estate + markets, with a bubble and + massive overbuilding + + in residential + and commercial sectors in + certain regions. For + +On line 769: + example, house prices + rose per year in Texas from to + In California, + +On line 769: + rose annually + from to The bubble burst first + in Texas in and but + +On line 769: + 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 + +On line 769: + nationally by + from July to February + 199220—the first such fall since + +On line 771: + Depression—driven + by steep drops in regional + markets.21 In the 1980s, + +On line 771: + considerably less + than current interest rates, + spiraling defaults + +On line 771: + residential and + commercial real estate + loans, and losses on + + energy-related, + leveraged-buyout, and overseas loans, + the industry was + +On line 773: + commercial banks and + thrifts failed in what became known + as the S&L crisis + +On line 773: + 1980s and early 1990s. + By comparison, only + banks had failed between + +On line 773: + of federally + insured depository + institutions had + +On line 773: + required financial + assistance, affecting of + the banking system’s + +On line 773: + assets.23 More than bank + and S&L executives were + convicted of felonies.24 + +On line 773: + the government cleanup + was complete, the ultimate + cost of the crisis + +On line 775: + was billion.25 Despite + new laws passed by Congress in + and in response to + +On line 777: + deregulatory + movement focused in part on + continuing to + +On line 777: + study calling for the + elimination of the old + regulatory + +On line 777: + all geographic + restrictions on banking and + repeal of the Glass-Steagall + +On line 777: + The study urged Congress + to abolish these restrictions + in the belief that + +On line 777: + banks closely tied to + the capital markets would + be more profitable and + +On line 777: + competitive with + the largest banks from the United + Kingdom, Europe, and + +On line 777: + proposals would let + banks embrace innovation + and produce a "stronger, + + more diversified + financial system that will + provide important + +On line 779: + to the consumer and + important protections to + the taxpayer."26 The + +On line 779: + were insurance agents, + real estate brokers, and + smaller banks, who felt + +On line 779: + possibility + that the largest banks and their huge + pools of deposits would + +On line 779: + unleashed to compete + without restraint. The House of + Representatives + +On line 779: + proposal in but + similar proposals were + adopted by Congress + + later in the 1990s. + In dealing with the banking + and thrift crisis of + +On line 781: + early 1990s, Congress + was greatly concerned by a + spate of high-profile + +On line 781: + the nation’s 7th-largest bank; + in First Republic, number + in MCorp, number in + +On line 781: + England, number These + banks had relied heavily + on uninsured short-term + +On line 781: + vulnerable to + abrupt withdrawals once confidence + in their solvency + +On line 783: + covered by the FDIC + were protected from loss, but + regulators felt + + obliged to protect the + uninsured depositors—those whose + balances exceeded + +On line 783: + prevent potential + runs on even larger banks that + reportedly may + + have lacked sufficient + assets to satisfy their + obligations, such as + +On line 785: + Bank of America, + and Manufacturers Hanover.27 + During a hearing + +On line 785: + of Continental + Illinois, Comptroller of the + Currency C. Todd + +On line 787: + regulators would + not allow the largest "money + center banks" to fail.28 + +On line 787: + 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 + +On line 789: + is a wonderful + bank."29 In during this era of + federal rescues + +On line 789: + banks, Drexel Burnham + Lambert—once the country’s fifth-largest + investment bank—failed. + + Crippled by legal + troubles and losses in its + junk bond portfolio, + +On line 789: + bankruptcy in the + securities industry + to date when lenders shunned + +On line 789: + and repo markets. + While creditors, including + other investment + +On line 789: + rattled and absorbed + heavy losses, the government + did not step in, and + +On line 789: + failure did not cause + a crisis. So far, it seemed + that among financial + +On line 791: + only commercial + banks were deemed too big to fail. + In Congress tried to + +On line 791: + Deposit Insurance + Corporation Improvement + Act (FDICIA), which sought + +On line 791: + early when a bank + or thrift got into trouble. + In addition, if + +On line 791: + had to resolve the + failed institution in a + manner that produced + +On line 791: + to the FDIC’s deposit + insurance fund. However, + the legislation + +On line 791: + exempted the FDIC + from the least-cost constraints + if it, the Treasury, + +On line 791: + institution posed + a "systemic risk" to markets. + The other loophole + +On line 791: + raised by some Wall Street + investment banks, Goldman Sachs + in particular: + +On line 791: + of commercial banks + to help securities firms + during previous + +On line 791: + for an amendment to + FDICIA to authorize the + Fed to act as lender + +On line 791: + banks by extending + loans collateralized by + the investment banks’ + +On line 795: + legislation sent + financial institutions + a mixed message: you + + are not too big to + fail—until and unless you are + too big to fail. So + +On line 795: + and shadow banking + industries—remained an open + question until the + +On line 807: + Mae and Freddie Mac: + "The whole army of lobbyists".............................38 + Structured finance: "It + +On line 809: + the risk"...................................................42 The growth of + derivatives: "By far the + most significant + +On line 813: + in finance during + the past decade" FANNIE MAE AND + FREDDIE MAC: "THE WHOLE + +On line 815: + crisis in the thrift + industry created an + opening for Fannie + +On line 815: + Freddie Mac, the two + massive government-sponsored + enterprises (GSEs) + +On line 817: + Congress to support + the mortgage market. Fannie + Mae (officially, + +On line 817: + the Great Depression + in to buy mortgages insured + by the Federal + +On line 817: + The new government + agency was authorized to + purchase mortgages that + +On line 817: + guaranteeing the + supply of mortgage credit + that banks and thrifts could + +On line 817: + homebuyers. Fannie + Mae either held the mortgages + in its portfolio + +On line 817: + often, resold them to + thrifts, insurance companies, + or other investors. + +On line 817: + War II, Fannie Mae + got authority to buy + home loans guaranteed + + by the Veterans + Administration (VA) as + well. This system worked + +On line 819: + weakness: Fannie Mae + bought mortgages by borrowing. + By Fannie’s mortgage + +On line 819: + portfolio had grown + to billion and its debt weighed + on the federal + +On line 819: + administration + and Congress reorganized + it as a publicly + +On line 819: + to take over Fannie’s + subsidized mortgage programs + and loan portfolio. + +On line 819: + insured mortgages, but + it was now a hybrid, a + "government-sponsored + +On line 819: + years later, in the + thrifts persuaded Congress to + charter a second + +On line 819: + (officially, the + Federal Home Loan Mortgage + Corporation), to + +On line 825: + help the thrifts sell their + mortgages. The legislation + also authorized + + Fannie and Freddie + to buy "conventional" fixed-rate + mortgages, which were not + +On line 829: + the FHA or the VA. + Conventional mortgages were + stiff competition + +On line 829: + because borrowers + could get them more quickly and + with lower fees. Still, + + the conventional + mortgages did have to conform + to the GSEs’ loan size + +On line 829: + and underwriting + guidelines, such as debt-to-income + and loan-to-value + +On line 833: + Mae generally + held the mortgages it purchased, + profiting from the + +On line 833: + spread—between its cost + of funds and the interest + paid on these mortgages. + +On line 833: + mortgages, in A lender + would assemble a pool of + mortgages and issue + +On line 833: + backed by the mortgage + pool. Those securities would + be sold to investors, + +On line 833: + timely payment of + principal and interest. + Ginnie charged a fee + +On line 835: + to issuers for this + guarantee. In Freddie got + into the business + +On line 835: + timely payment of + principal and interest. + In after a spike + +On line 837: + Fannie’s portfolio + of mortgages, Fannie followed. + During the 1980s and + +On line 837: + market expanded, + the GSEs grew in importance, + and the market share + + of the FHA and VA + declined. Fannie and Freddie + had dual missions, + +On line 839: + the mortgage market + and maximize returns for + shareholders. They did + +On line 839: + mortgages; they purchased + them—from banks, thrifts, and mortgage + companies—and either + +On line 839: + them. Congress granted + both enterprises special + privileges, such as + +On line 839: + from state and local + taxes and a billion line + of credit each from + +On line 839: + Federal Reserve + provided services such as + electronically + +On line 839: + payments for GSE debt + and securities as if + they were Treasury bonds. + +On line 839: + almost as low as + the Treasury paid. Federal + laws allowed banks, thrifts, + +On line 839: + and regulations + strictly limited the amount + of loans banks could make + +On line 839: + investments in the + debt obligations of other + firms. In addition, + +On line 839: + were required to hold + very little capital to + protect against losses: + +On line 839: + their guarantees of + mortgage-backed securities and + to back the mortgages + +On line 839: + of mortgages assets + under capital standards. + Such privileges led + +On line 839: + to believe that the + government implicitly + guaranteed the GSEs’ + +On line 839: + and debt and that GSE + securities were therefore + almost as safe as + + Treasury bills. As a + result, investors accepted + very low returns on + +On line 841: + funded by short-term + borrowings. For example, + thrifts generally + +On line 841: + their mortgages. Fannie + ought its mortgage portfolio + by borrowing short- + +On line 841: + 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 + +On line 841: + Development (HUD) + estimated Fannie had + a negative net + +On line 841: + primary business + was guaranteeing mortgage-backed + securities, not + +On line 841: + Freddie Mac avoided + taking the interest rate + risk that hit Fannie’s + +On line 843: + Congress provided + tax relief and HUD relaxed + Fannie’s capital + +On line 843: + a vibrant market + for home mortgages served the best + interests of the + +On line 843: + but the moves also + reinforced the impression + that the government + + would never abandon + Fannie and Freddie. Fannie + and Freddie would soon + +On line 843: + and either hold or + securitize mortgages worth + hundreds of billions, + +On line 843: + trillions, of dollars. + Among the investors were U.S. banks, + thrifts, investment funds, + +On line 845: + as well as central + banks and investment funds around + the world. Fannie and + +On line 847: + too big to fail. While + the government continued + to favor Fannie + +On line 847: + thrifts following the + savings and loan crisis. Thrifts + had previously + +On line 847: + the mortgage business + as large holders of mortgages. + In the Financial + +On line 847: + and Enforcement Act + of (FIRREA), Congress imposed + tougher, bank-style capital + +On line 847: + and regulations + on thrifts. By contrast, in the + Federal Housing + +On line 847: + Safety and Soundness + Act of Congress created + a supervisor + +On line 847: + Enterprise Oversight + (OFHEO), without legal powers + comparable to + +On line 847: + thrift supervisors + in enforcement, capital + requirements, funding, + +On line 847: + Crack-ing down on thrifts + while not on the GSEs was no + accident. The GSEs + +On line 847: + power during the + drafting of the law.3 "OFHEO was + structurally weak and + +On line 847: + designed to fail," said + Armando Falcon Jr., a + former director + +On line 849: + to the FCIC.4 All this + added up to a generous + federal subsidy. + +On line 849: + the value of that + subsidy at billion or more + and estimated + + that more than half of + these benefits accrued to + shareholders, not to + +On line 851: + worked as it always + does: the markets shifted to + the lowest-cost, + +On line 851: + requirements on thrifts, + it became increasingly + profitable for them to + + securitize with + or sell loans to Fannie and + Freddie rather than hold + +On line 853: + the loans. The stampede + was on. Fannie’s and Freddie’s + debt obligations and + +On line 855: + securities grew + from billion in to trillion + in and trillion in + +On line 857: + legislation that + transformed Fannie in also + authorized HUD to + +On line 857: + affordable housing + goals for Fannie: to "require + that a reasonable + +On line 857: + the national goal + of providing adequate + housing for low and + +On line 857: + but with reasonable + economic return to the + corporation."7 In + +On line 857: + to implement the + law and, after a barrage + of criticism from + +On line 857: + Federal Housing + Enterprises Financial + Safety and Soundness + +On line 857: + Congress extended + HUD’s authority to set + affordable housing + + goals for Fannie and + Freddie. Congress also changed + the language to say + +On line 857: + affordable housing, + "a reasonable economic + return may be less + + than the return earned + on other activities." + The law required HUD + +On line 859: + to maintain the sound + financial condition of + the enterprises." + + The act now ordered + HUD to set goals for Fannie + and Freddie to buy + +On line 859: + and moderate-income + housing, special affordable + housing, and housing + +On line 859: + rural areas, and + other underserved areas. + Congress instructed + +On line 859: + category as + a percentage of the GSEs’ + mortgage purchases. + +On line 861: + an initiative to + boost homeownership from to + of families by + +On line 861: + one component raised + the affordable housing goals + at the GSEs. Between + +On line 861: + and almost 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 + +On line 863: + security for + people who are doing the + right thing, and we have + +On line 863: + 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 + +On line 863: + economy."9 The push + to expand homeownership + continued under + +On line 863: + George W. Bush, who, for + example, introduced a + "Zero Down Payment + +On line 863: + that under certain + circumstances could remove the + down payment rule for + +On line 865: + Housing and Urban + Development from to and + now governor of + +On line 865: + means many things. There were + moderate income loans. These + were teachers, these were + + firefighters, these were + municipal employees, + these were people with + +On line 867: + who paid mortgages. These + were not subprime, predatory + loans at all."11 Fannie + +On line 869: + were problematic. + Former Fannie CEO Daniel Mudd + told the FCIC that "the + +On line 871: + structure required the + companies to maintain a + fine balance between + +On line 871: + financial goals and + what we call the mission goals + the root cause of the + +On line 871: + lies with their business + model."12 Former Freddie CEO + Richard Syron concurred: + +On line 873: + it’s a good business + model."13 Fannie and Freddie + accumulated + +On line 873: + and an implicit + government guarantee, and + because they had to + +On line 873: + with regulators, + affordable housing goals, and + capital standards + +On line 873: + the two reported + spending more than million on + lobbying, and their + +On line 873: + campaigns.14 The "Fannie + and Freddie political + machine resisted + +On line 873: + tactics," Falcon, who + regulated them from to + testified. "OFHEO was + +On line 873: + the director of + OFHEO and its successor, the + Federal Housing + +On line 875: + from through testified + that he argued for reform + from the moment he + +On line 875: + became director + and that the companies were + "allowed to be so + +On line 875: + they resisted the + very legislation that might + have saved them."16 Former + +On line 875: + a bipartisan + fashion through my offices. It’s + pretty amazing the + +On line 877: + number of people + that were in their employ."17 In + that army helped secure + +On line 877: + 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 + +On line 879: + Director June O’Neill + declared in that "the goals are + not difficult to + +On line 879: + and it is not clear + how much they have affected + the enterprises’ + +On line 879: + as the Federal + Housing Administration + devote a larger + +On line 879: + their mortgage lending + to targeted borrowers + and areas than do + + the enterprises."18 + Something else was clear: Fannie + and Freddie, with their + +On line 881: + and lax capital + requirements, were immensely + profitable throughout the + +On line 881: + 1990s. In Fannie had + a return on equity + of Freddie, That year, + +On line 881: + Fannie and Freddie + held or guaranteed more than + trillion of mortgages, + +On line 885: + by only billion + of shareholder equity.19 + STRUCTURED FINANCE: "IT + +On line 887: + T REDUCING THE + RISK" While Fannie and Freddie + enjoyed a near-monopoly + +On line 887: + securitizing + fixed-rate mortgages that were within + their permitted loan + +On line 887: + the 1980s the markets + began to securitize + many other types of + +On line 887: + other mortgages the + GSEs were not eligible + or willing to buy. + + The mechanism worked + the same: an investment bank, + such as Lehman Brothers + +On line 887: + a securities + affiliate of a bank), + bundled loans from a + + bank or other lender + into securities and + sold them to investors, + +On line 887: + by the principal + and interest payments from + the loans. Investors held + +On line 887: + more complicated + than the GSEs’ basic mortgage-backed + securities; the + +On line 887: + were not just mortgages + but equipment leases, credit + card debt, auto loans, + + and manufactured + housing loans. Over time, banks and + securities firms + +On line 887: + to mimic banking + activities outside the + regulatory + +On line 887: + 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 + +On line 887: + make loans, packaging + them into securities + to sell to investors. + + 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 + +On line 891: + generated cash + that could be used to make loans. + Banks could also keep + +On line 891: + securities on + their books as collateral + for borrowing, and + +On line 893: + an important source + of revenues. Lawrence Lindsey, a + former Federal + +On line 893: + of the National + Economic Council under + President George W. + + Bush, told the FCIC that + previous housing downturns + made regulators + +On line 893: + banks’ holding whole loans + on their books. "If you had a + regional real + +On line 893: + 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 + +On line 897: + key benefits to + investors: pooling and tranching. + If many loans were pooled + +On line 897: + securities could + also be sliced up and sold + in portions—known as + +On line 897: + buyers customize + their payments. Risk-averse investors + would buy tranches that + +On line 897: + 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 + +On line 899: + junior tranches. And + if payments came in below + expectations, those + +On line 903: + lenders, investment bankers, + and investors. Lenders earned fees for + originating and + +On line 903: + Investment banks earned + fees for issuing mortgage-backed + securities. These + + securities fetched + a higher price than if the + underlying loans + +On line 903: + investors’ needs, were more + diversified, and could be + easily traded. + +On line 903: + safer tranches got a + higher rate of return than + ultra-safe Treasury + +On line 903: + made them harder to + understand and to price than + individual + + loans. To determine + likely returns, investors had + to calculate the + +On line 903: + probabilities + that certain kinds of mortgages + might default, and to + +On line 903: + revenues that would be + lost because of those defaults. + Then investors had to + +On line 903: + the effect of the + losses on the payments to + different tranches. + +On line 905: + three leading credit + rating agencies—Moody’s, Standard Poor’s (S&P), + and Fitch—into key + +On line 905: + positioned between + the issuers and the investors + of securities. + +On line 905: + became common, the + credit rating agencies had + mainly helped investors + +On line 907: + that they needed to + secure favorable credit + ratings in order + +On line 907: + sell structured products + to investors. Investment banks + therefore paid handsome + +On line 907: + 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 + +On line 907: + They were looking for + an independent party + to develop an + + opinion," Jim Callahan + told the FCIC; Callahan is CEO + of PentAlpha, which services + +On line 909: + of the earliest + securitizations.21 With + these pieces in place—banks + +On line 909: + to shed assets and + transfer risk, investors ready to + put their money to + +On line 909: + and information + technology capable + of handling the job— + +On line 911: + market exploded. + By when the market was years + old, about billion worth + +On line 911: + beyond those done by + Fannie, Freddie, and Ginnie, + were outstanding (see + +On line 911: + billion of credit + card debt; nearly billion worth + of securities + +On line 913: + commercial banks; it + was also a lucrative + new line of business + +On line 913: + Wall Street investment + banks, with which the commercial + banks worked to create + +On line 913: + new securities. + Wall Street firms such as Salomon + Brothers and Morgan + +On line 913: + these complex markets + and relied increasingly + on quantitative + + analysts, called "quants." + As early as the 1970s, Wall + Street executives + +On line 913: + develop models + to predict how markets or + securities might + +On line 913: + importance of this + expertise. Scott Patterson, + author of The Quants, + +On line 915: + the FCIC that using + models dramatically + changed finance. "Wall Street + +On line 917: + Patterson said.23 The + increasing dependence on + mathematics let + + the quants create more + complex products and let their + managers say, and maybe + +On line 917: + that they could better + manage those products’ risk. JP + Morgan developed + +On line 917: + Risk" model (VaR), and + the industry soon adopted + different versions. + +On line 917: + predict with at least + certainty how much a firm + could lose if market + +On line 917: + assumptions based on + limited historical + data; for mortgage-backed + +On line 919: + modeling human + behavior was different + from the problems the + + quants had addressed in + graduate school. "It’s not like + trying to shoot a + +On line 919: + professor who worked + at Goldman Sachs for years, told + the Commission. "The + + way people feel about + gravity on a given + day isn’t going + +On line 921: + the way the rocket + behaves."25 Paul Volcker, Fed + chairman from to told + + the Commission that + regulators were concerned + as early as the + + late 1980s that once banks + began selling instead of + holding the loans they + +On line 921: + making, they would care + less about loan quality. Yet + as these instruments + +On line 921: + relied on the banks + to police their own risks. "It + was all tied up in + +On line 921: + hubris of financial + engineers, but the greater hubris + let markets take care + +On line 921: + said.26 Vincent Reinhart, + a former director of + the Fed’s Division + +On line 923: + in assessing risk.27 + Securitization "was + diversifying + +On line 925: + individual + can diversify your risk. + The system as a + +On line 927: + the risk. And that’s where + the confusion lies."28 THE GROWTH + OF DERIVATIVES: + +On line 929: + MOST SIGNIFICANT + EVENT IN FINANCE DURING THE + PAST DECADE" During the + +On line 929: + and complexity + became closely identified + with one element + +On line 929: + Derivatives are + financial contracts whose prices + are determined by, + +On line 929: + from, the value of + some underlying asset, + rate, index, r event. + + They are not used for + capital formation or + investment, as are + +On line 929: + they are instruments + for hedging business risk or + for speculating + +On line 929: + prices, interest rates, + and the like. Derivatives + come in many forms; the + +On line 929: + are over-the-counter-swaps and + exchange-traded futures and + options.29 They may be + + based on commodities + (including agricultural + products, metals, and + +On line 929: + currency rates, stocks + and indexes, and credit + risk. They can even be + +On line 931: + and commercial firms + use such derivatives. A + firm may hedge its price + + risk by entering + into a derivatives + contract that offsets + +On line 931: + recouped through gains on + the derivatives contract. + Institutional + +On line 931: + are risk-averse sometimes + use interest rate swaps to + reduce the risk to + +On line 931: + for floating payments + with risk-taking entities, + such as hedge funds. Hedge + +On line 931: + swaps for the purpose + of speculating, in hopes + of profiting on + + the rise or fall of + a price or interest rate. + The derivatives + +On line 933: + are organized as + exchanges or as over-the-counter (OTC) + markets, although some + + recent electronic + trading facilities blur + the distinctions. The + +On line 933: + Chicago Board of Trade, + where futures and options are + traded. Such exchanges + + are regulated + by federal law and play + a useful role in + +On line 933: + is, in revealing + the market’s view on prices of + commodities or rates + +On line 933: + investment banks—which act + as derivatives dealers, + buying and selling + +On line 933: + customers. Unlike the + futures and options exchanges, + the OTC market is + + neither centralized + nor regulated. Nor is + it transparent, and + +On line 933: + price discovery is + limited. No matter the + measurement—trading + +On line 933: + represent a very + significant sector of + the U.S. financial + +On line 935: + derivatives on + domestic agricultural + products. In Congress + +On line 935: + act to require that + futures and options contracts + on virtually + +On line 935: + be traded on a + regulated exchange, and + created a new + +On line 935: + the Commodity + Futures Trading Commission + (CFTC), to regulate + +On line 937: + market.30 Outside of + this regulated market, + an over-the-counter market + +On line 937: + 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 + +On line 937: + the products they were + buying and selling. In the + CFTC sought to address + +On line 939: + prohibitions against + fraud and manipulation.31 + As the OTC market + +On line 939: + the CFTC’s exemption, + a wave of significant + losses and scandals + +On line 939: + hit the market. Among + many examples, in Procter + Gamble, a leading + +On line 939: + products company, + reported a pretax loss + of million, the largest + +On line 939: + nonfinancial firm, + stemming from OTC interest + and foreign exchange + +On line 939: + derivatives sold + to it by Bankers Trust. Procter + Gamble sued Bankers Trust + +On line 939: + settled when Bankers Trust + forgave most of the money + that Procter Gamble + +On line 939: + it. That year, the CFTC + and the Securities and + Exchange Commission + +On line 939: + Bankers Trust million for + misleading Gibson Greeting + Cards on interest + +On line 939: + rate swaps resulting + in a mark-to-market loss + of million, larger + +On line 939: + announced it had lost + billion speculating in + OTC derivatives. + +On line 939: + for bankruptcy—the largest by + a municipality + in U.S. history. + +On line 939: + dealer, Merrill Lynch, + paid million to settle claims.32 + In response, the U.S. + +On line 939: + OTC derivatives + activity among major + dealers, concluding + +On line 939: + sudden failure or + abrupt withdrawal from trading + of any one of these + + large dealers could cause + liquidity problems in + the markets and could + +On line 939: + risks to the others, + including federally + insured banks and the + + financial system + as a whole."33 While Congress then + held hearings on the + +On line 939: + lobbying by the + OTC derivatives dealers + and opposition + +On line 941: + billion on copper + derivatives traded on + a London exchange. + +On line 941: + charged the company + with using derivatives + to manipulate + +On line 941: + to finance the scheme. + Sumitomo settled for + million in penalties + + and restitution. The + CFTC also charged Merrill Lynch + with knowingly and + +On line 943: + prices; it settled for + a fine of million.34 Debate + intensified in + +On line 943: + under Chairperson + Brooksley Born said the agency + would reexamine + +On line 943: + regulated the + OTC derivatives market, + given the market’s + +On line 943: + evolution and the + string of major losses since + The CFTC requested + +On line 945: + got them. Some came from + other regulators, who + took the unusual + +On line 945: + criticizing the + CFTC. On the day that the CFTC + issued a concept + +On line 945: + and SEC Chairman Arthur + Levitt issued a joint statement + denouncing the CFTC’s + +On line 945: + grave concerns about this + action and its possible + consequences. We are + +On line 945: + action may increase + the legal uncertainty + concerning certain + +On line 949: + derivatives. For + months, Rubin, Greenspan, Levitt, and Deputy + Treasury Secretary + +On line 949: + in testimony + to Congress and in other + public pronouncements. + +On line 949: + said: "Aside from safety + and soundness regulation + of derivatives + + dealers under the + banking and securities + laws, regulation + +On line 951: + unnecessary."36 In + September, the Federal + Reserve Bank of New + +On line 951: + of Long-Term Capital + Management (LTCM) by major + OTC erivatives dealers. + +On line 951: + An enormous hedge fund, + LTCM had amassed more than trillion + in notional amount + +On line 951: + of securities + on billion of capital + without the knowledge + +On line 951: + counterparties or + federal regulators.37 + Greenspan testified to + +On line 951: + that in the New York + Fed’s judgment, LTCM’s failure would + potentially have + +On line 951: + effects: a default + by LTCM "would not only have + a significant + +On line 951: + also in the process + could produce large losses, or + worse, for a number + +On line 951: + for other market + participants who were not + directly involved + +On line 955: + moratorium. Greenspan + continued to champion + derivatives and + +On line 955: + market. "By far the + most significant event in + finance during the + +On line 955: + development and + expansion of financial + derivatives," Greenspan + +On line 955: + Association + conference in March "The fact + that the OTC markets + +On line 955: + quite effectively + without the benefits of + [CFTC regulation] + +On line 955: + a strong argument + for development of a + less burdensome regime + +On line 957: + resignation—the + President’s Working Group on + Financial Markets, + +On line 957: + and Commodity + Futures Trading Commission + charged with tracking the + +On line 957: + view. The group issued + a report urging Congress + to deregulate OTC + +On line 959: + well.40 In December + in response, Congress passed and + President Clinton + +On line 959: + the Commodity + Futures Modernization Act + of (CFMA), which in + +On line 959: + deregulated the + OTC derivatives market + and eliminated + +On line 961: + the CFTC and the SEC. + The law also preempted + application of + +On line 961: + The SEC did retain + antifraud authority over + securities-based OTC + +On line 963: + all regulation + or oversight. Subsequently, + other laws enabled + +On line 963: + the expansion of + the market. For example, + under a amendment + +On line 963: + laws, derivatives + counterparties were given + the advantage over + +On line 963: + immediately + terminate their contracts and + seize collateral + +On line 965: + of bankruptcy. The + OTC derivatives market + boomed. At year-end when the + +On line 965: + OTC derivatives + outstanding globally was + trillion, and the gross + +On line 965: + market value was + trillion.41 In the seven and + a half years from then + +On line 965: + peaked, outstanding OTC + derivatives increased more + than sevenfold to + +On line 965: + a notional amount + of trillion; their gross market + value was trillion.42 + + Greenspan testified to + the FCIC that credit default + swaps—a small part of + +On line 967: + problems" during the + financial crisis.43 Rubin + testified that when + +On line 967: + he was "not opposed + to the regulation of + derivatives" and + + had personally + agreed with Born’s views, but that "very + strongly held views in + +On line 967: + to regulation" + were insurmountable.44 Summers + told the FCIC that while + +On line 967: + been foreseen years ago, + "by our regulatory + framework with respect + +On line 967: + was manifestly + inadequate," and that "the + derivatives that + +On line 967: + the most serious, + those associated with + credit default swaps, + +On line 969: + fold between and One + reason for the rapid growth of + the derivatives + +On line 969: + above, financial firms + may use derivatives to + hedge their risks. Such use + +On line 969: + derivatives can + lower a firm’s Value at + Risk as determined + +On line 969: + computer models. + In addition to gaining + this advantage in + + risk management, such + hedges can lower the amount of + capital that banks + +On line 969: + are required to hold, + thanks to a amendment to the + regulatory + +On line 971: + International + Capital Accord, or "Basel + I." Meeting in Basel, + +On line 971: + in the world’s central + banks and bank supervisors + adopted principles + +On line 971: + made adjustments to + implement them. Among the most + important was the + +On line 971: + looser than for all + other assets related + to corporate and + +On line 971: + holdings of Fannie’s + and Freddie’s securities + were less than for all + +On line 973: + assets except those + explicitly backed by the + U.S. government.47 These + +On line 973: + capital standards + accommodated the shift + to increased leverage. + +On line 973: + sought more favorable + capital treatment for their + trading, and the Basel + +On line 973: + adopted the Market + Risk Amendment to Basel I. This + provided that if + +On line 973: + market risks using + derivatives, they could hold + less capital against + +On line 975: + investment banks—increase + their leverage. For example, + entering into + + an equity swap + that mimicked the returns of + someone who owned the + +On line 975: + costs, but the amount of + collateral posted was + much smaller than the + +On line 975: + 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 + +On line 975: + a buyer’s initial + financial outlay.49 Warren + Buffett, the chairman + +On line 975: + to the FCIC about the + unique characteristics of + the derivatives + +On line 975: + view, the leverage in + the system." He went on to + call derivatives + +On line 975: + to understand—indeed, + he concluded, "I don’t think + I could manage" a + +On line 977: + derivative in + the financial crisis was + the credit default + +On line 977: + seller a little + potential upside at the + relatively small + +On line 977: + a potentially + large downside. The purchaser + of a CDS transferred + +On line 977: + the default risk of + an underlying debt. The + debt security + +On line 977: + be any bond or loan + obligation. The CDS buyer + made periodic + +On line 977: + seller during the + life of the swap. In return, + the seller offered + +On line 977: + "credit events" such as + a partial default. If a + credit event such as + +On line 979: + typically pay + the buyer the face value + of the debt. Credit + +On line 979: + as deregulated + OTC derivatives. This made + CDS very different + +On line 979: + 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 + +On line 981: + default swaps" and can + inflate potential losses + and corresponding + +On line 983: + on the default of + a loan or institution. + Before the CFMA + +On line 983: + uncertainty about + whether or not state insurance + regulators had + +On line 983: + authority over + credit default swaps. In June + in response to a + +On line 983: + letter from the law + firm of Skadden, Arps, Slate, Meagher + Flom, LLP, the New York + +On line 983: + determined that "naked" + credit default swaps did not + count as insurance + + and were therefore not + subject to regulation.51 + In addition, when + +On line 985: + 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 + +On line 985: + exposure. In the + run-up to the crisis, AIG, the + largest U.S. insurance + +On line 985: + one-half trillion dollar + position in credit risk + through the OTC market + +On line 985: + one dollar’s worth of + initial collateral or + making any other + +On line 985: + alone. The value of + the underlying assets + for CDS outstanding + +On line 987: + grew from trillion at + the end of to a peak of + trillion at the end + +On line 987: + A significant + portion was apparently + speculative or + +On line 989: + default swaps.54 Much of + the risk of CDS and other + derivatives was + + concentrated in + a few of the very largest banks, + investment banks, and + +On line 989: + derivatives. Among + U.S. bank holding companies, + of the notional + +On line 989: + millions of contracts, + were traded by just five large + institutions (in + +On line 989: + JPMorgan Chase, Citigroup, + Bank of America, Wachovia, + and HSBC)—many of the same + +On line 989: + crisis.56 The country’s + five largest investment banks were + also among the world’s + +On line 991: + the FCIC said they do + not track revenues and profits + generated by + + their derivatives + operations, some firms did + provide estimates. + +On line 991: + and of its revenues + from through were generated + by derivatives, + +On line 991: + including to of + the firm’s commodities business, + and half or more of + +On line 991: + its interest rate + and currencies business. From + May through November + +On line 993: + were derivative + transactions.57 When the nation’s + biggest financial + +On line 995: + find themselves straining + to understand an unknown + battlefield shaped by + + unseen exposures + and interconnections as + they fought to keep the + +On line 1005: + CONTENTS Expansion + of banking activities: + "Shatterer of Glass-Steagall" + +On line 1011: + Management: "That’s what + history had proved to them" + Dot-com crash: "Lay on + + more risk"......................................................................59 The wages of + finance: "Well, this one’s doing + it, so how can I + +On line 1023: + OF GLASSSTEAGALL" By the + mid-1990s, the parallel banking + system was booming, + +On line 1023: + largest commercial banks + appeared increasingly like + the large investment + +On line 1023: + telecommunications, + and information services + created economies of + +On line 1023: + more diversified, + innovative, efficient, + and better able to + +On line 1023: + that the largest banks were + not necessarily more + efficient but grew + +On line 1023: + commanding market + positions and creditors’ + perception they were + +On line 1023: + fail. As they grew, the + large banks pressed regulators, + state legislatures, + +On line 1023: + banks in every state, + and removed most restrictions + on opening branches + + in more than one state. + It preempted any state law + that restricted the + +On line 1025: + of out-of-state banks + to compete within the state’s + borders.1 Removing + +On line 1025: + consolidate the + banking industry. Between + and "megamergers" occurred + +On line 1025: + involving banks with + assets of more than billion + each. Meanwhile the largest + +On line 1025: + jumped from owning of + the industry’s assets to + From to the combined + +On line 1025: + the five largest U.S. banks—Bank + of America, Citigroup, + JP Morgan, Wachovia, + +On line 1025: + Wells Fargo—more than + tripled, from trillion to trillion.2 + And investment banks + +On line 1027: + acquired Shearson in + and Salomon Brothers in while + Paine Webber purchased + +On line 1027: + Kidder, Peabody in Two + years later, Morgan Stanley + merged with Dean Witter, + +On line 1027: + Bankers Trust purchased Alex. + Brown Sons. The assets of the + five largest investment + +On line 1027: + Sachs, Morgan Stanley, + Merrill Lynch, Lehman Brothers, and + Bear Stearns—quadrupled, from + +On line 1029: + in to trillion in + In the Economic Growth and + Regulatory + +On line 1029: + required federal + regulators to review + their rules every decade + +On line 1031: + Federal Deposit + Insurance Corporation’s + annual report + +On line 1031: + a photograph of + the vice chairman, John Reich; + the director of + +On line 1031: + using a chainsaw + and pruning shears to cut the + "red tape" binding a + +On line 1033: + Securities and + Exchange Commission chairman + Arthur Levitt told the FCIC + +On line 1033: + 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 + +On line 1033: + regulations. Levitt + described it as "kind of a + blood sport to make the + +On line 1035: + stupid or inept or + venal."5 However, others + said interference—at + +On line 1035: + the executive + branch—was modest. John Hawke, a + former comptroller + +On line 1035: + he found the Treasury + Department "exceedingly + sensitive" to his + +On line 1037: + its supporters were + also disin-clined to adopt + new regulations + +On line 1039: + with strong incentives + to protect shareholders, would + regulate themselves + +On line 1039: + truly impressive + improvement in methods of + risk measurement and + +On line 1039: + growing adoption of + these technologies by mostly + large banks and other + +On line 1039: + believed that markets + would self-regulate through the + activities of + +On line 1039: + and investors. "It is + critically important + to recognize that + +On line 1039: + market is ever + truly unregulated," + said Fed Chairman Alan + +On line 1039: + "The self-interest + of market participants + generates private + +On line 1039: + regulation. Thus, + the real question is not + whether a market should + +On line 1043: + or weakens private + regulation."8 Richard Spillenkothen, the + Fed’s director of + +On line 1043: + before management + weaknesses were reflected + in poor financial + +On line 1043: + might be viewed as i) + overly-intrusive, burdensome, + and heavy-handed, ii) an + +On line 1043: + availability, or + iii) inconsistent with the + Fed’s public posture."9 + +On line 1045: + and keep any agency + from becoming arbitrary + or inflexible, + +On line 1045: + makers pushed to keep + multiple regulators.10 + In Greenspan testified + +On line 1045: + consolidate bank + regulation: "The current + structure provides banks + +On line 1045: + regulator, an + effective test that provides + a limit on the + +On line 1045: + posture of any one + regulator. The pressure + of a potential + +On line 1045: + institutions has + inhibited excessive + regulation and + +On line 1045: + to the bias of a + regulatory agency + to overregulate."11 + +On line 1045: + the OTS and Office + of the Comptroller of the + Currency (OCC), were + +On line 1045: + the institutions + they regulated. As a + result, the larger + +On line 1045: + of institutions + that chose these regulators, + the greater their budget. + +On line 1047: + success and the tenor + of the times, the largest banks and + their regulators + +On line 1047: + to oppose limits + on banks’ activities or + growth. The barriers + +On line 1047: + banks and investment + banks had been crumbling, little + by little, and now + +On line 1047: + to remove the last + remnants of the restrictions + that separated + +On line 1049: + of after years of + opposing repeal of Glass-Steagall, + the Securities + +On line 1049: + such as Goldman Sachs + and Merrill Lynch—changed course. Because + restrictions on banks + +On line 1049: + the previous decade, + banks already had beachheads in + securities and + +On line 1049: + Despite numerous + lawsuits against the Fed and the + OCC, securities + +On line 1049: + of deregulation + through agency rulings.12 Edward + Yingling, the CEO of + +On line 1049: + organization), + said, "Because we had knocked so + many holes in the walls + +On line 1049: + investment banking + and insurance, we were able + to aggressively + +On line 1049: + their businesses—in some + cases more aggressively + than they could enter + +On line 1049: + industry, then the + insurance companies, and + finally the agents + + came over and said let’s + negotiate a deal and + work together."13 In + +On line 1051: + forced the issue by + seeking a merger with the + insurance giant + +On line 1051: + approved it, citing + a technical exemption + to the Bank Holding + +On line 1051: + 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 + +On line 1051: + prepared to break up + the nation’s largest financial + firm1 Was it time to + + repeal the Glass-Steagall Act, + once and for all1 As Congress + began fashioning + +On line 1055: + legislation, the + banks were close at hand. In the + financial sector + +On line 1055: + individuals + and political action + committees (PACs) in + +On line 1055: + election cycle. From + through federal lobbying + by the financial + +On line 1057: + campaign donations + from individuals and + PACs topped billion.15 In + +On line 1057: + President Clinton + signed the Gramm-Leach-Bliley Act (GLBA), which + lifted most of the + +On line 1057: + 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 + +On line 1059: + wide—etched with his portrait + and the words ‘The Shatterer + of Glass-Steagall.’"17 Now, as long + +On line 1059: + certain safety and + soundness conditions, they could + underwrite and sell + +On line 1059: + were no longer bound by + the Fed’s limit—their primary + regulator, the + +On line 1059: + the legislation + argued that the new holding + companies would be + +On line 1059: + safer (through a broader + diversification of + risks), more useful to + +On line 1059: + of one-stop shopping for + financial services), and more + competitive with + +On line 1059: + opponents warned that + allowing banks to combine + with securities + +On line 1059: + speculation and + could trigger a crisis like + the crash of John Reed, + +On line 1059: + FCIC that, in hindsight, + "the compartmentalization + that was created + +On line 1059: + be a positive + factor," making less likely + a "catastrophic + +On line 1061: + financial system.18 + To win the securities + industry’s support, + + the new law left in + place two exceptions that let + securities firms + +On line 1061: + and industrial + loan companies, a type of + depository + +On line 1061: + with stricter limits on + its activities. Through them, + securities firms + +On line 1061: + FDIC-insured deposits without + supervision by the Fed. + Some securities + +On line 1063: + industrial loan + company grew from less than + billion in assets + +On line 1065: + in to billion in + and to billion in Lehman’s thrift + grew from million in + +On line 1067: + in and its assets + rose as high as billion in + For institutions + +On line 1067: + colloquially + as "Fed-Lite." The Fed supervised + financial holding + +On line 1067: + across the various + subsidiaries owned by the holding + company. To avoid + +On line 1067: + to rely "to the + fullest extent possible" on + examinations + +On line 1067: + securities firms, + and insurance companies. + The expressed intent + +On line 1067: + Fed Chairman Ben Bernanke + told the FCIC that Fed-Lite "made it + difficult for any + +On line 1067: + the whole picture of + activities and risks of + large, complex banking + +On line 1069: + the Fed, would fail to + identify excessive risks + and unsound practices + +On line 1071: + companies such as + Citigroup and Wachovia.22 The + convergence of banks + +On line 1071: + between banking and + securities markets that + Fed Chairman Greenspan had + +On line 1071: + stability. He + compared it to a "spare tire": + if large commercial + +On line 1071: + ran into trouble, + their large customers could borrow + from investment banks + + and others in the + capital markets; if those + markets froze, banks could + +On line 1071: + lending provided + another source of credit + to home buyers and + + other borrowers + that softened a steep decline + in lending by thrifts + +On line 1071: + the crisis in Asian + financial markets in the + late 1990s further proved + + his point, Greenspan said.23 The + new regime encouraged growth and + consolidation + +On line 1073: + securities, and + insurance. The bank-centered + financial holding + + companies such as + Citigroup, JP Morgan, and + Bank of America + +On line 1073: + five" investment banks—Goldman + Sachs, Morgan Stanley, Merrill + Lynch, Lehman Brothers, and + +On line 1073: + loan syndication, + and trading in over-the-counter (OTC) + derivatives. The + +On line 1073: + 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 + +On line 1073: + insured deposits, and + the investment banks enjoyed + less regulation. + + Both prospered from the + late 1990s until the outbreak + of the financial + +On line 1073: + 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 + +On line 1079: + MANAGEMENT: "THAT’S WHAT + HISTORY HAD PROVED TO THEM" + In August Russia + +On line 1079: + Russia announced it + would restructure its debt and + postpone some payments. + +On line 1079: + investors dumped higher-risk + securities, including + those having nothing + + to do with Russia, + and fled to the safety of + U.S. Treasury bills and + +On line 1079: + deposits. In response, + the Federal Reserve cut + short-term interest + +On line 1079: + 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 + +On line 1079: + short-term paper. Banks + loaned billion in September + and October of + +On line 1081: + amount25—and helped prevent + a serious disruption + from becoming much + +On line 1083: + a slump. Not so for + Long-Term Capital Management, + a large U.S. hedge fund. + +On line 1083: + debt securities, + including the junk bonds and + emerging market debt + +On line 1083: + investors were dumping.26 + To buy these securities, + the firm had borrowed + +On line 1083: + investors’ equity;27 + lenders included Merrill Lynch, + JP Morgan, Morgan + +On line 1083: + Lehman Brothers, Goldman + Sachs, and Chase Manhattan. The + previous four years, + +On line 1087: + returns: and while the + S&P yielded an average + But leverage works both + + ways, and in just one + month after Russia’s partial + default, the fund lost + +On line 1087: + more than billion—or more + than of its nearly billion + in capital. Its + +On line 1089: + debt was about billion. + The firm faced insolvency.29 + If it were only + +On line 1089: + a matter of less + than billion, LTCM’s failure might + have been manageable. + +On line 1089: + entering into + derivatives contracts with + more than trillion in + +On line 1089: + derivatives.30 With + very little capital in + reserve, it threatened + +On line 1089: + in the opaque over-the-counter + market, the markets did not + know the size of its + +On line 1089: + that it had posted + very little collateral + against those positions. + +On line 1089: + noted then, if all + the fund’s counterparties had + tried to liquidate + +On line 1089: + would have created + "exaggerated" losses. + This was a classic + +On line 1089: + for a run: losses + were likely, but nobody knew + who would get burned. The + + Fed worried that with + financial markets already + fragile, these losses + +On line 1089: + spill over to investors + with no relationship to + LTCM, and credit and + +On line 1089: + markets might "cease to + function for a period + of one or more days + + and maybe longer."31 To avert + such a disaster, the Fed + called an emergency + + meeting of major + banks and securities firms + with large exposures + +On line 1091: + agreed to organize + a consortium to inject + billion into LTCM + +On line 1091: + in return for of + its stock.33 The firms contributed + between million and + +On line 1093: + securities and + derivatives followed. William + McDonough, then president + + of the New York Fed, + insisted "no Federal + Reserve official + +On line 1093: + were made."35 The rescue + involved no government funds. + Nevertheless, the + + Fed’s orchestration + raised a question: how far would + it go to forestall + +On line 1095: + saw as a systemic + crisis1 The Fed’s aggressive + response had precedents + +On line 1097: + decades. In the Fed had + supported the commercial + paper market; in + +On line 1097: + silver futures; in + the repo market; in the + stock market after + +On line 1097: + fell by percent in + three days. All provided a + template for future + +On line 1097: + interest rates and + encouraged financial firms + in the parallel + +On line 1097: + help ailing markets. + And sometimes it organized + a consortium of + +On line 1099: + several large banks + that they viewed as "too big to + fail" and protected + +On line 1099: + those banks, including + uninsured depositors. Their + rationale was that + +On line 1099: + banks were crucial to + the financial markets and + the economy, and + +On line 1099: + could not allow the + collapse of one arge bank to + trigger a panic + +On line 1101: + was a completely + different proposition to + argue that a hedge + +On line 1101: + big to fail because + its collapse might destabilize + capital markets. + +On line 1101: + rescue indicate + that the Fed was prepared to + protect creditors + +On line 1101: + any type of firm if + its collapse might threaten the + capital markets1 + +On line 1101: + Miller, the bankruptcy + counsel for Lehman Brothers when + it failed in 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 + +On line 1105: + 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 + +On line 1107: + have been one of those."38 + Greenspan argued that the events of + had confirmed the spare + +On line 1107: + in a speech that the + successful resolution + of the crisis showed + +On line 1107: + financial sector + provides insurance against a + financial problem + +On line 1107: + Financial Markets + came to a less definite + conclusion. In a + +On line 1107: + its counterparties + had "underestimated + the likelihood that + +On line 1107: + and volatility spreads + would move in a similar + fashion in markets + +On line 1107: + the world at the same + time."40 Many financial firms would + make essentially + +On line 1107: + the Working Group, this + miscalculation raised an + important issue: + +On line 1107: + fostered a major + expansion in the volume + and, in some cases, + +On line 1107: + severe losses. This + shows the need for insuring + that decisions about + +On line 1109: + is explicitly + considered."41 The need for risk + management grew in + + the following decade. + The Working Group was already + concerned that neither + +On line 1109: + and the economy. + Nevertheless, it cautioned + that overreacting + + to threats such as LTCM + would diminish the dynamism + of the financial + +On line 1111: + real economy: + "Policy initiatives that + are aimed at simply + + reducing default + likelihoods to extremely + low levels might be + +On line 1111: + activity and + the intermediation + of risks that support + +On line 1113: + 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 + +On line 1113: + register with the + SEC. The rule would be struck down + in by the United + +On line 1113: + Court of Appeals for + the District of Columbia + after the SEC was + +On line 1115: + were relatively + calm after Glass-Steagall would be deemed + unnecessary, OTC + + derivatives would + be deregulated, and the + stock market and the + +On line 1115: + would continue to + prosper for some time. Like all + the others (with the + + exception of the + Great Depression), this crisis + soon faded into + +On line 1115: + memory. But not + before, in February Time + magazine featured + +On line 1115: + Larry Summers, and + Alan Greenspan on its cover as + "The Committee to + +On line 1115: + the World." Federal + Reserve Chairman Greenspan became + a cult hero—the "Maestro"—who + +On line 1119: + emergency since the + stock market crash.44 DOTCOM CRASH: + "LAY ON MORE RISK" The + + late 1990s was a good + time for investment banking. + Annual public + +On line 1119: + securities in + U.S. markets almost quadrupled, + from billion in to + +On line 1119: + Annual initial + public offerings of stocks + (IPOs) soared from billion + +On line 1119: + in to billion in + as banks and securities + firms sponsored IPOs for + +On line 1119: + telecommunications + companies—the dot-coms + and telecoms.45 A stock + + market boom ensued + comparable to the great + bull market of the + +On line 1119: + value of publicly + traded stocks rose from trillion + in December to + +On line 1119: + trillion in March The + boom was particularly + striking in recent + +On line 1119: + and telecom issues + on the NASDAQ exchange. Over + this period, the + +On line 1121: + skyrocketed from + to In the spring of the tech + bubble burst. The "new + +On line 1121: + telecoms had failed to + match the lofty expectations + of investors, who had + +On line 1121: + bullish—and, as it turned + out, sometimes deceptive—research + reports issued by + +On line 1121: + and securities + firms that had underwritten + the tech companies’ + +On line 1121: + offerings. Between + March and March the NASDAQ fell + by almost two-thirds. This + +On line 1121: + as the nation slipped + into recession. Investors + were further shaken + +On line 1121: + and other scandals + at prominent firms such as + Enron and World-com. + +On line 1121: + leading commercial + and investment banks settled + with regulators + +On line 1121: + improper practices + in the allocation of + IPO shares during the + +On line 1121: + spinning (doling out + shares in "hot" IPOs in return + for reciprocal + +On line 1121: + laddering (doling + out shares to investors who agreed + to buy more later + + at higher prices).47 The + regulators also found + that public research + +On line 1121: + New York’s attorney + general, the National + Association + +On line 1121: + state regulators + settled enforcement actions + against firms for million, + +On line 1123: + certain practices, and + instituted reforms.48 The + sudden collapses + +On line 1123: + of Enron and WorldCom + were shocking; with assets of + billion and billion, + +On line 1125: + Morgan, Merrill Lynch, + and other Wall Street banks paid + billions of dollars—although + +On line 1125: + 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 + +On line 1125: + banks had pressured their + analysts to write glowing + valuations of + + Enron. The scandal + cost Citigroup, JP Morgan, + CIBC, Merrill Lynch, and + +On line 1125: + settlements with the + SEC; Citigroup, JP Morgan, + CIBC, Lehman Brothers, and + +On line 1127: + Bank of America + paid another billion to + investors to settle + +On line 1127: + response, the Sarbanes-Oxley Act + of required the personal + certification + +On line 1127: + reports by CEOs and + CFOs; independent audit + committees; longer jail + + sentences and larger + fines for executives who + misstate financial + +On line 1129: + and protections for + whistleblowers. Some firms that lent + to companies that + +On line 1129: + stock market bust were + successfully hedged, having + earlier purchased + + credit default swaps + on these firms. Regulators + seemed to draw comfort + +On line 1131: + banks had succeeded + in transferring losses from + those relationships + +On line 1131: + investors through these and + other hedging transactions. + In November Fed + +On line 1131: + have effectively + spread losses" from defaults by + Enron and other + + large corporations. + Although he conceded the + market was "still too + +On line 1131: + to have been tested" + thoroughly, he observed that + "to date, it appears + +On line 1133: + following year, Fed + Vice Chairman Roger Ferguson + noted that "the most + +On line 1133: + fact regarding the + banking industry during + this period is + +On line 1135: + achieved unprecedented + stability and strong risk + management. The Wall + +On line 1135: + banks’ pivotal role in + the Enron debacle did + not seem to trouble + +On line 1135: + Fed officials. In + a memorandum to the + FCIC, Richard Spillenkothen described + +On line 1135: + Board of Governors + in which some Fed governors + received details of + +On line 1135: + "The message to some + supervisory staff was + neither ambiguous + + nor subtle," Spillenkothen wrote. + Earlier in the decade, he + remembered, senior + +On line 1135: + at the Fed had called + Enron an example of + a derivatives + +On line 1135: + regulated by + market discipline without + government oversight.52 + +On line 1137: + cut interest rates + aggressively in order + to contain damage + +On line 1137: + dot-com and telecom + bust, the terrorist attacks, + and the financial + +On line 1137: + In January the + federal funds rate, the overnight + bank-to-bank lending rate, + +On line 1139: + was By mid-2003, the Fed + had cut that rate to just the + lowest in half a + +On line 1139: + another year. In + addition, to offset the + market disruptions + +On line 1141: + financial markets + with money by purchasing + more than billion in + +On line 1141: + securities and + lending billion to banks. It + also suspended + + restrictions on bank + holding companies so the + banks could make large loans + +On line 1141: + these actions the Fed + prevented a protracted + liquidity crunch + +On line 1141: + in the financial + markets during the fall of + just as it had done + +On line 1143: + the stock market crash + and the Russian crisis. Why + wouldn’t the markets + + assume the central + bank would act again—and again save the + day1 Two weeks before + +On line 1143: + cut short-term rates in + January the Economist + anticipated + +On line 1145: + it: "the ‘Greenspan put’ is + once again the talk of Wall Street. + The idea is that the + + Federal Reserve + can be relied upon in + times of crisis to + +On line 1145: + the rescue, cutting + interest rates and pumping + in liquidity, + +On line 1145: + providing a floor + for equity prices."53 The "Greenspan + put" was analysts’ + + shorthand for investors’ + faith that the Fed would keep the + capital markets + +On line 1145: + 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 + +On line 1145: + bursting a bubble + would heavily damage the + economy. "Instead + +On line 1145: + trying to contain + a putative bubble by + drastic actions with + +On line 1145: + in when housing prices + were ballooning, "we chose to + focus on policies + + ‘to mitigate the + fallout when it occurs and, + hopefully, ease the + +On line 1147: + policy—allowing + unrestrained growth, then working + hard to cushion the + +On line 1147: + the question of "moral + hazard": did the policy + encourage investors + +On line 1147: + institutions to + gamble because their upside + was unlimited + +On line 1147: + their downside (at least + against catastrophic losses)1 + Greenspan himself warned about + +On line 1147: + a speech, noting that + higher asset prices were "in + part the indirect + +On line 1147: + investors accepting + lower compensation for + risk" and cautioning + +On line 1147: + liquidity can + readily disappear."55 Yet + the only real + +On line 1147: + would be an upward + march of the federal funds + rate that had begun + +On line 1147: + in the summer of + although, as he pointed out + in the same speech, this + +On line 1149: + And the markets were + undeterred. "We had convinced + ourselves that we were + +On line 1149: + Federal Reserve + governor and National + Economic Council + +On line 1151: + under President + George W. Bush Lawrence Lindsey told + the Commission. "And + +On line 1151: + should any rational + investor respond to a less + risky world1 They should lay + +On line 1155: + more risk."56 THE WAGES OF + FINANCE: "WELL, THIS ONE’S DOING + IT, SO HOW CAN I + +On line 1155: + DO IT1 As figure + demonstrates, for almost half a + century after + + the Great Depression, + pay inside the financial + industry and out + +On line 1155: + financial sector + compensation was more than + greater than in other + +On line 1157: + gap than before the + Great Depression. Until the + New York Stock Exchange, + +On line 1157: + required members to + operate as partnerships.57 + Peter J. Solomon, a + +On line 1157: + Lehman Brothers partner, + testified before the FCIC + that this profoundly + +On line 1157: + bank’s culture. Before + the change, he and the other + partners had sat in + +On line 1157: + room at headquarters, + not to socialize but to + "overhear, interact, + + and monitor" each + other. They were all on the + hook together. "Since + +On line 1157: + seriously," Solomon + said.58 Brian Leach, formerly + an executive + +On line 1157: + 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. + +On line 1157: + 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 + +On line 1159: + close relationship + between bankers’ decisions and + their compensation + +On line 1159: + shareholders’ money. + Talented traders and managers + once tethered to their + + firms were now free agents + who could play companies against + each other for more + +On line 1159: + up, commercial banks + did the same. Some included + "clawback" provisions + +On line 1159: + require the return + of compensation under + narrow circumstances, + +On line 1159: + proved too limited + to restrain the behavior + of traders and managers. + +On line 1161: + found that the real + value of executive + pay, adjusted for + +On line 1161: + the years after World + War II, lagging companies’ + increasing size.60 But + +On line 1163: + rate picked up during + the 1970s and rose faster each decade, + reaching a year from + +On line 1163: + to Much of the change + reflected higher earnings + in the financial + +On line 1163: + averaged million + annually, the highest + of any industry. + + Though base salaries differed + relatively little across + sectors, banking and + +On line 1163: + higher bonuses and + awarded more stock. And brokers + and dealers did by + +On line 1165: + more than million in + compensation.62 Both before + and after going + + public, investment + banks typically paid out + half their revenues in + +On line 1165: + compensation. For + example, Goldman Sachs spent + between and a year + +On line 1167: + and Merrill paid out + similar percentages in + and but gave in 2007—a + +On line 1169: + suffered dramatic + losses.63 As the scale, revenue, + and profitability + +On line 1169: + key employees. John + Gutfreund, reported to + be the highest-paid + +On line 1171: + on Wall Street in the + late 1980s, received million in + as CEO of Salomon + +On line 1173: + Stanley O’Neal’s package + was worth more than million in + the last full year he + +On line 1173: + was CEO of Merrill + Lynch.65 In Lloyd Blankfein, CEO at + Goldman Sachs, received + +On line 1173: + Richard Fuld, CEO of Lehman + Brothers, and Jamie Dimon, CEO + of JPMorgan Chase, received + +On line 1173: + million and million, + respectively.67 That year Wall + Street paid workers in + +On line 1173: + York roughly billion + in year-end bonuses alone.68 Total + compensation for + + the major U.S. banks + and securities firms was + estimated at + +On line 1175: + billion.69 Stock options + became a popular form + of compensation, + +On line 1175: + buy the company’s + stock in the future at some + predetermined price, + +On line 1175: + to reap rewards when + the stock price was higher than + that predetermined + +On line 1175: + In fact, the option + would have no value if the + stock price was below + +On line 1175: + price. Encouraging + the awarding of stock options + was legislation + +On line 1175: + while the downside was + simply to receive nothing + if the stock didn’t + +On line 1175: + predetermined price. + The same applied to plans that + tied pay to return + + on equity: they + meant that executives could + win more than they could + +On line 1177: + to increase both risk + and leverage, which could lead to + larger jumps in a + +On line 1179: + price. As these options + motivated financial + firms to take more risk + +On line 1179: + use more leverage, the + evolution of the system + provided the means. + +On line 1179: + commercial banks. OTC + derivatives allowing + for enormous leverage + + proliferated. + And risk management, thought to + be keeping ahead of + +On line 1181: + in the increasing + risks. The dangers of the new + pay structures were clear, + +On line 1181: + 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 + +On line 1181: + if I don’t do it, + then the people are going + to leave my place and + +On line 1181: + of an important + function in a broad base of + companies, I would + +On line 1183: + regulatory + entities, one source of checks + on excessive risk + +On line 1183: + challenges recruiting + financial experts who could + otherwise work in + + the private sector. + Lord Adair Turner, chairman of + the U.K. Financial + +On line 1185: + told the Commission, + "It’s not easy. This is like a + continual process + +On line 1185: + high-skilled people, and + the poachers are better paid + than the game-keepers."71 + +On line 1185: + 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 + +On line 1187: + to earnings also, + in some cases, created + the temptation to + +On line 1187: + the numbers. Former + Fannie Mae regulator + Armando Falcon + +On line 1187: + "Fannie began the + last decade with an ambitious + goal—double earnings + +On line 1187: + to [per share]. A large + part of the executives’ + compensation was + +On line 1187: + tied to meeting that + goal." Achieving it brought CEO Franklin + Raines million of his + +On line 1187: + million pay from to + However, Falcon said, the + goal "turned out to be + +On line 1187: + hiding risks. Fannie + and Freddie executives + worked hard to persuade + +On line 1187: + investment, while at + the same time covering up + the volatility and + +On line 1187: + of their own mortgage + portfolios and balance sheets." + Fannie’s estimate + +On line 1187: + of how many mortgage + holders would pay off was off + by million at year-end + +On line 1187: + which meant no bonuses. + So Fannie counted only + half the million on + + its books, enabling Raines + and other executives + to meet the earnings + +On line 1189: + chain, from people who + originated mortgages to + people on Wall Street + +On line 1189: + often the first link + in the process, FDIC Chairman Sheila + Bair told the FCIC that + +On line 1189: + based on the volume + of loans originated rather + than the performance + + and quality of + the loans made." She concluded, + "The crisis has shown + +On line 1189: + Formula-driven + compensation allows high + short-term profits to + +On line 1189: + into generous + bonus payments, without regard + to any longer-term risks."74 SEC + +On line 1189: + success, even if these + same decisions result in + significant long-term + + losses or failure + for investors and taxpayers."75 + FINANCIAL SECTOR + +On line 1193: + "I THINK WE OVERDID + FINANCE VERSUS THE REAL + ECONOMY" For about + +On line 1193: + beginning in the + early 1980s, the financial + sector grew faster than + +On line 1193: + the economy—rising + from about of gross domestic + product (GDP) to about + +On line 1193: + in the early 21st + century. In financial + sector profits were + +On line 1193: + about of corporate + profits. In they hit a high + of but fell back to + +On line 1193: + larger. JP Morgan’s + assets increased from billion + in to trillion in + +On line 1195: + annual growth rate + of Bank of America and + Citigroup grew by + +On line 1197: + respectively, with + Citigroup reaching trillion + in assets in (down + +On line 1197: + from trillion in and + Bank of America trillion. + The investment banks + +On line 1197: + Goldman’s assets grew + from billion in to trillion + by an annual + +On line 1201: + growth rate of At Lehman, + assets rose from billion to + billion, or Fannie + +On line 1201: + Fannie’s assets and + guaranteed mortgages increased + from trillion in to + +On line 1201: + or annually. + At Freddie, they increased from + trillion to trillion, + +On line 1203: + or a year.77 As they + grew, many financial firms added + lots of leverage. That + +On line 1203: + higher returns for + shareholders, and more money + for compensation. + + Increasing leverage + also meant less capital + to absorb losses. + +On line 1205: + and Freddie were the + most leveraged. The law set the + government-sponsored + +On line 1205: + requirement at of + assets plus of the mortgage-backed + securities they + +On line 1207: + So they could borrow + more than for each dollar of + capital used to + +On line 1207: + If they wanted to + own the securities, they + could borrow for each + +On line 1207: + capital. Combined, + Fannie and Freddie owned or + guaranteed trillion + +On line 1209: + at the end of against + just billion of capital, + a ratio of From + +On line 1209: + to in assets for + each dollar of capital, + for leverage ratios + +On line 1209: + between and:1. For some + banks, leverage remained roughly + constant. JP Morgan’s + +On line 1211: + reported leverage + was between and:1. Wells Fargo’s + generally ranged + +On line 1211: + between and Other + banks upped their leverage. Bank of + America’s rose + +On line 1211: + to in Citigroup’s + increased from to:1, then shot up + to by the end of + +On line 1211: + 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 + +On line 1213: + bringing billion worth + of assets on balance sheet, + substantial assets + +On line 1215: + remained off. If those + had been included, leverage + in would have been or + +On line 1215: + Wells Fargo and Bank + of America, including + off-balance-sheet assets + +On line 1219: + have raised the leverage + ratios and respectively.78 + Because investment + +On line 1219: + not subject to the + same capital requirements + as commercial and + +On line 1219: + banks, they were given + greater latitude to rely + on their internal + +On line 1221: + and they reported + higher leverage. At Goldman + Sachs, leverage increased + +On line 1221: + in to in Morgan + Stanley and Lehman increased about + and%, respectively, + +On line 1223: + reached by the end of + Several investment banks + artificially + +On line 1223: + assets right before + the reporting period + and subsequently + + buying them back. As + the investment banks grew, their + business models changed. + +On line 1225: + of the investment + banks’ revenues and earnings was + generated by + +On line 1225: + and derivatives + activities. At Goldman, + revenues from trading + +On line 1227: + investments increased + from of the total in to + in At Merrill Lynch, + +On line 1229: + they generated + of revenue in up from in + At Lehman, similar + +On line 1231: + generated up + to of pretax earnings in + up from in At Bear + +On line 1231: + they accounted for + more than of pretax earnings + in some years after + +On line 1233: + losses in other + businesses.80 Between and debt + held by financial + +On line 1235: + companies grew from + trillion to trillion, more than + doubling from to of + +On line 1235: + told the FCIC that while + the financial sector must + play a "critical" + +On line 1235: + capital to the + most productive uses, it + was reasonable to + +On line 1235: + ask whether over the last + or years it had become too + large. Financial firms + +On line 1235: + companies borrowed + in the credit markets for + every borrowed by + +On line 1235: + were borrowing for + every "We have a lot more + debt than we used to + + have, which means we have + a much bigger financial + sector," said Snow. "I + +On line 1235: + versus the real + economy and got it a + little lopsided + +On line 1247: + so complicated + how is anybody going to + know1" Greater access to + +On line 1249: + business where we can + make some money".............72 Subprime lenders + in turmoil: "Adverse + +On line 1253: + market conditions"..................................74 + The regulators: "Oh, I + see" 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 + +On line 1253: + and the like. Banks might + have been unwilling to lend + to these borrowers, + +On line 1253: + a subprime lender would + if the borrower paid a + higher interest + +On line 1253: + the extra risk. "No + one can debate the need for + legitimate non-prime + +On line 1253: + president of the + Nevada Fair Housing Center, + Inc., testified to + +On line 1257: + 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 + +On line 1257: + over other forms of + debt were solidified in + with the Tax Reform + +On line 1257: + consumer loans but kept + the deduction for mortgage + interest payments. + +On line 1259: + 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 + +On line 1259: + the four C’s: credit + (quantity, quality, and + duration of the + +On line 1259: + income), capital + (sufficient liquid funds to + cover down payments, + +On line 1259: + costs, and reserves), and + collateral (value and + condition of the + +On line 1259: + how strength in one area, + such as collateral, might + offset weaknesses + +On line 1259: + such as credit. They + underwrote borrowers one + at a time, out of + + local offices. In + a few cases, such as CitiFinancial, + subprime lending firms + +On line 1261: + finance companies. + Without access to deposits, + they generally + +On line 1261: + themselves with short-term + lines of credit, or "warehouse + lines," from commercial + + or investment banks. + In many cases, the finance + companies did not + +On line 1261: + 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 + +On line 1261: + other cases, the + finance company itself + packaged and sold the + +On line 1261: + partnering with the + banks extending the warehouse + lines. Meanwhile, the S&Ls + +On line 1267: + SO COMPLICATED + HOW IS ANYBODY GOING TO + KNOW1 Debt outstanding + +On line 1267: + markets tripled during + the 1980s, reaching trillion in + was securitized + +On line 1267: + as the single largest + component—a position + they maintained through the + +On line 1269: + In the 1990s mortgage + companies, banks, and Wall Street + securities firms + +On line 1269: + securitizing + mortgages (see figure And more + of them were subprime. + +On line 1271: + 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. + +On line 1271: + handled by Fannie + and Freddie, the question was + not "will you get the + +On line 1271: + "when," former Salomon + Brothers trader and CEO of + PentAlpha Jim Callahan told + +On line 1271: + and that created + an opportunity for + S&P and Moody’s. As Lewis + +On line 1271: + pioneer in the + market, told the Commission, + when he presented + +On line 1271: + they asked, "‘This stuff is + so complicated how is + anybody going to + +On line 1271: + 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 + +On line 1273: + 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 + +On line 1273: + with billion in loans + and real estate from failed + thrifts and banks. Congress + +On line 1275: + the Resolution + Trust Corporation (RTC) in + to offload mortgages + +On line 1275: + estate, and sometimes + the failed thrifts themselves, now owned + by the government. + +On line 1275: + RTC was able to sell + billion of these mortgages to + Fannie and Freddie, + +On line 1277: + did not meet the GSEs’ + standards. Some were what might be + called subprime today, + +On line 1279: + 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 + +On line 1279: + real estate and + financial professionals + to securitize + +On line 1279: + had securitized + billion in residential + mortgages.7 The RTC in + +On line 1279: + familiar with the + securitization of + these assets, mortgage + +On line 1279: + in hand. As figure + shows, subprime originations + increased from billion + +On line 1279: + to billion in The + proportion securitized + in the late 1990s peaked + +On line 1285: + the RTC and by Wall + Street were similar to the + Fannie and Freddie + +On line 1285: + first step was to get + principal and interest + payments from a group + +On line 1285: + securities (that + is, securitizations + not done by Fannie + +On line 1285: + Freddie), the payments + were then "tranched" in a way to + protect some investors + +On line 1287: + of principal and + interest in different + orders. Most of the + +On line 1287: + late 1980s and early + 1990s, used a rudimentary + form of tranching. There + + were typically + two tranches in each deal. The + less risky tranche received + +On line 1287: + guaranteed by an + insurance company. The + more risky tranche received + +On line 1287: + was not guaranteed, + and was usually kept by + the company that + +On line 1289: + mortgages. Within a + decade, securitizations + had become much more + +On line 1289: + they had more tranches, + each with different payment + streams and different + + risks, which were tailored + to meet investors’ demands. The + entire private-label + +On line 1289: + created, sold, and + bought the investments—would become + highly dependent + + on this slice-and-dice process, and + regulators and market + participants alike + +On line 1289: + it efficiently + allocated risk to those + best able and willing + +On line 1291: + that risk. To demonstrate + how this process worked, we’ll describe + a typical deal, + +On line 1291: + mortgage-backed bonds.9 In New + Century Financial, a + California-based + +On line 1291: + lender, originated + and sold subprime mortgages to + Citigroup, which sold + +On line 1291: + separate legal + entity that Citigroup + sponsored that would own + +On line 1291: + mortgages and issue + the tranches. The entity + purchased the loans with + + cash it had raised by + selling the securities + these loans would back. The + +On line 1291: + had been created + as a separate legal + structure so that the + + assets would sit off + Citigroup’s balance sheet, an + arrangement with tax + +On line 1293: + The mortgages carried + the rights to the borrowers’ + monthly payments, which + +On line 1293: + into tranches of + mortgage-backed securities; each + tranche gave investors a + +On line 1293: + priority claim + on the flow of payments from + the borrowers, and + +On line 1293: + repayment schedule. + The credit rating agencies + assigned ratings to + +On line 1295: + heavily on these + ratings. Tranches were assigned + letter ratings by + + the rating agencies + based on their riskiness. In + this report, ratings + +On line 1297: + presented in S&P’s + classification system, + which assigns ratings + +On line 1297: + highest rating for + the safest investments, referred + to here as triple-A), "AA" + +On line 1297: + and "BB," and further + distinguishes ratings with + and Anything rated + +On line 1297: + 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. + +On line 1301: + this Citigroup deal, + the four senior tranches—the + safest— were rated triple-A + +On line 1303: + the agencies. Below + the senior tranches and next + in line for payments + + were eleven "mezzanine" + tranches—so named because they sat + between the riskiest + +On line 1305: + the safest tranches. These + were riskier than the senior + tranches and, because + +On line 1305: + slowly, carried a + higher risk that an increase + in interest rates + +On line 1305: + the locked-in interest + payments less valuable. As a + result, they paid a + + correspondingly + higher interest rate. Three + of these tranches in + +On line 1305: + 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 + +On line 1309: + most junior tranche, called + the "equity," "residual," + or "first-loss" tranche, set up + +On line 1309: + whatever cash flow + was left over after all the + other investors had + +On line 1309: + This tranche would suffer + the first losses from any efaults + of the mortgages in + +On line 1309: + Commensurate with + this high risk, it provided + the highest yields (see + +On line 1309: + In the Citigroup + deal, as was common, this piece + of the deal was not + +On line 1309: + at all. Citigroup + and a hedge fund each held half + the equity tranche.10 + + While investors in the + lower-rated tranches received + higher interest + +On line 1311: + because they knew there + was a risk of loss, investors + in the triple-A tranches + +On line 1311: + not expect payments + from the mortgages to stop. This + expectation of + +On line 1311: + the firms structuring + securities focused on + achieving high ratings. + +On line 1311: + In the structure of + this Citigroup deal, which was + typical, million, + +On line 1315: + or was rated triple-A. + GREATER ACCESS TO LENDING: "A + BUSINESS WHERE WE CAN + +On line 1317: + hold, new computer + and modeling technologies + were reshaping the + +On line 1317: + data with loan-level + information on mortgage + performance became + +On line 1317: + widely available. Lenders + underwrote mortgages using + credit scores, such as + +On line 1317: + score, developed by + Fair Isaac Corporation. In + Freddie Mac rolled out + +On line 1317: + system for mortgage + underwriting for use by + lenders, and Fannie Mae + +On line 1317: + later. The days of + labori-ous, slow, and manual + underwriting of + + individual + mortgage applicants were over, + lowering cost and + +On line 1319: + on quantitative + expectations: Given the + borrower, the home, + +On line 1319: + would be on time1 What + was the probability + that borrowers would + +On line 1321: + the Community + Reinvestment Act (CRA). Congress + enacted the CRA + +On line 1321: + banks and thrifts served their + communities, in response + to concerns that banks + +On line 1321: + were refusing to + lend in certain neighborhoods + without regard to + +On line 1321: + creditworthiness + of individuals and + businesses in those + +On line 1323: + (a practice known as + redlining).11 The CRA called on banks + and thrifts to invest, + +On line 1323: + took in deposits, so + long as these activities + didn’t impair their + +On line 1323: + financial safety + and soundness. It directed + regulators to + +On line 1323: + or thrift applied for + regulatory approval + for mergers, to open + + new branches, or to + engage in new businesses.12 + The CRA encouraged + +On line 1325: + borrowers to whom + they may have previously + denied credit. While + +On line 1327: + loans made under the + CRA performed consistently + with the rest of the + +On line 1327: + 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 + +On line 1327: + often report sound + business opportunities," + Federal Reserve + +On line 1331: + Alan Greenspan said of CRA + lending in Residential + Mortgage-Backed Securities + +On line 1333: + packaged subprime, Alt-A + and other mortgages into + securities. As + + long as the housing + market continued to boom, + these securities + +On line 1333: + perform. But when the + economy faltered and the + mortgages defaulted, + +On line 1335: + were left worthless. In + President Bill Clinton asked + regulators to + +On line 1335: + while responding to + industry complaints that the + regulatory + +On line 1335: + process for compliance + was too burdensome and too + subjective. In the + + Fed, Office of Thrift + Supervision (OTS), Office + of the Comptroller + +On line 1335: + Deposit Insurance + Corporation (FDIC) issued + regulations that + +On line 1335: + regulatory + focus from the efforts that + banks made to comply + +On line 1337: + 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 + +On line 1339: + are quite impressive. + And the bankers conversely say, + ‘This is proven to be + +On line 1339: + business where we can + make some money; not a lot, + but when you factor + +On line 1341: + in plus the good will + that we get from it, it kind + of works.’"15 Lawrence Lindsey, + +On line 1341: + Fed governor who + was responsible for the + Fed’s Division of + +On line 1341: + enforcement, told the + FCIC that improved enforcement + had given the banks + + an incentive to + invest in technology + that would make lending + +On line 1341: + 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 + +On line 1341: + to underwrite loans. + "We basically got a + cycle going which + +On line 1341: + historic data, show + the default rates on this type + of lending were very, + +On line 1341: + low," he said.16 Indeed, + default rates were low during + the prosper-ous 1990s, and + +On line 1341: + bankers, and lenders in the + shadow banking system took + note of this success. + +On line 1347: + Among nonbank mortgage + originators, the late 1990s + were a turning point. + +On line 1347: + 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 + +On line 1349: + in to in Meanwhile, + subprime originators saw + the interest rate + +On line 1349: + they could borrow in + credit markets skyrocket. + They were caught in a + + squeeze: borrowing costs + increased at the very moment + that their revenue stream + +On line 1349: + up.17 And some were caught + holding tranches of subprime + securities that + +On line 1351: + out to be worth far + less than the value they had + been assigned. Mortgage + +On line 1351: + 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 + +On line 1351: + in August Then, in + September, SFC notified + investors about "recent + +On line 1351: + conditions" in the + securities markets and + expressed concern about + +On line 1351: + viability + of securitization + in the foreseeable + +On line 1353: + week later, SFC filed + for bankruptcy protection. + Several other + +On line 1353: + financing from the + capital markets also + filed for bankruptcy + +On line 1353: + in and In the two + years following the Russian + default crisis, of + +On line 1355: + declared bankruptcy, + ceased operations, or sold + out to stronger firms.19 When + +On line 1357: + were sold, their buyers + would frequently absorb large + losses. First Union, a + +On line 1357: + bank headquartered in + North Carolina, incurred charges + of almost billion + +On line 1357: + it bought The Money + Store. First Union eventually + shut down or sold off + +On line 1359: + of The Money Store’s + operations. Conseco, a + leading insurance + +On line 1359: + lender. Disruptions in + the securitization + markets, as well as + +On line 1359: + eventually drove + Conseco into bankruptcy + in December At + +On line 1361: + bankruptcy in U.S. + history (after WorldCom and + Enron). Accounting + +On line 1361: + would also bring down + subprime lenders. Keystone, a small + national bank in + + West Virginia that made + and securitized subprime + mortgage loans, failed in + +On line 1361: + in the 1990s—Keystone retained + the riskiest "first-loss" residual + tranches for its own + +On line 1361: + far exceeded the + bank’s capital. But Keystone + assigned them grossly + +On line 1361: + bank in September + after discovering "fraud + committed by the + +On line 1361: + as executives + had overstated the value + of the residual + +On line 1361: + failure occurred at + Superior Bank, one of + the most aggressive + +On line 1361: + 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 + +On line 1363: + Mortgage (which was in + turn purchased by Washington + Mutual), two of + + the more aggressive + lenders during the first decade of + the new century. + +On line 1363: + to Citigroup, and + Household bought Beneficial + Mortgage before it + +On line 1365: + itself acquired by + HSBC in With the subprime + market disrupted, + +On line 1365: + billion in down from + billion two years earlier.21 + Over the next few years, + +On line 1367: + subprime lending and + securitization would + more than rebound. THE + +On line 1369: + I SEE" During the + 1990s, various federal + agencies had taken + +On line 1369: + regulatory + system was not well equipped to + respond consistently—and + +On line 1369: + protect borrowers. + State regulators, as well + as either the Fed + +On line 1369: + FDIC, supervised the + mortgage practices of state anks. + The OCC supervised + +On line 1369: + national banks. The + OTS or state regulators + were responsible + +On line 1369: + brokers, a growing + portion of the market, but + did not supervise + +On line 1371: + one entity was + unquestionably authorized + by Congress to write + + strong and consistent + rules regulating mortgages + for all types of lenders: + +On line 1371: + the Truth in Lending + Act of In the Fed adopted + Regulation Z + + for the purpose of + implementing the act. But + while Regulation + +On line 1373: + America’s many + financial regulators. + One sticking point was + + the supervision + of nonbank subsidiaries such as + subprime lenders. The Fed + +On line 1373: + enforce the consumer + protections embodied in + the Truth in Lending + +On line 1373: + with respect to these + nonbank lenders. Although the FTC + brought some enforcement + +On line 1373: + mortgage companies, + Henry Cisneros, a former + secretary of the + +On line 1373: + Housing and Urban + Development (HUD), worried + that its budget and + +On line 1373: + 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 + +On line 1375: + staff to go out and + search out mortgage problems."23 Glenn + Loney, deputy director + +On line 1375: + of the Fed’s Consumer + and Community Affairs + Division from to + +On line 1377: + the FCIC that ever + since he joined the agency in + Fed officials had + +On line 1377: + whether they—in addition + to the FTC—should enforce rules for + nonbank lenders. But they + +On line 1377: + whether the Fed would be + stepping on congressional + prerogatives by + +On line 1377: + 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 + +On line 1377: + would not exert its + authority in this area, + nor others that came + +On line 1377: + under its purview in + with any real force until + after the housing + +On line 1379: + that gave the Fed new + responsibilities was + the Home Ownership + +On line 1379: + Protection Act (HOEPA), + passed by Congress and signed by + President Clinton + +On line 1379: + lending practices that + especially affected + low-income borrowers. + +On line 1379: + 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 + +On line 1379: + she paid more than in + upfront finance charges on a + second mortgage. In + +On line 1381: + refinance mortgage + loans, including prepayment + penalties, negative + + amortization, and + balloon payments with a term + of less than five years. + +On line 1381: + the property alone + and "without regard to the + consumers’ repayment + +On line 1383: + a small percentage + of mortgages were initially + subject to the HOEPA + +On line 1383: + interest rate and + fee levels for triggering + HOEPA’s coverage were + +On line 1383: + catch most subprime loans.28 + Even so, HOEPA specifically + directed the Fed + +On line 1383: + act more broadly to + "prohibit acts or practices + in connection with + +On line 1385: + loans] that [the Board] finds + to be unfair, deceptive + or designed to evade + +On line 1387: + provisions of this + [act]."29 In June two years after + HOEPA took effect, the + + Fed held the first set + of public hearings required + under the act. The + +On line 1387: + were Los Angeles, + Atlanta, and Washington, D.C. + Consumer advocates + +On line 1387: + home equity lenders. + A report summarizing + the hearings, jointly + +On line 1387: + Housing and Urban + Development and released + in July said that + +On line 1387: + acknowledged that some + abuses existed, blamed some + of these on mortgage + +On line 1387: + that the increasing + securitization of + subprime mortgages was + + likely to limit + the opportunity for + widespread abuses. The + +On line 1387: + equity loans must + comply with a series of + representations + +On line 1387: + include creditors’ + representations that they + have complied with strict + +On line 1387: + guidelines concerning + the borrower’s ability + to repay the loan."30 + + But in the years to + come, these representations + and warranties would prove + +On line 1391: + Fed continued not + to press its prerogatives. + In January it + +On line 1391: + examinations + of nonbank subsidiaries of bank + holding companies,"31 + +On line 1391: + be criticized by + a November General + Accounting Office + +On line 1391: + for creating a + "lack of regulatory + oversight."32 The July + +On line 1391: + While preparing draft + recommendations for the + report, Fed staff wrote + +On line 1391: + Fed’s Committee on + Consumer and Community + Affairs that "given + +On line 1391: + support substantive + limitations on market + behavior, the draft + + report discusses + various options but does + not advocate any + +On line 1393: + to addressing these + problems."34 In the end, although + the two agencies did + +On line 1393: + both the Fed and HUD + supported legislative bans + on balloon payments + +On line 1393: + lump-sum insurance + premiums, stronger enforcement + of current laws, and + +On line 1393: + as community + outreach efforts and consumer + education and + +On line 1395: + Congress did not act + on these recommendations. + The Fed-Lite provisions + +On line 1395: + 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 + +On line 1395: + the late 1990s had drawn + regulators’ attention + to at least some of + +On line 1395: + with this lending. For + that reason, the Federal + Reserve, FDIC, OCC, and + +On line 1397: + guidance on March his + guidance applied only to + regulated banks + + and thrifts, and even for + them it would not be binding + but merely laid out + +On line 1397: + in the equity + and asset-backed securities + market has caused some + +On line 1397: + subprime specialists + to exit the market, thus + creating increased + +On line 1397: + 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 + +On line 1399: + 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 + +On line 1401: + protection laws and + regulations. Higher fees + and interest rates + +On line 1401: + predatory pricing. + An adequate compliance + management program + +On line 1401: + consumer protection + hazards associated + with subprime lending."36 + +On line 1403: + spring in response to + growing complaints about lending + practices, and at the + + urging of members + of Congress, HUD Secretary + Andrew Cuomo and + +On line 1403: + Summers convened the + joint National Predatory + Lending Task Force. It + + included members + of consumer advocacy + groups; industry trade + +On line 1403: + mortgage lenders, brokers, + and appraisers; local and + state officials; and + + academics. As the Fed + had done three years earlier, + this new entity + +On line 1403: + conducting hearings + in Atlanta, Los Angeles, + New York, Baltimore, + + and Chicago. The task + force found "patterns" of abusive + practices, reporting + +On line 1403: + too-frequent abuses in + the subprime lending market." + Questionable practices + +On line 1403: + of borrowers’ loans + in a short time), high fees and + prepayment penalties + +On line 1403: + borrowers’ losing + the equity in their homes, + and outright fraud and + +On line 1403: + The report cited + testimony regarding + incidents of forged + +On line 1405: + lenders often preyed on + the elderly, minorities, + and borrowers with + +On line 1405: + "limited access + to the mainstream financial + sector"—meaning the banks, + +On line 1405: + unions, which it viewed as + subject to more extensive + government oversight.37 + + Consumer protection + groups took the same message to + public officials. + +On line 1407: + interviews with and + testimony to the FCIC, + representatives + +On line 1407: + National Consumer + Law Center (NCLC), Nevada Fair + Housing Center, Inc., + + and California + Reinvestment Coalition each said + they had contacted + +On line 1407: + multiple times about + their concerns over unfair and + deceptive lending + +On line 1407: + "It was apparent + on the ground as early as + or that the market + +On line 1407: + being flooded with + inappropriate products," + Diane Thompson of + +On line 1409: + the Commission.39 The + HUD-Treasury task force recommended + a set of reforms + +On line 1409: + disclosure, improved + financial literacy, + strengthened enforcement, + +On line 1409: + also recognized + the downside of restricting + the lending practices + +On line 1409: + with less-than-prime credit a + chance at homeownership. It + was a dilemma. Gary + +On line 1409: + the report as a + senior Treasury official + and is currently + +On line 1409: + the Commodity + Futures Trading Commission, + told the FCIC that the + +On line 1409: + on Capitol Hill a + very short time. There wasn’t much + appetite or mood to + +On line 1411: + recommendations."40 + But problems persisted, and + others would take up + +On line 1411: + decade, "the really + poorly underwritten loans, + the payment shock loans" + +On line 1411: + to proliferate + outside the traditional + banking sector, said + +On line 1413: + as the assistant + secretary for financial + institutions from + +On line 1413: + testimony to + the Commission, she observed + that these poor-quality + +On line 1413: + banks and "created + negative competitive + pressure for the banks + +On line 1415: + to start following + suit." She added, [Subprime lending] + was started and the + +On line 1415: + of it occurred in + the nonbank sector, but it + clearly created + +On line 1415: + pressures on banks. I + think nipping this in the bud + in and with some strong + +On line 1415: + that just simply said + you’ve got to document + a customer’s income + +On line 1415: + sure they can repay + the loan, you’ve got to make + sure the income is + +On line 1415: + to pay the loans when + the interest rate resets, + just simple rules like + +On line 1417: + 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 + +On line 1417: + Sarbanes, chairman of + the Committee on Banking, + Housing, and Urban + +On line 1417: + 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, + +On line 1417: + the issue. Sarbanes + introduced legislation + to remedy the + +On line 1417: + mortgage industry + and within Congress, Bair told + the Commission. Bair + + decided to try + to get the industry to + adopt a set of "best + +On line 1417: + that would include a + voluntary ban on mortgages + that strip borrowers + +On line 1417: + 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 + +On line 1417: + 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 + +On line 1417: + the director of + the Division of Consumer + and Community + +On line 1417: + Fed, said that Gramlich + told the staff that Greenspan was not + interested in + +On line 1419: + regulation.43 When + Bair and Gramlich approached a + number of lenders about + +On line 1419: + voluntary rogram, + Bair said some originators + appeared willing to + +On line 1419: + But the Wall Street firms + that securitized the loans + resisted, saying + +On line 1421: + did not adhere to + the proposed best practices, she + recalled. The effort + + died.44 Of course, even as + these initiatives went nowhere, the + market did not stand + +On line 1425: + Subprime mortgages were + proliferating rapidly, + becoming mainstream + +On line 1427: + Originations were + increasing, and products were + changing. By three of + +On line 1427: + every four subprime + mortgages was a first mortgage, + and of those were used + +On line 1427: + Fifty-nine percent of + those refinancings were cash-outs,45 + helping to fuel + +On line 1438: + spending while whittling + away homeowners’ equity. + PART III The Boom and + +On line 1452: + stabilizing force" + Subprime loans: "Buyers will pay + a high premium" + +On line 1456: + regulatory + scrutiny" Federal rules: + "Intended to curb + +On line 1460: + abusive lending" States: + "Long-standing position"...........................................................................96 + Community-lending + +On line 1462: + pledges: "What we do is + reaffirm our intention" Bank + capital standards: + +On line 1464: + the economy had + grown straight quarters. Federal + Reserve Chairman Alan + +On line 1464: + companies were—or + at least to many observers at + the time, appeared to + +On line 1466: + managing risk. The + housing market was also + strong. Between and prices + +On line 1466: + an annual rate + of over the next five years, the + rate would hit Lower + +On line 1466: + mortgage borrowers + were partly the reason, as + was greater access to + +On line 1466: + left out—including + subprime borrowers. Lower + interest rates and + +On line 1466: + access to credit + were available for other types + of borrowing, too, + +On line 1468: + as credit cards and + auto loans. Increased access + to credit meant a + + more stable, secure + life for those who managed their + finances prudently. + +On line 1468: + meant families could + borrow during temporary + income drops, pay for + +On line 1468: + expenses, or buy + major appliances and cars. + It allowed other + +On line 1468: + to borrow and spend + beyond their means. Most of all, + it meant a shot at + +On line 1468: + benefits; and for + some, an opportunity + to speculate in + +On line 1470: + 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. + +On line 1470: + between and mortgage + debt nationally nearly + doubled. Household debt + +On line 1470: + from of disposable + personal income in to + almost by mid-2006. More + + than three-quarters of + this increase was mortgage debt. + Part of the increase + +On line 1472: + new home purchases, + part from new debt on older + homes. Mortgage credit + + became more available + when subprime lending started + to grow again after + +On line 1474: + the major subprime + lenders failed or were purchased in + and Afterward, the + +On line 1474: + billion in assets, + paid billion for Associates + First Capital, the + + second-biggest subprime lender. + Still, subprime lending remained + only a niche, just + +On line 1476: + mortgages in Subprime + lending risks and questionable + practices remained a + +On line 1476: + the Home Ownership + and Equity Protection + Act (HOEPA). Although in + +On line 1476: + rules for a narrow + set of high-cost mortgages.3 + Following losses + +On line 1480: + beginning of the + economy was slowing, even + though unemployment + +On line 1480: + of To stimulate + borrowing and spending, the + Federal Reserve’s + +On line 1480: + Market Committee + lowered short-term interest + rates aggressively. + +On line 1480: + January in a + rare conference call between + scheduled meetings, it + +On line 1480: + 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 + +On line 1482: + the committee cut + the rate another half point, + and it continued + +On line 1484: + throughout the year—11 times + in all—to the lowest in + years. In the end, the + +On line 1484: + recession of was + relatively mild, lasting + only eight months, from + + March to November, + and gross domestic product, + or GDP—the most common + +On line 1484: + the economy—dropped + by only Some policy + makers concluded + +On line 1484: + the economy had + reached the so-called end of the + business cycle, which + +On line 1484: + economists had been + predicting since before the + tech crash. "Recessions + +On line 1484: + less frequent and less + severe," said Ben Bernanke, then a + Fed governor, in + +On line 1484: + speech early in "Whether + the dominant cause of the + Great Moderation + +On line 1484: + structural change, improved + monetary policy, or + simply good luck is + +On line 1486: + 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 + +On line 1486: + lose more than nonfarm + jobs in but make small gains in + construction. In states + +On line 1486: + with a total of + only more jobs, but with new + construction jobs. In + +On line 1486: + Florida, of net + job growth was in construction. + In builders started more + +On line 1486: + the late 1970s. From to + residential construction + contributed three times + +On line 1488: + to the economy + than it had contributed on + average since But + +On line 1488: + economy remained + sluggish, and employment gains + were frus-tratingly + +On line 1488: + began talking about + a "jobless recovery"—more + production without + +On line 1488: + in employment. For + those with jobs, wages stagnated. + Between and weekly + +On line 1488: + nonsupervisory + wages actually fell by + after adjusting + +On line 1488: + Faced with these challenges, + the Fed shifted perspective, + now considering + +On line 1488: + possibility + that consumer prices could fall, an + event that had worsened + +On line 1488: + quoted speech, Bernanke said + the chances of deflation were + "extremely small" for + +On line 1488: + First, the economy’s + natural resilience: "Despite + the adverse shocks of + +On line 1488: + 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 + +On line 1488: + am confident that + the Fed would take whatever + means necessary to + +On line 1488: + in the United States. + [T]he U.S. government has a + technology, called + +On line 1488: + that allows it to + produce as many U.S. dollars + as it wishes at + +On line 1490: + short-term interest + rates low. During the strongest + U.S. companies could + +On line 1490: + commercial paper + market at an average + compared with just three + +On line 1490: + years earlier; rates + on three-month Treasury bills + dropped below in mid-2003 + +On line 1492: + from in Low rates cut + the cost of homeownership: + interest rates for + +On line 1492: + typical 30-year fixed-rate + mortgage traditionally + moved with the overnight fed + +On line 1494: + held (see figure By + creditworthy home buyers + could get fixed-rate mortgages + +On line 1494: + points lower than three + years earlier. The savings + were immediate + +On line 1494: + large. For a home bought + at the median price of + with a down payment, + +On line 1494: + mortgage payment would + be less than in Or to turn + the perspective around—as + +On line 1494: + many people did—for + the same monthly payment of + a homeowner could + +On line 1498: + up from a home to + a one.7 An adjustable-rate mortgage + (ARM) gave buyers even + +On line 1498: + affordable—unless + interest rates rose. In just + of prime borrowers + +On line 1498: + new mortgages chose ARMs; + in did. In the proportion + rose to Among subprime + +On line 1500: + borrowers, already + heavy users of ARMs, it rose from + around to As people + +On line 1500: + the housing market, + prices rose, and in hot markets + they really took + +On line 1500: + then annually + from to In California, + those numbers were even + +On line 1502: + bought for in was worth + nine years later. However, + soaring prices were not + + necessarily + the norm. In Washington State, + prices continued to + +On line 1502: + annually from + to annually from to + In Ohio, the numbers + +On line 1502: + Nationwide, home prices + rose annually from to + 2003—historically + +On line 1504: + steadily, peaking at + of households in Because so + many families were + + benefiting from + higher home values, household + wealth rose to nearly + +On line 1504: + income, up from five + times a few years earlier. + The top of households + +On line 1504: + by net worth, of whom + owned their homes, saw the value + of their primary + +On line 1504: + between and from to + (adjusted for inflation), + an increase of more + +On line 1504: + Median net worth + for all households in the top + after accounting + +On line 1504: + up from to between + and the median value + of their primary + +On line 1506: + residences rose from + to an increase of more than + Median net worth + +On line 1508: + the bottom was in + Historically, every + increase in housing + +On line 1508: + debated whether the + wealth increases would affect + spending more than in + + past years, because so + many homeowners at so many + levels of wealth saw + +On line 1508: + and because it was + easier and cheaper to + tap home equity. + + Higher home prices and + low mortgage rates brought a wave + of refinancing + +On line 1510: + prime mortgage market. + In alone, lenders refinanced over + million mortgages, more + +On line 1510: + four—an unprecedented + level.14 Many homeowners took + out cash while cutting + +On line 1510: + their interest rates. + From through cash-out refinancings + netted these households + +On line 1510: + an estimated + billion; homeowners accessed + another billion + +On line 1510: + home equity loans.15 + Some were typical second + liens; others were a + +On line 1510: + 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 + +On line 1512: + Survey of Consumer + Finances, of homeowners who + tapped their equity + +On line 1512: + such as medical + bills, taxes, electronics, and + vacations, or to + +On line 1512: + consolidate debt; + another used it for home + improvements; and the + +On line 1514: + A Congressional + Budget Office paper from + reported on the + + recent history: + "As housing prices surged in the + late 1990s and early + +On line 1516: + boosted their spending + faster than their income rose. That + was reflected in + +On line 1516: + Between and increased + consumer spending accounted + for between and of + +On line 1516: + year—rising above in + years when spending growth offset + declines elsewhere in + +On line 1516: + rate dropped from to Some + components of spending grew + remarkably fast: home + +On line 1516: + durables, recreational goods + and vehicles, spending at + restaurants, and health care. + +On line 1516: + consumer spending grew + faster than the economy, and + in some years it grew + +On line 1518: + disposable income. + Nonetheless, the economy + looked stable. By it + +On line 1518: + the brief recession + of and the dot-com bust, which + had caused the largest loss + + of wealth in ecades. With + new financial products like + the home equity + +On line 1518: + against which the Fed had + struck preemptively, did not + materialize. + +On line 1520: + a congressional + hearing in November Greenspan + acknowledged—at least + +On line 1520: + dot-com bubble burst, + the Fed cut interest rates + in part to promote + +On line 1520: + Greenspan argued that the + Fed’s low-interest-rate policy + had stimulated + +On line 1520: + by encouraging + home sales and housing starts with + "mortgage interest + +On line 1520: + that are at lows not + seen in decades." As Greenspan explained, + "Mortgage markets have + +On line 1520: + over the past two years + of economic distress by + facilitating + + the extraction of + some of the equity that + home - owners had + +On line 1522: + up."17 In February + he reiterated his + point, referring to + + "a large extraction + of cash from home equity."18 + SUBPRIME LOANS: "BUYERS + +On line 1526: + A HIGH PREMIUM" + The subprime market roared back + from its shakeout in + +On line 1526: + 1990s. The value of + subprime loans originated + almost doubled from + +On line 1528: + through to billion. In + of these were securitized; + in Low interest + +On line 1528: + spurred this boom, which would + have long-term repercussions, but so + did increasingly + +On line 1530: + borrowers, and the + scale of the firms entering + the market. Subprime + + was dominated + by a narrowing field of + ever-larger firms; the + +On line 1530: + marginal players + from the past decade had merged or + vanished. By the top + +On line 1532: + subprime lenders made of + all subprime loans, up from in + There were now three main + +On line 1532: + commercial banks and + thrifts, Wall Street investment banks, + and independent + +On line 1532: + City Bank, HSBC, and + Washington Mutual—spent + billions on boosting + +On line 1532: + units, acquiring firms, + or offering financing + to other mortgage + +On line 1532: + Almost always, these + operations were sequestered + in nonbank subsidiaries, + +On line 1534: + regulatory + no-man’s-land. When it came + to subprime lending, + + now it was Wall Street + investment banks that worried + about competition + +On line 1534: + commercial banks and + thrifts. Former Lehman president + Bart McDade told the FCIC + +On line 1534: + the banks had gained their + own securitization + skills and didn’t need + + the investment banks + to structure and distribute.21 + So the investment + +On line 1534: + a supply of loans + they could securitize and + sell to the growing + + legions of investors. + For example, Lehman Brothers, + the fourth-largest investment + +On line 1534: + including BNC and + Aurora.22 Bear Stearns, the fifth-largest, + ramped up its subprime + +On line 1534: + originators in + the United States, including + Encore. In Merrill + +On line 1536: + and Morgan Stanley + bought Saxon Capital; in + Goldman Sachs upped its + +On line 1538: + subprime lender. Meanwhile, + several independent + mortgage companies + +On line 1544: + plan concentrated + on "originating loans with + characteristics + +On line 1544: + 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 + +On line 1544: + eager customers. In + New Century sold billion + in whole loans, up from + +On line 1544: + tenth to second place + among subprime originators. + Three-quarters went to + +On line 1544: + Suisse—but New + Century reassured its + investors that there were + +On line 1546: + prospective buyers."25 Ameriquest, + in particular, pursued + volume. According + +On line 1546: + company’s public + statements, it paid its account + executives less + +On line 1546: + competition, but + it encouraged them to make + up the difference + +On line 1546: + loans. "Our people make + more volume per employee + than the rest of the + +On line 1546: + Aseem Mital, CEO of + Ameriquest, said in The company + cut costs elsewhere in + +On line 1546: + The back office for + the firm’s retail division + operated in + +On line 1546: + told a reporter for + American Banker; the work was + divided into + +On line 1548: + and funding. Ameriquest used + its savings to undercut + by as much as what + +On line 1548: + firms, according to + an industry analyst’s + estimate. Between + +On line 1548: + loan origination + rose from an estimated + billion to billion + + annually. That + vaulted the firm from eleventh to + first place among subprime + +On line 1548: + "They are clearly the + aggressor," Countrywide CEO + Angelo Mozilo + +On line 1550: + told his investors in + By Countrywide was third on + the list. The subprime + +On line 1550: + involving them in + every link of the mortgage + chain: originating + +On line 1550: + loans, packaging them + into securities, and + finally selling + +On line 1550: + 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 + +On line 1552: + mortgages to sell, for + securitization or + otherwise—known as + +On line 1552: + risked losses if the + loan defaulted. As long as + they made accurate + +On line 1552: + 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 + +On line 1552: + carried more than half + of all mortgages before the + crisis, and a much + +On line 1554: + 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 + +On line 1556: + 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 + +On line 1556: + who is issuing + the security and the + underwriter and + +On line 1556: + underwriting group + and blah, blah, blah, then nobody + in this entire chain + +On line 1556: + an early leader + in securitization, + told the FCIC, ot the + +On line 1556: + 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. + +On line 1560: + a mortgage broker. + These independent brokers, + with access to a + +On line 1560: + with borrowers to + complete the application + process. Using brokers + +On line 1560: + more rapid expansion, + with no need to build branches; + lowered costs, with no + + need for full-time + salespeople; and extended + geographic reach. + +On line 1562: + came as up-front fees—from + the borrower, from the lender, + or both—so the loan’s + +On line 1562: + These fees were often + paid without the borrower’s + knowledge. Indeed, many + +On line 1562: + brokers acted in + borrowers’ best interest.28 + One common fee paid + +On line 1562: + lender to the broker + was the "yield spread premium": + on higher-interest + +On line 1562: + 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 line 1562: + said Jay Jeffries, a + former sales manager for + Fremont Investment + +On line 1562: + the Commission. "We’ve + got a higher rate loan, we’re + paying the broker + +On line 1564: + yield spread premium."29 + In theory, borrowers + are the first defense + +On line 1564: + 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 + +On line 1564: + But many borrowers + do not understand the most + basic aspects of + +On line 1564: + least of borrowers + with adjustable-rate mortgages did not + understand how much + +On line 1564: + one time, and more than + half underestimated + how high their rates could + +On line 1564: + over the years.30 The same + lack of awareness extended + to other terms of + +On line 1566: + 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 + +On line 1566: + their W-2 and end up + with a no-doc loan simply + because the broker + +On line 1566: + getting paid more and + the lender was getting paid more + and there was extra + +On line 1566: + left over for Wall Street + because the loan carried a + higher interest + +On line 1568: + And borrowers with + less access to credit are + particularly + +On line 1568: + equipped to challenge the + more experienced person + across the desk. "While many + +On line 1568: + they are pretty good + at dealing with day-to-day + financial matters, + +On line 1568: + expenses and fees: + overdrawing checking accounts, + making late credit + +On line 1568: + limits on credit + card charges," Annamaria Lusardi, + a professor of + +On line 1570: + Dartmouth College, told + the FCIC. "Comparing terms of + financial contracts + +On line 1570: + around before making + financial decisions are + not at all common + +On line 1572: + Recall our case study + securitization deal + discussed earlier—in which + +On line 1572: + New Century sold + mortgages to Citigroup, which + then sold them to the + +On line 1572: + trust, which then bundled + them into tranches for sale + to investors. Out of + +On line 1574: + those mortgages, brokers + originated on behalf + of New Century. + + For each, the brokers + received an average fee + from the borrowers + +On line 1574: + or of the loan amount. + On top of that, the brokers + also received yield + +On line 1574: + spread premiums from + New Century for of these + loans, averaging + +On line 1576: + brokers received more + than million in fees for the + loans.33 Critics argued + +On line 1576: + with this much money + at stake, mortgage brokers had + every incentive + + to seek "the highest + combination of fees and + mortgage interest + +On line 1576: + the market will bear."34 + Herb Sandler, the founder and CEO + of the thrift Golden + +On line 1576: + Corporation, told + the FCIC that brokers were the + "whores of the world."35 As + +On line 1576: + mortgage market boomed, + so did the brokers. Wholesale + Access, which tracks the + +On line 1576: + from to the number + of brokerage firms rose from + about to In brokers + +On line 1578: + loans; in they peaked at + JP Morgan CEO Jamie Dimon + testified to the + +On line 1578: + loans had more than twice + the losses of the loans that + JP Morgan itself + +On line 1580: + emerged, in subprime and + prime mortgages alike: inflated + appraisals. For the lender, + +On line 1580: + greater losses if a + borrower defaulted. But + for the borrower + + or for the broker + or loan officer who hired + the appraiser, an + +On line 1580: + value could make the + difference between closing + and losing the deal. + +On line 1580: + a home selling for + that an appraiser says is + actually worth + +On line 1582: + In this case, a bank + won’t lend a borrower, say, + to buy the home. The + +On line 1582: + Sure enough, appraisers + began feeling pressure. One + survey found that of + +On line 1582: + appraisers had felt + pressed to inflate the value + of homes; by this had + +On line 1582: + climbed to The pressure + came most frequently from the + mortgage brokers, but + +On line 1582: + from real estate + agents, lenders, and in many cases + borrowers themselves. + +On line 1582: + often, refusal to + raise the appraisal meant losing + the client.38 Dennis J. + + Black, president of + the Florida appraisal and + brokerage services + +On line 1582: + firm D. J. Black Co. + and an appraiser with years’ + experience, held + +On line 1582: + sessions all over the + country for the National + Association + +On line 1582: + Independent Fee + Appraisers. He heard complaints + from the appraisers + +On line 1582: + pressured to ignore + missing kitchens, damaged walls, and + inoperable + +On line 1582: + 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. Changes + in regulations + +On line 1584: + appraiser with years’ + experience, explained in + testimony to + +On line 1584: + Federal Reserve, + Office of the Comptroller + of the Currency, + +On line 1584: + Federal Deposit + Insurance Corporation + loosened the appraisal + +On line 1586: + requirements for the + lenders they regulated by + raising from to the + +On line 1586: + home value at which + an appraisal from a licensed + professional was + +On line 1586: + Mann cited the lack + of oversight of appraisers, + noting, "We had a + +On line 1586: + Crabtree told the FCIC + that California’s Office + of Real Estate + +On line 1590: + to strengthen appraisals. + They recommended that an + originator’s loan + +On line 1592: + "appraisal management + company," First American + Corporation, to + +On line 1592: + Nevertheless, in + the New York State attorney + general sued First + +On line 1592: + improperly let + Washington Mutual’s loan + production staff "hand-pick + + appraisers who bring + in appraisal values high enough + to permit WaMu’s loans + +On line 1594: + and improperly + permit[ted] WaMu to pressure + appraisers to change + + appraisal values that + are too low to permit loans + to close."42 CITIGROUP: + +On line 1598: + originations grew, + Citigroup decided to + expand, with troubling + + consequences. Barely + a year after the Gramm-Leach-Bliley Act + validated its + +On line 1598: + Citigroup made its + next big move. In September + it paid billion for + + Associates First, then + the second-largest subprime lender in + the country (after + + Household Finance.). Such + a merger would usually + have required approval + +On line 1598: + 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, + +On line 1600: + New York State banking + regulators reviewed the + deal. Consumer groups fought + +On line 1600: + citing a long record + of alleged lending abuses + by Associates First, + +On line 1600: + evaluate the forms. + "It’s simply unacceptable + to have the largest bank + + in America take + over the icon of predatory + lending," said Martin + +On line 1602: + in North Carolina.43 + Advocates for the merger + argued that a large + +On line 1602: + regulator could + reform the company, and + Citigroup promised to + +On line 1602: + suspending mortgage + purchases from close to two-thirds + of the brokers and + +On line 1602: + 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 + +On line 1604: + Trade Commission, which + regulates independent + mortgage companies’ + +On line 1604: + that the company + had pressured borrowers to + refinance into + +On line 1604: + expensive mortgage + insurance. In Citigroup + reached a record million + + civil settlement + with the FTC over Associates’ + "systematic and + +On line 1606: + widespread deceptive + and abusive lending practices."45 + In the New York Fed + + used the occasion + of Citigroup’s next proposed + acquisition—European American Bank + +On line 1606: + New York—to launch its + own investigation of + CitiFinancial, which now contained + +On line 1606: + [Citigroup] approached + that transaction invited + regulatory + + scrutiny," former + Fed Governor Mark Olson + told the FCIC. "They bought + +On line 1606: + passel of problems + for themselves and it was at + least a two-year [issue]."46 + +On line 1608: + loans (usually for + borrowers in financial + trouble) into home + +On line 1608: + repay. Reviewing + lending practices from and the + Fed also accused + +On line 1608: + of selling credit + insurance to borrowers + without checking if + +On line 1608: + would qualify for + a mortgage without it. For + these violations + +On line 1608: + for impeding its + investigation, the Fed + in assessed million + +On line 1608: + said it expected + to pay another million + in restitution to + +On line 1614: + "INTENDED TO CURB + UNFAIR OR ABUSIVE LENDING" + As Citigroup was + +On line 1614: + predatory conduct. + It conducted its second + round of hearings on + +On line 1614: + Protection Act (HOEPA), + and subsequently the staff + offered two reform + + proposals. The first + would have effectively barred + lenders from granting any + +On line 1614: + limited set of + high-cost loans defined by + HOEPA—solely on the value + +On line 1614: + to the borrower’s + ability to repay. For + high-cost loans, the + +On line 1614: + to verify and + document the borrower’s + income and debt; for + +On line 1614: + documentation + standard was weaker, as the + lender could rely on + +On line 1614: + borrower’s payment + history and the like. The + staff memo explained this + +On line 1616: + Despite evidence + of predatory tactics from + their own hearings and + +On line 1616: + recently released + HUD-Treasury report, Fed officials + remained divided + +On line 1616: + strengthen borrower + protections. They grappled with + the same trade-off that the + +On line 1616: + recently noted. + "We want to encourage the + growth in the subprime + +On line 1616: + at the Financial + Services Roundtable in early + "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 + +On line 1616: + 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 + +On line 1620: + prohibit certain + products might be harmful. "These + and other kinds of + +On line 1620: + ore broadly available."51 + Instead, at least for certain + violations of + +On line 1620: + laws, he suggested + another approach: "If there + is egregious fraud, if + +On line 1620: + egregious practice, one + doesn’t need supervision + and regulation, + +On line 1620: + law enforcement."52 But + the Federal Reserve would + not use the legal + +On line 1620: + system to rein in + predatory lenders. From to the + end of Greenspan’s tenure + +On line 1620: + Fed referred to the + Justice Department only + three institutions + +On line 1620: + First American Bank, + in Carpentersville, Illinois; Desert + Community Bank, + +On line 1620: + California; and + the New York branch of Société + Générale, a large French + +On line 1622: + After some wrangling, + in December the Fed did + modify HOEPA, but + +On line 1622: + the board highlighted + compromise: "The final rule + is intended to + +On line 1622: + or abusive lending + practices without unduly + interfering with + + the flow of credit, + creating unnecessary + creditor burden, + +On line 1622: + consumers’ options in + legitimate transactions." + The status quo would + +On line 1622: + had estimated + the percentage of subprime + loans covered by HOEPA + +On line 1622: + would increase from to + as much as under the new + regulations.53 But + + lenders changed the terms of + mortgages to avoid the new rules’ + revised interest + +On line 1622: + rate and fee triggers. + By late it was clear that the + new regulations + +On line 1622: + about of subprime loans.54 + Nevertheless, reflecting + on the Federal + +On line 1622: + Greenspan contended in + an FCIC interview that the + Fed had developed + +On line 1624: + rules that have held up + to this day.55 This was a missed + opportunity, + +On line 1624: + Chairman Sheila Bair, who + described the "one bullet" that + might have prevented + +On line 1624: + financial crisis: + "I absolutely would have + been over at the Fed + +On line 1624: + prescribing mortgage + lending standards across the board + for everybody, bank + +On line 1624: + mortgage unless you + have documented income + that the borrower + +On line 1626: + repay the loan."56 The + Fed held back on enforcement + and supervision, + +On line 1626: + too. While discussing HOEPA + rule changes in the staff of the + Fed’s Division of + +On line 1626: + and Community + Affairs also proposed a + pilot program to + +On line 1626: + holding companies’ + nonbank subsidiaries,57 such as CitiFinancial + and HSBC Finance, + +On line 1626: + influence in the + subprime market was growing. + The nonbank subsidiaries + +On line 1626: + by the Federal + Trade Commission, while the banks + and thrifts were overseen + +On line 1626: + holding company + regulator, the Fed had + the authority + +On line 1626: + for "compliance with + the [Bank Holding Company + Act] or any other + +On line 1628: + the Fed enforcement + authority in this area.58 + The Fed resisted + +On line 1628: + these companies, and + despite the support of Fed + Governor Gramlich, + + the initiative stalled. + Sandra Braunstein, then a staff + member in the Fed’s + +On line 1628: + and Community + Affairs Division and now + its director, told + +On line 1628: + other officials + were concerned that routinely + examining the + +On line 1628: + an uneven playing + field because the subsidiaries had + to compete with the + +On line 1628: + supervisory + authority (although the + Fed’s HOEPA rules applied + +On line 1628: + In an interview + with the FCIC, Greenspan went further, + arguing that with + +On line 1628: + Fed lacked sufficient + resources to examine the + nonbank subsidiaries. Worse, + +On line 1628: + misleading message + to the firms and the market; + if you examine + +On line 1628: + organization + incompletely, it tends to + put a sign in their + +On line 1630: + because it creates + a Good Housekeeping stamp.60 But + if resources were the + +On line 1630: + could have argued for + more. The Fed draws income from + interest on the + +On line 1630: + it owns, so it did + not have to ask Congress for + appropriations. + +On line 1632: + it could be subject + to a government audit + of its finances. In + +On line 1632: + 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 + +On line 1634: + chaired the Fed’s consumer + subcommittee, favored tighter + supervision of + +On line 1634: + authority to + firms (such as independent + mortgage companies) + + whose lending practices + were not subject to routine + supervision, the + +On line 1634: + 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 + +On line 1634: + Street Journal that he + privately urged Greenspan to clamp + down on predatory + + lending. Greenspan demurred + and, lacking support on the + board, Gramlich backed away. + +On line 1634: + told the Journal, "He + was opposed to it, so I + did not really + +On line 1638: + pursue it."63 (Gramlich + died in of leukemia, at age 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 + +On line 1638: + a law professor + at the University of + Connecticut who served + +On line 1638: + individual + consumers. "That is classic Fed + mindset," said McCoy. "If + + you cannot prove that + it is a broad-based problem + that threatens systemic + +On line 1638: + will be dismissed." It + frustrated Margot Saunders + of the National + +On line 1638: + Center: "I stood up + at a Fed meeting in and + said, ‘How many anecdotes + +On line 1638: + 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 + +On line 1640: + report and reports + issued by the General + Accounting Office + +On line 1640: + subsidiaries until a + pilot program in July + under new chairman + + Ben Bernanke.66 The Fed did + not issue new rules under + HOEPA until July + +On line 1640: + rules banned deceptive + practices in a much broader + category of + +On line 1640: + without regard to + the borrower’s ability + o pay, and required + +On line 1640: + verify income + and assets.67 The rules would not + take effect until + +On line 1642: + October which was + too little, too late. Looking + back, Fed General + + Counsel Alvarez said + his institution succumbed + to the climate of + +On line 1642: + times. He told the FCIC, + "The mind-set was that there should be + no regulation; + +On line 1642: + take care of policing, + unless there already is an + identified problem. + +On line 1642: + 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. + +On line 1642: + the long history + of low mortgage default rates + and the desire to + +On line 1646: + become homeowners.68 + STATES: "LONGSTANDING POSITION" + As the Fed balked, many + + states proceeded on + their own, enacting "mini-HOEPA" laws + and undertaking + +On line 1648: + the OCC and the OTS. + In North Carolina led the + way, establishing + +On line 1648: + a fee trigger of + that is, for the most part any + mortgage with points and + +On line 1648: + more than of the loan + qualified as "high-cost + mortgage" subject to + +On line 1648: + regulations. This + was considerably lower + than the set by the + +On line 1648: + HOEPA regulations. + Other provisions addressed + an even broader class + +On line 1648: + mortgage loans under + and prohibiting repeated + refinancing, known + +On line 1652: + rules did not apply + to federally chartered + thrifts. In the Office + +On line 1652: + position" that its + regulations "occupy + the entire field of + +On line 1652: + from "a hodgepodge of + conflicting and over-lapping state + lending requirements," + +On line 1652: + OTS said, would let thrifts + deliver "low-cost credit + to the public free + +On line 1656: + would protect consumers.70 + Nevertheless, other states + copied North Carolina’s + +On line 1656: + in alone.71 By states and + the District of Columbia + would pass some form of + +On line 1656: + legislation. In + some cases, two or more states + teamed up to produce + +On line 1656: + Massachusetts, and + Minnesota recovered more + than million from First + +On line 1656: + Mortgage Company, + even though the firm had filed for + bankruptcy. Also + +On line 1658: + million in penalties + and restitution to consumers. + In a coalition of + +On line 1658: + states and the District + of Columbia settled with + Ameriquest for million and + +On line 1660: + the company to + follow restrictions on its + lending practices. As + +On line 1660: + see, however, these + efforts would be severely + hindered with respect + +On line 1660: + banks when the OCC in + officially joined the OTS + in constraining states + +On line 1660: + products served as an + implicit endorsement of + their legality," + +On line 1664: + testified to the + Commission.72 COMMUNITYLENDING + PLEDGES: "WHAT WE DO IS + +On line 1666: + more protection against + predatory lenders, they also + lobbied the banks to + + invest in and loan + to low- and moderate-income + communities. The + +On line 1666: + law, including the + Community Reinvestment + Act of in fact, they + +On line 1666: + outside the scope of + the CRA. For example, they + frequently involved + +On line 1666: + individuals + whose incomes exceeded those + covered by the CRA, + +On line 1666: + in geographic + areas not covered by the + CRA, or lending to + + minorities, on which + the CRA is silent. The banks would + either sign agreements + +On line 1666: + community groups + or else unilaterally + pledge to lend to and + +On line 1668: + communities or + populations. Banks often + made these commitments + + when courting public + opinion during the merger + mania at the turn + +On line 1668: + century. One of + the most notable promises was + made by Citigroup + +On line 1668: + billion lending and + investment commitment, some + of which would include + +On line 1670: + with FleetBoston Financial + Corporation in Bank of + America announced + +On line 1670: + its largest commitment + to date: billion over years. Chase + announced commitments + +On line 1670: + respectively, in + its mergers with Chemical + Bank and Bank One. The + +On line 1670: + an advocacy + group, eventually tallied + more than trillion in + +On line 1672: + of them.73 Although banks + touted these commitments in + press releases, the + +On line 1674: + could not verify + this lending happened.74 The FCIC + sent a series of + +On line 1674: + of America, JP + Morgan, Citigroup, and Wells + Fargo, the nation’s + +On line 1674: + largest banks, regarding + their "CRA and community + lending commitments." + +On line 1674: + banks indicated + they had fulfilled most promises. + According to the + +On line 1674: + much smaller than the + larger unilateral pledges + by the banks. Further, + +On line 1674: + categories than did + the CRA, including mortgages + to minority + +On line 1674: + example, only% + of the mortgages made under + JP Morgan’s billion + +On line 1674: + initiative" would have + fallen under the CRA.75 Bank + of America, which + +On line 1674: + and moderate-income + and minority lending + as satisfying + + its pledges, stated that + just over half were likely to + meet CRA requirements. + +On line 1676: + not very risky. This is + not surprising, because such + broad definitions + +On line 1676: + included loans to + borrowers with strong credit + histories—low ncome + +On line 1676: + and weak or subprime + credit are not the same. In + fact, Citigroup’s pledge + +On line 1676: + in mortgage lending + "consisted of entirely + prime loans" to low- and + +On line 1676: + and minority + borrowers. These loans performed + well.76 JP Morgan’s largest + +On line 1676: + a community + group was to the Chicago CRA + Coalition: billion in + +On line 1676: + and fewer than have + been 90-or-more-days delinquent, even + as of late Wachovia + +On line 1676: + mortgage loans between + and under its billion in + unilateral pledges: + +On line 1676: + about were ever more + than days delinquent over the life + of the loan, compared + +On line 1676: + result of Wachovia’s + lending concentration in + the relatively + + stable Southeast, and + partly a reflection of + the credit profile + +On line 1678: + years of the CRA, the + Federal Reserve Board, when + considering whether + +On line 1678: + approve mergers, gave + some weight to commitments made + to regulators. + +On line 1680: + February when the + board denied Continental + Bank’s application + +On line 1680: + not offset its poor + lending record.79 In April the FDIC, + OCC, and Federal + +On line 1680: + OTS) joined the Fed in + announcing that commitments + to regulators + +On line 1682: + documents, and its + public statements, show the Fed + never considered + +On line 1682: + 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 + +On line 1682: + banks into making + deals with community groups + so that they can get + +On line 1684: + through."81 In fact, the rules + implementing the changes to + the CRA made it clear + +On line 1684: + Federal Reserve + would not consider promises + to third parties or + +On line 1684: + prior agreements with + those parties. The rules state "an + institution’s record + +On line 1684: + these types of agreements + [with third parties] is not an + appropriate CRA + +On line 1684: + criterion."82 Still, + the banks highlighted past acts + and assurances for + +On line 1684: + the future. In for + example, when NationsBank said it + was merging with BankAmerica, + +On line 1684: + it also announced + a 10-year, billion initiative + that included pledges + +On line 1684: + housing, billion for + consumer lending, billion for + small businesses, and + +On line 1686: + respectively. This + merger was perhaps the most + controversial of + + its time because of + the size of the two banks. The + Fed held four public + +On line 1686: + and received more than + comments. Supporters touted + the community + +On line 1686: + opponents decried + its lack of specificity. The + Fed’s internal staff + +On line 1686: + approval repeated + the Fed’s insistence on not + considering these + +On line 1686: + be agreements between + private parties and has not + facilitated, + +On line 1686: + or enforced agreements + or specific portions of + agreements. NationsBank remains + +On line 1686: + the credit needs of + its entire community, + including [low- and + +On line 1688: + its public order + approving the merger, the + Federal Reserve + +On line 1688: + on to state that "an + applicant must demonstrate a + satisfactory + +On line 1688: + performance under + the CRA without reliance on + plans or commitments + +On line 1688: + for future action. + The Board believes that the CRA + plan—whether made as a + +On line 1688: + relevance in this + case without the demonstrated + record of performance + +On line 1690: + companies involved."84 + So were these commitments a + meaningful step, or + +On line 1690: + a gesture1 Lloyd Brown, + a managing director + at Citigroup, told + +On line 1690: + business.85 Speaking of + the merger with Countrywide, + Andrew Plepler, head + +On line 1690: + Corporate Social + Responsibility at + Bank of America, + +On line 1690: + 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 + +On line 1690: + the acquired bank has + been investing. So, what we + do is reaffirm our + +On line 1690: + to continue to + lend and invest so that the + communities where + +On line 1690: + work will continue + to economically thrive." + He explained further + +On line 1690: + pledge amount was arrived + at by working "closely with + our business partners" + +On line 1690: + current levels of + business activity that + qualifies toward + +On line 1690: + lending goals into + the future to assure the + community that + +On line 1692: + investing practices + will continue.86 In essence, banks + promised to keep doing + +On line 1692: + they had been doing, + and community groups had + the assurance that + +On line 1696: + "ARBITRAGE" Although + the Federal Reserve had + decided against stronger + +On line 1696: + it internalized + the lessons of and when the first + generation of + +On line 1696: + at serious risk; + some, such as Keystone Bank and + Superior Bank, + +On line 1696: + when the values of + the subprime securitized + assets they held proved + + to be inflated. + In response, the Federal + Reserve and other + +On line 1698: + thrifts. In October + they introduced the "Recourse + Rule" governing how + +On line 1698: + bank needed to hold + against securitized assets. + If a bank retained + +On line 1698: + 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 + +On line 1698: + in this instance, would + be the first to take losses + on the loans in the + +On line 1698: + the old rules, banks held + only in capital to + protect against losses + +On line 1698: + and others had been + allowed to seriously + understate their risks + +On line 1698: + not hold sufficient + capital. Ironically, + because the new rule + +On line 1698: + charge on residual + interests it increased banks’ + incentive to sell + +On line 1700: + 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. The + +On line 1702: + would be directly + linked to the rating agencies’ + assessment of the + +On line 1702: + holding lower-rated + investments. For example, + invested in AAA + +On line 1702: + holding only in + capital (the same as for + securities backed + +On line 1702: + government-sponsored + enterprises). But the same + amount invested in + +On line 1704: + BB rating required + in capital, or times more. + Banks could reduce the + + capital they were + required to hold for a pool + of mortgages simply + +On line 1704: + securitizing + them, rather than holding them on + their books as whole loans. + +On line 1706: + If a bank kept in + mortgages on its books, it might + have to set aside about + +On line 1706: + against unexpected + losses and in reserves against + expected losses. + +On line 1706: + bank created a + mortgage-backed security, sold + that security + +On line 1708: + "Regulatory + capital arbitrage does + play a role in bank + +On line 1708: + making," said David Jones, + a Fed economist who wrote + an article about + +On line 1708: + the subject in in + an FCIC interview. But "it + is not the only + +On line 1710: + triple-A corporate bond + required in capital—five + times as much as the + +On line 1710: + 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 + +On line 1712: + crutch," former Treasury + Secretary Henry Paulson + testified to the + +On line 1712: + it was better than + the alternative—"to let + the banks rate their own + +On line 1714: + That alternative + "would be terrible," he said, + noting that banks had + +On line 1714: + lower capital + requirements on the grounds that + the rating agencies + +On line 1716: + which were, after all, + supposed to be among the safest + investments. Nor were + +On line 1716: + for ratings downgrades + due to expected losses, + which would require banks + +On line 1716: + post more capital. + And were downgrades to occur + at the moment the + + banks wanted to sell + their securities to raise + capital, there would + +On line 1720: + buyers. All these things + would occur within a few + years. The Commission + +On line 1722: + in significant + ways by major financial + institutions. Some + +On line 1722: + as Citigroup, Lehman + Brothers, and Morgan Stanley, + acquired subprime lenders. + +On line 1722: + addition, major + financial institutions + facilitated + + the growth in subprime + mortgage–lending companies + with lines of credit, + +On line 1724: + other mechanisms. + Regulators failed to rein + in risky home mortgage + +On line 1724: + particular, the + Federal Reserve failed to + meet its statutory + +On line 1730: + lending standards and + to protect against predatory + lending. THE MORTGAGE + +On line 1738: + Mortgages: "A good loan" + Federal regulators: + "Immunity from + +On line 1740: + benefit" Mortgage + securities players: "Wall + Street was very hungry + +On line 1744: + for our product" Moody’s: + "Given a blank check"..........................................................................118 Fannie + Mae and Freddie Mac: + +On line 1746: + in the marketplace"................122 + In commercial banks, thrifts, and + investment banks caught + +On line 1746: + and Freddie Mac in + securitizing home loans. + By they had taken + +On line 1748: + securitizing + prime mortgages below their loan + limits, but the wave + +On line 1748: + refinancing by + prime borrowers spurred by very + low, steady interest + +On line 1748: + out. Meanwhile, Wall Street + focused on the higher-yield loans + that the GSEs could not + +On line 1748: + 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" + +On line 1748: + for borrowers with + weak credit and "Alt-A" loans, with + characteristics + +On line 1750: + borrowers with strong + credit.1 By and Wall Street was + securitizing + +On line 1750: + more loans than Fannie + and Freddie. In just two years, + private-label mortgage-backed + +On line 1750: + securities had + grown more than reaching trillion + in were subprime or + +On line 1752: + rating agencies—or were + encouraged or restricted + by regulations + +On line 1752: + hungered for Wall Street + mortgage securities backed + by higher-yield mortgages—those + +On line 1752: + borrowers, those with + nontraditional features, + those with limited + +On line 1752: + documentation + ("no-doc loans"), or those that failed + in some other way + +On line 1754: + 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 + +On line 1754: + not surprisingly + in hindsight, more and more of + it was of lower + +On line 1760: + at the end of that + process, the raw material + going into it + +On line 1760: + actually bad + quality, it was toxic + quality, and that + + is what ended up + coming out the other end + of the pipeline. Wall + +On line 1762: + origination and + securitization of + these mortgages also + +On line 1762: + access to deposits, + investment banks relied more + on money market + +On line 1762: + and other investors + for cash; commercial paper + and repo loans were + +On line 1762: + the main sources. With house + prices already up from to this + flood of money and + +On line 1762: + apparatus helped + boost home prices another from + the beginning of + +On line 1762: + peak in April 2006—even as + homeownership was falling. + The biggest gains over + +On line 1762: + period were in + the "sand states": places like the Los + Angeles suburbs + +On line 1768: + From June through June the + Federal Reserve kept the + federal funds rate + +On line 1768: + at to stimulate + the economy following + the recession. Over + + the next two years, as + deflation fears waned, the Fed + gradually raised + +On line 1770: + to in quarter-point + increases. In the view of + some, the Fed simply + +On line 1770: + and former under + secretary of treasury for + international + +On line 1770: + primarily on + this action. If the Fed had + followed its usual + +On line 1770: + 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 + +On line 1770: + A. Fleckenstein, the + president of a Seattle-based + money management + +On line 1772: + Ben Bernanke and Alan Greenspan + disagree. Both the current and + former Fed chairman + +On line 1772: + 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 + +On line 1772: + long-term rates had become + de-linked. "Between and the fed funds + rate and the mortgage + +On line 1772: + in lock-step," Greenspan said.6 + When the Fed started to raise + rates in officials + + expected mortgage + rates to rise, too, slowing growth. + Instead, mortgage rates + +On line 1772: + for another year. + The construction industry + continued to build + +On line 1774: + rate of million starts + in January 2006—more than a + 30-year high. As Greenspan told + +On line 1774: + and—vulnerable + to financial problems in + the past—encouraged + +On line 1774: + saving. Investors in + these countries placed their savings + in apparently + +On line 1774: + in the United States. + Fed Chairman Bernanke called it a + "global savings glut."8 + + s the United States + ran a large current account + deficit, flows into the + +On line 1776: + unprecedented. Over + six years from to U.S. Treasury + debt held by foreign + +On line 1776: + official public + entities rose from trillion + to trillion; as a + + percentage of U.S. + debt held by the public, these + holdings increased from + +On line 1776: + Foreigners also + bought securities backed by + Fannie and Freddie, + +On line 1776: + with their implicit + government guarantee, seemed + nearly as safe as + +On line 1776: + Treasuries. As the Asian + financial crisis ended + in foreign holdings + +On line 1776: + steady at the level + of almost years earlier, + about billion. By 2000—just + +On line 1778: + of situation + where poor countries like China + were shipping money + +On line 1778: + so weak that they [were] + better off shipping [money] + to countries like the + +On line 1778: + own countries," former + Fed governor Frederic + Mishkin told the FCIC. "The + +On line 1780: + liquidity, which + helped lower long-term interest + rates."9 Foreign investors + +On line 1780: + safe as Treasuries and + GSE securities but with + a slightly higher + +On line 1780: + overseas demand drove + up prices for securitized + debt, it "created + +On line 1782: + the U.S. financial + system: to engineer ‘quasi’ + safe debt instruments + +On line 1782: + riskier assets and + selling the senior tranches," + Pierre-Olivier Gourinchas, an + +On line 1784: + University of + California, Berkeley, told + the FCIC.10 Paul Krugman, + + an economist at + Princeton University, told + the FCIC, "It’s hard to + +On line 1784: + bubble was financed + by large capital inflows. + So were Spanish and + + Irish and Baltic bubbles. + It’s a combination of, + in the narrow sense, + +On line 1786: + international + capital movements."11 It was + an ocean of money. + +On line 1790: + refinancing boom + was over, but originators + still needed mortgages + + to sell to the Street. + They needed new products that, + as prices kept rising, + +On line 1790: + homes more affordable + to still-eager borrowers. + The solution was + +On line 1790: + risks for borrowers. + "Holding a subprime loan has + become something of + +On line 1794: + subprime borrowers + used hybrid adjustable-rate mortgages + (ARMs) such as 2/28s and + +On line 1794: + whose low "teaser" rate + lasts for the first two or three + years, and then adjusts + +On line 1794: + dollar volume of + Alt-A securitization + rose almost from to + +On line 1794: + In general, these + loans made borrowers’ monthly + mortgage payments on + +On line 1794: + homes affordable—at least + initially. Popular Alt-A + products included + +On line 1796: + payment-option ARMs. + Option ARMs let borrowers + pick their payment each + +On line 1796: + amortization. If + the balance got large enough, the + loan would convert to + +On line 1796: + mortgage, increasing + the monthly payment—perhaps + dramatically. + +On line 1798: + first, second, and even + third mortgages—rose. Debt-to-income + ratios climbed, as did + +On line 1798: + for non-owner-occupied + properties. Fannie Mae and + Freddie Mac’s market + +On line 1798: + from of all mortgages + purchased in to in and down + to by Taking their + +On line 1800: + by the GSEs. In this + new market, originators + competed fiercely; + +On line 1800: + It was the biggest + mortgage originator from + until the market + +On line 1800: + failed, buckling under + a mortgage portfolio with + loans that its co-founder + +On line 1800: + "toxic," Mozilo would + describe his 40-year-old company + to the Commission + +On line 1800: + people buy homes and + prevented social unrest + by extending loans + +On line 1800: + discrimination: + "Countrywide was one of the + greatest companies + +On line 1800: + the history of + this country and probably + made more difference + +On line 1800: + to the integrity + of our society, than any + company in the + +On line 1800: + America."19 Lending + to home buyers was only + part of the business. + +On line 1800: + and COO David Sambol + told the Commission, as long + as a loan did not + +On line 1800: + from a financial + or reputation standpoint, + Countrywide was "a + +On line 1802: + The company sold + or securitized of the + trillion in mortgages + +On line 1804: + aggressive goal of + gaining "market dominance" + by capturing of + +On line 1804: + the origination + market.21 His share at the time + was But Countrywide + +On line 1804: + Ameriquest, New Century, + Washington Mutual, and + others all pursued + +On line 1804: + by originating + types of mortgages created + years before as niche + +On line 1804: + now transformed into + riskier, mass-market versions. + "The definition + +On line 1804: + 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 + +On line 1808: + 2/28s and 3/27s: "Adjust + for the affordability" + Historically, + +On line 1808: + 3/27s, also known as + hybrid ARMs, let credit-impaired + borrowers repair + + their credit. During + the first two or three years, a + lower interest + +On line 1808: + they could make timely + payments. Eventually the + interest rates would + +On line 1808: + sharply, and payments ould + double or even triple, leaving + borrowers with few + +On line 1808: + had established their + creditworthiness, they could + refinance into + +On line 1808: + 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 + +On line 1810: + payments, they would have + to default. But as house prices + rose after the 2/28s + +On line 1810: + 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 + +On line 1810: + affordability + in the mortgage because you + couldn’t really + +On line 1810: + the president of + Andrew Davidson Co. and a + veteran of the + +On line 1810: + markets, told the FCIC.24 + Lenders qualified borrowers + at low teaser rates, + +On line 1810: + little thought to what + might happen when rates reset. + Hybrid ARMs became + +On line 1812: + as the Leadership + Conference on Civil Rights + railed against 2/28s and 3/27s, + +On line 1812: + credit nor turned renters + into owners. David Berenbaum + from the National + +On line 1812: + Reinvestment Coalition + testified to Congress in + the summer of "The + +On line 1812: + exotic mortgage + lending such as and ARMs. These + exotic subprime + +On line 1812: + rates shoot up after + an introductory time + period."25 To their + +On line 1812: + 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 + +On line 1812: + 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 + +On line 1816: + Option ARMs: "Our most + profitable mortgage loan" When they + were originally + +On line 1816: + in the 1980s, option + ARMs were niche products, too, but + by they too became + + loans of choice because + their payments were lower than + more traditional + + mortgages. During the + housing boom, many borrowers + repeatedly made + +On line 1816: + payments required, adding + to the principal balance + of their loan every + +On line 1818: + early seller of + option ARMs was Golden West + Savings, an Oakland, + +On line 1818: + California–based + thrift founded in and acquired + in by Marion + +On line 1818: + and Herbert Sandler. + In the Sandlers merged Golden + West with World Savings; + +On line 1818: + branches under the + name World Savings Bank. The thrift + issued about billion + +On line 1820: + option ARMs between + and Unlike other mortgage + companies, Golden + +On line 1822: + 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 + +On line 1822: + almost entirely + in option ARMs, Golden West’s + losses were low by + + industry standards. + Sandler attributed Golden + West’s performance to + +On line 1822: + diligence in running + simulations about what would + happen to its loans + + under various + scenarios—for example, + if interest rates + +On line 1822: + or down or if house + prices dropped even "For a quarter + of a century, + + it worked exactly + as the simulations showed + that it would," Sandler + +On line 1822: + "And we have never + been able to identify a + single loan that was + +On line 1822: + loss or foreclosure."27 + But after Wachovia acquired + Golden West in and + +On line 1822: + housing market soured, + charge-offs on the Pick-a-Pay portfolio + would suddenly jump + +On line 1824: + by September And + foreclosures would climb. Early + in the decade, banks and + +On line 1824: + their origination + of option ARM loans, changing + the product in ways + +On line 1824: + that made payment shocks + more likely. At Golden West, + after years, or if + +On line 1824: + principal balance + grew to of its original + size, the Pick-a-Pay mortgage + +On line 1824: + 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 + +On line 1824: + the original size. + They also offered lower + teaser rates—as low + +On line 1824: + 1%—and loan-to-value + ratios as high as All of + these features raised the + +On line 1824: + that the borrower’s + required payment could rise more + sharply, more quickly, and + +On line 1826: + with less cushion. In + Washington Mutual was + the second-largest mortgage + + originator, just + ahead of Countrywide. It had + offered the option + +On line 1826: + and in as cited + by the Senate Permanent + Subcommittee on + +On line 1826: + conducted a study + "to explore what Washington + Mutual could do + +On line 1826: + 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 + +On line 1826: + be by choosing the + Option Arm versus a fixed-rate + loan."30 The study also + +On line 1828: + many WaMu brokers "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 + +On line 1828: + and don’t think [it’s] good + for the customer. You’re going + to have to change the + +On line 1830: + Despite these challenges, + option ARM originations + soared at Washington + +On line 1830: + in to billion in + when they were more than half of + WaMu’s originations + +On line 1830: + the thrift’s signature + adjustable-rate home loan product.33 The + average FICO + +On line 1832: + was around well into + the range considered "prime," and + about two-thirds were jumbo + +On line 1834: + Mae and Freddie Mac + were allowed to purchase or + guarantee.34 More than + +On line 1836: + Countrywide’s option + ARM business peaked at billion + in originations + +On line 1836: + quarter of about of + all its loans originated + that quarter.36 But it + +On line 1836: + get there. In July + Countrywide decided it + would lend up to of + +On line 1836: + up from and reduced + the minimum credit score + to as low as In + +On line 1836: + ratio (including + second liens) to he risk in + these loans was growing. + +On line 1836: + rose about the combined + loan-to-value ratio rose + about and debt-to-income + +On line 1836: + ratios had risen from + to borrowers were pledging + more of their income + +On line 1836: + option ARMs had low + documentation in The + percentage of these + +On line 1836: + and speculators—that + is, borrowers with no plans + to use the home as + +On line 1838: + residence—also rose. + These changes worried the lenders even + as they continued + +On line 1838: + loans. In September + and August Mozilo emailed to + senior management + +On line 1838: + reputational + catastrophe."40 Countrywide should + not market them to + +On line 1838: + he insisted. "Pay + option loans being used by + investors is a pure + +On line 1838: + spec[ulation] loan + and not the traditional + home loan that we have + +On line 1838: + managed throughout our + history," Mozilo wrote to + Carlos Garcia, CEO + + of Countrywide Bank. + Speculative investors "should + go to Chase or Wells + +On line 1840: + us. It is also + important for you and your + team to understand + +On line 1840: + of view that there is + nothing intrinsically + wrong with pay options + +On line 1840: + the quality of + borrowers who are being + offered the product + +On line 1840: + and the abuse by third + party originators. [I]f + you are unable to + +On line 1842: + growth of the Bank for + the time being."41 However, + Countrywide’s growth did + +On line 1842: + volume of option + ARMs retained on its balance + sheet, increasing from + +On line 1842: + in to billion in + and peaking in at billion.42 + Finding these loans very + +On line 1842: + billion with the bulk + from California, followed + by Florida.43 But + +On line 1842: + the end, these loans would + cause significant losses + during the crisis. + +On line 1844: + and WaMu as tough, "in + our face" competitors, John Stumpf, + the CEO, chairman, and + +On line 1844: + Wells Fargo, recalled + Wells’s decision not to write + option ARMs, even as + +On line 1846: + 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 + +On line 1848: + Across the market, the + volume of option ARMs had + risen nearly fourfold + +On line 1850: + approximately + billion to billion. By then, + WaMu and Countrywide + +On line 1850: + were making only + the minimum payments and + that their mortgages were + +On line 1850: + The percentage of + Countrywide’s option ARMs that + were negatively + +On line 1850: + amortizing grew from + just in to in and then to + more than by At WaMu, + +On line 1850: + was in in and in + Declines in house prices added to + borrowers’ problems: + +On line 1850: + simply be eroded. + Increasingly, borrowers + would owe more on their + +On line 1850: + than their homes were worth + on the market, giving them + an incentive to + +On line 1852: + home and mortgage. Kevin + Stein, from the California + Reinvestment Coalition, + +On line 1854: + option ARMs were sold + inappropriately: "Nowhere + was this dynamic + +On line 1854: + summer of when the + Federal Reserve convened + HOEPA (Home Ownership + +On line 1854: + Act) hearings in San + Francisco. At the hearing, + consumers testified + +On line 1854: + being sold option + ARM loans in their primary + non-English language, only + +On line 1854: + be pressured to sign + English-only documents with + significantly + +On line 1854: + being unable to + make even their initial payments + because they had been + +On line 1856: + to so completely + by their brokers."47 Mona Tawatao, a + regional counsel + +On line 1856: + Services of Northern + California, described the + borrowers she was + +On line 1856: + as "people who got + steered or defrauded into + entering option + +On line 1856: + with teaser rates or + pick-a-pay loans forcing them + to pay into—pay + +On line 1856: + that they could never + pay off. Prevalent among these clients + are seniors, people + +On line 1856: + disabilities, and + limited English speakers + and seniors who are + +On line 1858: + going to have to + hold our nose" Another shift + would have serious + +On line 1858: + consequences. For decades, + the down payment for a prime + mortgage had been (in + +On line 1858: + the loan-to-value + ratio (LTV) had been As prices + continued to rise, + +On line 1858: + finding the cash to + put down became harder, and + from on, lenders began + +On line 1860: + smaller down payments. + There had always been a place + for borrowers with + +On line 1862: + down payments below + Typically, lenders required + such borrower to + +On line 1862: + mortgage insurance + for a monthly fee. If a + mortgage ended in + +On line 1862: + the lender whole. Worried + about defaults, the GSEs would not + buy or guarantee + +On line 1862: + borrower bought the + insurance. Unluckily + for many homeowners, + +On line 1862: + industry, and for + the financial system, lenders + devised a way to + +On line 1862: + rid of these monthly + fees that had added to the cost + of homeownership: + +On line 1864: + down payments that did + not require insurance. Lenders + had latitude in + +On line 1864: + In Congress ordered + federal regulators + to prescribe standards + + for real estate + lending that would apply to + banks and thrifts. The goal + +On line 1864: + reduce risk to the + deposit insurance funds and + enhance the safety + +On line 1864: + LTV standards, but chose + not to, leaving that to the + regulators. In + +On line 1866: + LTV ratios or for + documentation for home + mortgages.50 The agencies + +On line 1866: + a regulation + implementing LTV ratios + would constrict credit, + +On line 1866: + lending costs, reduce + lending flexibility, + impede economic + +On line 1868: + growth, and cause other + undesirable consequences."51 + In regulators + + revisited the + issue, as high LTV lending + was increasing. They + +On line 1868: + and limited a + bank’s total holdings of loans + with LTVs above that lacked + +On line 1868: + other protection; + they also reminded the + banks and thrifts that they + +On line 1870: + internal guidelines + to manage the risk of these + loans.52 High LTV lending + + soon became even more + common, thanks to the so-called + iggyback mortgage. + +On line 1870: + The lender offered a + first mortgage for perhaps of + the home’s value and + +On line 1870: + another or even + Borrowers liked these because + their monthly payments + +On line 1870: + mortgage insurance, + and the interest payments + were tax deductible. Lenders + +On line 1872: + potentially be + sold to the GSEs. At the same + time, the piggybacks + +On line 1872: + risks. A borrower + with a higher combined LTV + had less equity + +On line 1872: + home. In a rising + market, should payments become + unmanageable, the + +On line 1872: + a falling market, + the borrower might owe more + than the home was worth. + +On line 1872: + that many borrowers + would end up with negative + equity if house + +On line 1872: + especially if + the appraisal had overstated + the initial value. + +On line 1874: + lending helped address + a significant challenge + for companies like + +On line 1874: + Century, which were + big players in the market + for mortgages. Meeting + +On line 1874: + required finding new + borrowers, and homebuyers + without down payments + +On line 1874: + Yet among borrowers + with mortgages originated + in by September + +On line 1874: + piggybacks were four + times as likely as other + mortgage holders to + +On line 1874: + or more days delinquent. + When senior management at + New Century heard + + these numbers, the head + of the Secondary Marketing + Department asked for + +On line 1876: + Century increased + mortgages with piggybacks to + of loan production + +On line 1876: + the end of up from + only in They were not alone. + Across securitized + +On line 1876: + subprime mortgages, the + average combined LTV rose + from to between and + +On line 1878: + into mortgages—and + quickly—was to require less + information of + +On line 1880: + years earlier for + people with fluctuating + or hard-to-verify + +On line 1880: + as the self-employed, + or to serve longtime customers + with strong credit. Or + +On line 1880: + looked safe in other + respects. "If I’m making a + loan-to-value, I’m + +On line 1880: + going to get all + of the documentation," + Sandler of Golden + + West told the FCIC. The + process was too cumbersome and + unnecessary. He + +On line 1880: + teachers, accountants, + and engineers made—and if + he didn’t, he could + +On line 1880: + out. All he needed + was to verify that his + borrowers worked where + +On line 1880: + did. If he guessed wrong, + the loan-to-value ratio + still protected his + +On line 1882: + offer borrowers + the convenience of quicker + decisions and not + +On line 1882: + of paperwork. In + return, they charged a higher + interest rate. The + +On line 1882: + to low- and no-doc + loans skyrocketed from less + than to roughly of + +On line 1882: + outstanding loans.56 Among + Alt-A securitizations, + of loans issued in + +On line 1882: + had limited or + no documentation.57 As + William Black, a former + +On line 1882: + before the FCIC, the + mortgage industry’s own fraud + specialists described + +On line 1882: + income loans as "an + open ‘invitation to fraud’ + that justified the + +On line 1884: + industry term ‘liar’s + loans.’"58 Speaking of lending up + to at Citigroup, + +On line 1884: + 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 + +On line 1884: + stated product if + we want to stay in business.’"59 + Jamie Dimon, the CEO + +On line 1884: + told the Commission, + "In mortgage underwriting, + somehow we just missed, + +On line 1884: + know, that home prices don’t + go up forever and that + it’s not sufficient + +On line 1886: + 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 + +On line 1888: + rising. This was the + only scenario that would keep + the mortgage machine + +On line 1888: + The evidence is + present in our case study mortgage-backed + security, CMLTI + +On line 1890: + 2006-NC2, whose loans have many + of the characteristics + just described. The loans + +On line 1890: + deal were adjustable-rate and + fixed-rate residential mortgages + originated by + +On line 1892: + home price of in The + vast majority had a + 30-year maturity, + +On line 1894: + were originated + in May, June, and July just + after national + +On line 1894: + reportedly for + primary residences, with + for home purchases + +On line 1896: + were from all states and + the District of Columbia, + but more than a fifth + +On line 1898: + and more than a tenth + from Florida.62 About of the + loans were ARMs, and most + +On line 1898: + In a twist, many of + these hybrid ARMs had other + "affordability + +On line 1898: + more than 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 + +On line 1898: + pay any principal. + In addition, more than of + the ARMs were hybrid + +On line 1898: + balloon" loans, in which + the principal would amortize + over years—lowering the + +On line 1898: + payments even further, + but as a result leaving + the borrower with + +On line 1900: + end of the 30-year term. + The great majority of + the pool was secured + +On line 1900: + mortgages; of these, had + a piggyback mortgage on + the same property. + +On line 1900: + a result, more than + one-third of the mortgages in this + deal had a combined + +On line 1902: + ratio between and + Raising the risk a bit more, + of the mortgages were + + no-doc loans. The rest + were "full-doc," although their + documentation + +On line 1904: + fuller in some cases + than in others.63 In sum, the + loans bundled in this + +On line 1904: + high LTVs and little + documentation. And even + as many warned of this + +On line 1906: + not on the same page. + FEDERAL REGULATORS: + "IMMUNITY FROM + + MANY STATE LAWS IS A + SIGNIFICANT BENEFIT" + For years, some states had + +On line 1910: + the mortgage business, + especially to clamp down + on the predatory + +On line 1910: + proliferating + in the subprime market. The + national thrifts and + +On line 1910: + Thrift Supervision + (OTS) and the Office of the + Comptroller of the + +On line 1910: + to regulate those + national banks and thrifts. The + companies claimed that + +On line 1910: + one uniform set of + rules, they could not easily + do business across the + +On line 1910: + regulators agreed. + In August as the market + for riskier subprime + + and AltA loans grew, and + as lenders piled on more risk with + smaller down payments, + +On line 1910: + interest-only loans, + and payment-option loans, the + OCC fired a salvo. + +On line 1910: + rules for national + banks, nearly identical to + earlier OTS rules + +On line 1912: + thrifts to disregard + state consumer laws.64 Back in the + OTS had issued rules + +On line 1912: + for federally + regulated thrifts.65 In the + OTS referred to these + + rules in issuing + four opinion letters declaring + that laws in Georgia, + +On line 1912: + New Jersey, and New + Mexico did not apply + to national thrifts. + +On line 1912: + the New Mexico + opinion, the regulator + pronounced invalid New + +On line 1912: + on balloon payments, + negative amortization, + prepayment penalties, + +On line 1914: + to the borrower’s + ability to repay. The + Comptroller of the + +On line 1914: + it regulated, + offering preemption as + an inducement to + +On line 1916: + a national bank + charter. In a speech, before + the final OCC rules + +On line 1918: + 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 + +On line 1920: + OCC "was a matter + of concern."67 In August the + OCC issued its first + +On line 1920: + preemptive order, + aimed at Georgia’s mini-HOEPA statute, and + in January the + +On line 1920: + adopted a sweeping + preemption rule applying + to all state laws that + +On line 1920: + on national banks’ + ability to lend. Shortly + afterward, three large + +On line 1920: + with combined assets + of more than trillion said they + would convert from state + +On line 1922: + another point of + contention in the preemption + battle. In the OCC + +On line 1922: + regarding state-chartered + operating subsidiaries of + national banks. In + +On line 1922: + into subsidiaries and + asserted that the subsidiaries + were exempt from state + +On line 1924: + lending laws. Four states + challenged the regulation, + but the Supreme Court ruled + +On line 1928: + them in Once OCC and + OTS preemption was in place, + the two federal + +On line 1928: + lending practices by + national banks and thrifts and + their direct subsidiaries. + +On line 1928: + Dugan, who succeeded + Hawke, defended preemption, + noting that of all + + nonprime mortgages were + made by lenders that were subject + to state law. Well over + +On line 1928: + were made by mortgage + lenders that were exclusively + subject to state law."70 + +On line 1928: + of Illinois, flipped the + argument around, noting that + national banks and + +On line 1928: + heavily involved + in subprime lending. Using + different data, + +On line 1928: + and their subsidiaries were + responsible for almost + percent of subprime + +On line 1928: + mortgage loans, percent + of the Alt-A loans, and 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 + +On line 1930: + lending, the OCC and + OTS were actively engaged + in a campaign to + +On line 1930: + efforts to avert the + coming crisis. In the wake + of the federal + +On line 1930: + push to curtail state + authority, many of the + largest mortgage-lenders shed + +On line 1930: + state licenses and + sought shelter behind the shield + of a national + +On line 1930: + I think that it is + no coincidence that the + era of expanded + +On line 1932: + nation’s history.71 + Comptroller Hawke offered the + FCIC a different + +On line 1932: + suggested that the + OCC’s actions on preemption + have been a grab for + +On line 1932: + to increasingly + aggressive initiatives at + the state level to + +On line 1938: + depended on a + complex supply chain, largely + funded through short-term + +On line 1938: + repo market—which would + become critical as the + financial crisis + +On line 1940: + securities but + by highly rated mortgage + securities backed + +On line 1940: + increasingly risky + loans. Independent mortgage + originators such + +On line 1940: + originate mortgages + from warehouse lines of credit + extended by banks, + +On line 1942: + paper programs, or + from money borrowed in the + repo market. For + +On line 1942: + multibillion-dollar + business. From to Citigroup + made available at any + +On line 1942: + one time as much as + billion in warehouse lines of + credit to mortgage + +On line 1942: + including million + to New Century and more + than billion to Ameriquest.73 + + Citigroup CEO Chuck + Prince told the FCIC he would not + have approved, had he + +On line 1944: + "I found out at the + end of my tenure, I did + not know it before, + +On line 1944: + had some warehouse lines + out to some originators. + And I think getting + +On line 1946: + products—is something + that I wasn’t comfortable + with and that I did + +On line 1946: + consistent with the + prescription I had laid down + for the company + +On line 1948: + to be involved in + originating these products."74 + As early as Moody’s + +On line 1948: + ball game."75 As asset-backed + commercial paper became + a popular method + +On line 1948: + mortgage business, it + grew from about one-quarter to about + one-half of commercial + +On line 1950: + paper sold between + and n only five mortgage + companies borrowed + +On line 1950: + borrowed billion.76 For + instance, Countrywide launched the + commercial paper + +On line 1952: + Park Granada in and + Park Sienna in By May + it was borrowing + +On line 1952: + through Park Granada and + billion through Park Sienna. + These programs would house + + subprime and other + mortgages until they were sold.78 + Commercial banks used + +On line 1956: + arbitrage. When banks + kept mortgages on their balance + sheets, regulators + +On line 1956: + required them to hold + in capital to protect + against loss. When banks put + +On line 1956: + such as commercial + paper programs, there was no + capital charge (in + +On line 1956: + small charge was imposed). + But to make the deals work for + investors, banks had to + +On line 1956: + which they earned a fee. + This liquidity support + meant that the bank would + +On line 1956: + commercial paper + that investors were unwilling + to buy when it came + +On line 1956: + renewal. During + the financial crisis these + promises had to be + + kept, eventually + putting substantial pressure on + banks’ balance sheets. When + +On line 1958: + the private group that + establishes standards for + financial reports, + +On line 1958: + the Enron scandal + by making it harder for + companies to get + +On line 1958: + for these programs, the + favorable capital rules + were in jeopardy. The + +On line 1958: + commercial paper + market stalled. Banks protested that + their programs differed + +On line 1958: + practices at Enron + and should be excluded from + the new standards. In + +On line 1958: + bank regulators + responded by proposing to + let banks remove these + +On line 1958: + introduced for the + first time a capital charge + amounting to at most + +On line 1958: + association, + called that charge "arbitrary," and + State Street Bank complained + +On line 1958: + announced a final + rule setting the charge at up + to or half the amount + +On line 1960: + the first proposal. + Growth in this market resumed. + Regulatory + + changes—in this case, changes + in the bankruptcy laws—also + boosted growth in the + +On line 1960: + transforming the types + of repo collateral. + Prior to repo + +On line 1960: + their collateral + following the borrower’s + bankruptcy only + +On line 1960: + In the Bankruptcy + Abuse Prevention and Consumer + Protection Act of + +On line 1960: + Congress expanded + that provision to include + many other assets, + + including mortgage + loans, mortgage-backed securities, + collateralized + +On line 1960: + reliant on highly + rated non-agency mortgage-backed + securities; but + +On line 1960: + in mid-2007, when banks and + investors became skittish about + the mortgage market, + +On line 1960: + they would prove to be + an unstable funding source + (see figure Once the + +On line 1960: + a greater share of the + tri-party repo market + than most people would + +On line 1960: + Darryll Hendricks, a + UBS executive and chair + of a New York Fed + +On line 1960: + force examining + the repo market after + the crisis, told the + +On line 1962: + worked in practice. Eight + banks and securities firms + provided most of + +On line 1962: + Century needed + to make the mortgages it would + sell to Citigroup. + + Most of the funds came + through repo agreements from a + set of banks—including + +On line 1964: + Barclays Capital, + a division of a U.K.-based + bank million); Bank of + +On line 1964: + million); and Bear Stearns + million).81 The financing was + provided when New + +On line 1964: + originated these + mortgages; so for about two months, + New Century owed + +On line 1964: + its own commercial + paper program. On August + Citigroup paid New + +On line 1964: + Century million + for the mortgages (and accrued + interest), and New + +On line 1966: + lenders after keeping + a million premium.82 The + investors in the deal + + Investors for mortgage-backed + securities came from all + over the globe; what made + +On line 1970: + were the customized + tranches catering to every + one of them. CMLTI 2006-NC2 + +On line 1970: + tranches, whose investors + are shown in figure Fannie + Mae bought the entire + +On line 1970: + a better return + than super-safe U.S. Treasuries.83 The + other triple-A-rated tranches, + +On line 1970: + worth million, went to + more than institutional + investors around the world, + +On line 1970: + risk globally.84 These + triple-A tranches represented + 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 + +On line 1970: + securities-lending + operation.85 (In other + words, JP Morgan lent + +On line 1970: + its clients to other + financial institutions + in exchange for cash + +On line 1970: + and then put that cash + to work investing in this + deal. Securities + +On line 1972: + market.) The middle, + mezzanine tranches in this + deal constituted + +On line 1972: + the total value + of the security. If + losses rose above to + +On line 1972: + design the threshold + would increase over time), investors + in the residual + +On line 1972: + would be wiped out, and + the mezzanine investors would + start to lose money. + +On line 1972: + collateralized + debt obligations, or CDOs—discussed in + the next chapter—bought + +On line 1972: + of the mezzanine + tranches rated below triple-A + and nearly all those + +On line 1972: + below AA. Only + a few of the highest-rated + mezzanine tranches + +On line 1972: + not put into CDOs. + For example, Cheyne Finance + Limited purchased + +On line 1972: + the top mezzanine + tranche. Cheyne—a structured investment + vehicle (SIV)—would be + +On line 1972: + casualties of + the crisis, sparking panic + during the summer + +On line 1974: + which purchased million + of the second mezzanine + tranche,86 would be one of + + the BNP Paribas funds which + helped ignite the financial + crisis that summer.87 + +On line 1976: + 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 + +On line 1976: + there were problems. These + investors anticipated + returns of or even + +On line 1976: + Citigroup retained + part of the residual or + "first-loss" tranches, sharing + +On line 1980: + very well" The business + of structuring, selling, and + distributing this deal, + +On line 1980: + the banks. The mortgage + originators profited + when they sold loans for + +On line 1980: + profit flowed down to + employees—particularly + those generating + +On line 1982: + volume. Part of the + million premium received + by New Century + +On line 1982: + analyzed went to + pay the many employees who + participated. + +On line 1982: + salespeople [who] were + the reason our loans came in + were compensated + +On line 1982: + the FCIC. And volume + mattered more than quality. + She noted, "Wall Street + +On line 1982: + 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 + +On line 1984: + subprime division + of Washington Mutual, + which organized its + +On line 1984: + Incentive Plan by + volume. As WaMu showed in a + plan, "Home Loans Product + +On line 1986: + in higher margin + products (Option ARM, Alt A, + Home Equity, ubprime)," + +On line 1986: + sales force," and "maintain + a compensation structure + that supports the high + +On line 1988: + a security, + an underwriter, often + an investment bank, + +On line 1988: + For a billion deal + like CMLTI 2006-NC2, a fee would earn + Citigroup million. + +On line 1988: + Citigroup instead + kept parts of the residual + tranches. Doing so + +On line 1990: + yield large profits as + long as the deal performed as + expected. Options + +On line 1990: + banks, examined the + mortgage-backed securities sales + and trading desks at + +On line 1990: + from to It found that + associates had average + annual base salaries + +On line 1990: + of to from through but + received bonuses that could well + exceed their salaries. On + +On line 1990: + salaries and bonuses from + to Directors averaged + to At the top was + +On line 1990: + the head of the unit. + For example, in Dow Kim, + the head of Merrill’s + + Global Markets and + Investment Banking segment, + received a base salary + +On line 1992: + plus a million bonus, + a package second only + to Merrill Lynch’s CEO.95 + + MOODY’S: "GIVEN A BLANK + CHECK" The rating agencies were + essential to the + +On line 1996: + Issuers needed them + to approve the structure of + their deals; banks needed + +On line 1996: + markets needed their + ratings to determine loan + terms; some investors could + +On line 1996: + agencies’ judgment was + baked into collateral + agreements and other + + financial contracts. + To examine the rating + process, the Commission + +On line 1996: + Moody’s Investors Service, + the largest and oldest of the + three rating agencies. + +On line 1998: + finance products such + as mortgage-backed securities + made up close to half + +On line 2000: + and From to revenues + from rating such financial + instruments increased + + more than fourfold.97 But + the rating process involved many + conflicts, which would come + +On line 2002: + using models based, + in part, on periods of + relatively strong + +On line 2002: + in underwriting + standards or a dramatic + decline in home prices. + +On line 2002: + even develop a + model specifically to + take into account + +On line 2006: + securities.98 "In + the business forevermore" Credit + ratings have been linked + +On line 2006: + three-quarters of a + century.99 In the Office + of the Comptroller + +On line 2006: + 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, + +On line 2006: + on lower-rated bonds + held by insurers.100 But the + watershed event in + +On line 2006: + broker-dealers to base + them on credit ratings by + a "nationally + +On line 2006: + organization" + (NRSRO); at the time, that was Moody’s, + S&P, or Fitch. Ratings + +On line 2006: + built into banking + capital regulations + under the Recourse + +On line 2006: + less capital for + higher-rated securities. + For example, BBB + +On line 2006: + Banks in some countries + were subject to similar + requirements under + +On line 2006: + international + capital agreement, signed in + June although U.S. banks + +On line 2008: + also determined + whether investors could buy certain + investments at all. + +On line 2008: + SEC restricts money + market funds to purchasing + "securities that + +On line 2008: + credit ratings from + any two NRSROs in one of the + two highest short-term + +On line 2008: + or comparable + unrated securities."101 + The Department of + +On line 2008: + fund investments to + securities rated A + or higher. Credit + + ratings affect even + private transactions: contracts + may contain triggers + +On line 2008: + or entity be + downgraded. Triggers played an + important role in + +On line 2010: + the mortgage market, + the Secondary Mortgage Market + Enhancement Act of + +On line 2010: + 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 + +On line 2012: + 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 + +On line 2012: + Kolchinsky, a former + Moody’s managing director, + would summarize the + +On line 2014: + "the rating agencies + were given a blank check."103 The + agencies themselves were + +On line 2016: + avoid regulation + for decades. Beginning in the + SEC had to approve + +On line 2016: + application to + become an NRSRO—but if approved, + a company faced + +On line 2018: + later, the SEC got + limited authority + to oversee NRSROs in + +On line 2020: + the Credit Rating + Agency Reform Act of That + law, taking effect + +On line 2020: + in June focused on + mandatory disclosure of + the rating agencies’ + +On line 2022: + or the procedures + and methodologies."104 Many investors, + such as some pension + +On line 2022: + ratings because they + had neither access to the + same data as the + +On line 2022: + analytical + ability to assess the + securities they + +On line 2026: + acknowledged, "Subprime + [residential mortgage–backed + securities] and + +On line 2026: + composition and + characteristics of the + loan collateral. + +On line 2026: + their home-work were + skeptical of these products + despite their ratings. + +On line 2026: + of Mission Bank in + Bakersfield, California, + described deciding + +On line 2028: + the bank’s holdings of + mortgage-backed securities and + CDOs: At one meeting, + +On line 2028: + getting difficult, + maybe in I asked the CFO what + the mechanical + +On line 2028: + securities, if + a borrower in Des Moines, + Iowa, defaulted. I + +On line 2028: + what it is if a + borrower in Bakersfield + defaults, and somebody + +On line 2028: + 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 + +On line 2028: + to understand the + financial complexities; + didn’t want any part + +On line 2030: + rating agencies were + not liable for misstatements + in securities + +On line 2030: + ruled that their ratings + were opinions, protected by + the First Amendment. Moody’s + +On line 2030: + 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 + +On line 2030: + director at Moody’s, + told the FCIC, "People expect + too much from ratings + +On line 2032: + always be based on + much more than just a rating."107 + "Everything but the + +On line 2032: + on the table" The + ratings were intended to + provide a means of + + comparing risks across + asset classes and time. In + other words, the risk + +On line 2032: + 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 + +On line 2034: + In Moody’s created + a new model, M3 Prime, to + rate prime, jumbo, and + +On line 2034: + Alt-A deals. Only in + the fall of when the housing + market had already + +On line 2034: + it develop its + model for rating subprime + deals, called M3 Subprime.108 + +On line 2036: + and legal factors, + and macroeconomic trends. The + M3 Prime model let + +On line 2036: + automate more of + the process. Although Moody’s did not + sample or review + +On line 2036: + issuer. Relying + on loan-to-value ratios, + borrower credit + +On line 2036: + loan terms and other + information, the model + simulated the + +On line 2038: + loan in scenarios, + including variations in + interest rates and + +On line 2038: + as well as home price + changes. On average, across the + scenarios, home prices + +On line 2038: + little weight on the + possibility prices would + fall sharply nationwide. + +On line 2038: + in developing + the model, told the FCIC, "There + may have been [state-level] + + components of this + real estate drop that the + statistics would have + +On line 2038: + down over this short but + multiple-year period, is + more stressful than the + +On line 2038: + for." Even as housing + prices rose to unprecedented + levels, Moody’s never + +On line 2038: + put greater weight on the + possibility of a + decline. According + +On line 2042: + position was that + there was not a national + housing bubble."110 When + +On line 2042: + on the deal convened + a rating committee of + other analysts + +On line 2042: + it and determine + the overall ratings for the + securities.111 Siegel + +On line 2042: + also integral: + "One common misperception + is that Moody’s credit + +On line 2042: + derived solely from + the application of a + mathematical + +On line 2042: + process or model. This + is not the case. The credit + rating process involves + +On line 2042: + of independent + judgment by members of the + rating committee. + +On line 2042: + majority view + of the committee’s members."112 + As Roger Stein, a Moody’s + +On line 2042: + director, noted, + "Overall, the model has to + contemplate events for + +On line 2044: + there is no data."113 + After rating subprime deals + with the model for + +On line 2046: + subprime mortgage–backed + securities. Like M3 Prime, + the subprime model + +On line 2046: + through scenarios.114 Moody’s + officials told the FCIC they + recognized that stress + +On line 2046: + most stressful scenario, + which reduced the portion of + each deal rated triple-A. + +On line 2046: + was manually + "calibrated" to be more + conservative to + + ensure predicted + losses were consistent with + analysts’ "expert + +On line 2046: + for example, as + one step, analysts took the + "single worst case" from + +On line 2048: + in order to add + deterioration.115 Moody’s + did not, however, + +On line 2048: + of the loans being + securitized. Fons described + this problem to the + + FCIC: "I sat on this + high-level Structured Credit + committee, which you’d + +On line 2048: + would be dealing with + such issues [of declining + mortgage-underwriting + +On line 2048: + and never once was + it raised to this group or put + on our agenda that + +On line 2048: + in quality that + was going into pools, the + impact possibly + +On line 2048: + ratings, other things. + We talked about everything but, + you know, the elephant + +On line 2050: + the table."116 To rate + CMLTI 2006-NC2, our sample deal, Moody’s + first used its model + +On line 2050: + pool. Those estimates, + in turn, determined how big + the junior tranches + +On line 2050: + the deal would have to + be in order to protect + the senior tranches + +On line 2050: + was similar to + another Citigroup deal + of New Century + +On line 2050: + rated earlier + and recommended the same + amount.117 Then the deal was + +On line 2050: + of loans, including + interest-only mortgages.118 For + its efforts, Moody’s was + +On line 2054: + an estimated + (S&P also rated this deal + and received As we + + will describe later, + three tranches of this deal would + be downgraded less + +On line 2054: + Moody’s mass downgrade on + July when housing prices had + declined by only + +On line 2054: + October the M4–M11 + tranches ere downgraded and + by all the tranches + +On line 2054: + been downgraded. Of + all mortgage-backed securities + it had rated triple-A + +On line 2054: + The consequences would + reverberate throughout the + financial system. + +On line 2060: + had violated + accounting rules and now faced + corrections and fines.122 + +On line 2060: + standards, purchasing + and guaranteeing riskier + loans, and increasing + +On line 2060: + their regulator, + the Office of Federal + Housing Enterprise + +On line 2060: + Freddie’s increasing + investments in risky mortgages + and securities. + +On line 2062: + accounting firms. The + company had been using + Arthur Andersen for + +On line 2062: + but when Andersen + got into trouble in the + Enron debacle + + (which put both Enron + and its accountant out of + business), Freddie switched + +On line 2062: + the company had + understated its earnings + by billion from through + +On line 2062: + quarter of in an + effort to smooth reported + earnings and promote + +On line 2062: + as "Steady Freddie," a + company of strong and steady + growth. Bonuses were tied + +On line 2064: + to the accounting + manipulations. Freddie’s + board ousted most top + +On line 2064: + CEO Leland Brendsel, + President and COO David Glenn, + and CFO Vaughn Clarke.124 In + +On line 2064: + risk management. In + January OFHEO directed + Freddie to maintain + +On line 2064: + requirement until + it reduced operational + risk and could produce + +On line 2066: + settle shareholder + lawsuits for million and pay + million in penalties + +On line 2068: + Fannie was next. In + September OFHEO discovered + violations of + +On line 2068: + rules that called into + question previous filings. + In OFHEO reported + +On line 2068: + earnings from through by + billion and that it, too, had + manipulated + +On line 2068: + in ways influenced + by compensation plans.125 OFHEO + made Fannie improve + +On line 2068: + accounting controls, + maintain the same capital + surplus imposed on + + Freddie, and improve + governance and internal + controls. Fannie’s board + +On line 2068: + Raines and others, and + the SEC required Fannie to + restate its results + +On line 2070: + actions for million + in penalties. Donald Bisenius, + an executive + +On line 2070: + at Freddie Mac, told + the FCIC that the accounting + issues distracted + +On line 2070: + the mortgage business, + taking "a tremendous amount of + management’s time and + +On line 2070: + less aggressive or + less competitive in the + marketplace [than] we + +On line 2074: + been."126 As the scandals + unfolded, subprime private + label mortgage–backed + +On line 2074: + securities (PLS) + issued by Wall Street increased + from billion in to + +On line 2078: + the value of Alt-A + mortgage–backed securities + increased from billion + +On line 2078: + billion. Starting in + for Freddie and for Fannie, + the GSEs—particularly Freddie—became + +On line 2078: + market. While private + investors always bought the most, + the GSEs purchased of + +On line 2078: + private-issued subprime + mortgage–backed securities + in The share peaked at + +On line 2078: + then fell back to in + The share for Alt-A mortgage–backed + securities was + + always lower.127 The + GSEs almost always bought the + safest, triple-A-rated tranches. From + +On line 2082: + purchases declined, + both in dollar amount and as + a percentage. These + +On line 2082: + profitable at first, but + as delinquencies increased in + and both GSEs began + +On line 2084: + from their purchases + of Alt-A securities. By + the third quarter of + +On line 2084: + total impairments + on securities totaled + billion at the two + +On line 2086: + to wipe out nearly + of their pre-crisis capital.128 + OFHEO knew about the GSEs’ + +On line 2088: + backed securities. + In its examination, + the regulator + +On line 2088: + Freddie’s purchases + of these securities. It + also noted that + +On line 2090: + mortgages with "higher + risk attributes which exceeded + the Enterprise’s + +On line 2090: + capabilities," + including "No Income/No Asset + loans" that introduced + +On line 2090: + mortgage insurers + were already seeing abuses + with these loans.129 But the + +On line 2090: + that the purchases + of mortgage-backed securities + and riskier mortgages + +On line 2090: + efforts to address + accounting and internal + deficiencies.130 OFHEO + +On line 2090: + nothing in Fannie’s + report about its purchases + of subprime and Alt-A + +On line 2092: + risk management was + deemed satisfactory.131 The + reasons for the GSEs’ + +On line 2092: + of subprime and Alt-A + mortgage–backed securities + have been debated. + +On line 2092: + push to fulfill their + higher goals for affordable + housing. The former + +On line 2092: + a working paper + submitted as part of his + testimony to + +On line 2094: + that when the GSEs were + pressed to "expand ‘affordable + housing commitments,’ + +On line 2094: + multifamily + purchases alone met each of + the goals; in other + +On line 2094: + enterprise would have + met its obligations without + buying subprime or + +On line 2096: + none of Fannie Mae’s + purchases of subprime or + Alt-A securities + +On line 2098: + submitted to HUD + to be counted toward the + goals. Before or less + +On line 2098: + purchases had to + satisfy the affordable + housing goals. In the + +On line 2098: + met the overall goals.133 + Securities purchases + did, in several + +On line 2098: + requiring the GSEs + to purchase or guarantee + loans to purchase homes. + +On line 2098: + Fannie missed one of + these subgoals and would have missed + a second without + +On line 2098: + purchases; in the + securities purchases + helped Fannie meet those + +On line 2100: + the FCIC show that from + through Freddie would have met the + affordable housing + +On line 2100: + of Alt-A or subprime + securities, but used the + securities to + +On line 2102: + Robert Levin, the former + chief business officer of + Fannie Mae, told the + +On line 2102: + was no trade-off [between + making money and hitting + goals], it was a very + + broad-brushed effort" that + could be characterized as + "win-win-win: money, goals, and + +On line 2104: + Winer, the head of + Fannie’s Business, Analysis, + and Decisions Group, + +On line 2104: + of triple-A tranches of + mortgage-backed securities backed + by subprime loans was + +On line 2104: + as an attractive + opportunity with good + returns. He said that + +On line 2104: + satisfied housing + goals, and that the goals became + a factor in the + +On line 2106: + of private label + securities. Overall, while + the mortgages behind + +On line 2106: + were often issued + to borrowers that could help + Fannie and Freddie + +On line 2106: + the mortgages behind + the Alt-A securities were + not. Alt-A mortgages were + + not generally + extended to lower-income + borrowers, and the + +On line 2106: + Alt-A loans—from counting + toward affordability + goals.138 Levin told the FCIC + +On line 2106: + the purchase of Alt-A + securities "did not have + a net positive + + effect on Fannie + Mae’s housing goals."139 Instead, they + had to be offset + +On line 2108: + and moderate-income + borrowers to meet the goals. + Fannie and Freddie + +On line 2108: + from to and also + bought and securitized greater + numbers of riskier + +On line 2110: + their shareholders, and + American taxpayers. The + Commission concludes + +On line 2110: + policy of the + Federal Reserve, along with + capital flows from + +On line 2110: + a housing bubble + could develop. However, + these conditions need + +On line 2110: + Federal Reserve + and other regulators + did not take actions + +On line 2110: + constrain the credit + bubble. In addition, the + Federal Reserve’s + +On line 2110: + encouraged rather than + inhibited the growth of + mortgage debt and the + +On line 2112: + accountability + and responsibility + throughout each level + +On line 2112: + securitizers, + credit rating agencies, and + investors, and ranged from + + corporate boardrooms + to individuals. Loans + were often premised on + + ever-rising home prices + and were made regardless of + ability to pay. + +On line 2114: + process created a + pipeline through which risky mortgages + were conveyed and sold + +On line 2116: + was essential to + the origination of the + burgeoning numbers + +On line 2116: + model undermined + responsibility and + accountability + +On line 2120: + Federal and state + rules required or encouraged + financial firms and + +On line 2120: + institutional + investors to make investments + based on the ratings + +On line 2120: + to undue reliance + on those ratings. However, + the rating agencies + +On line 2120: + regulator to + ensure the quality and + accuracy of + + their ratings. Moody’s, the + Commission’s case study in this + area, relied on flawed + +On line 2120: + issue erroneous + ratings on mortgage-related + securities, failed + +On line 2120: + perform meaningful + due diligence on the assets + underlying the + +On line 2120: + and continued to + rely on those models even + after it became + + obvious that the + models were wrong. Not only + did the federal + +On line 2122: + in risky mortgage-lending + practices, but the Office of + the Comptroller of + +On line 2132: + on this segment of + the mortgage market. THE CDO + MACHINE CONTENTS CDOs: + +On line 2134: + the investor" Bear Stearns’s + hedge funds: "It functioned fine up + until one day it + + just didn’t function".....................................................................................134 + Citigroup’s liquidity + puts: "A potential + +On line 2140: + goose for the entire + Street" Goldman Sachs: "Multiplied + the effects of the + +On line 2144: + collapse in subprime"..................142 + Moody’s: "Achieved through some alchemy" SEC: + "It’s going to be + + an awfully big + mess"..........................................................150 In the first decade of the + 21st century, a + +On line 2146: + financial product + called the collateralized + debt obligation, or + +On line 2146: + transformed the mortgage + market by creating a + new source of demand + +On line 2148: + tranches of mortgage-backed + securities.* Despite their + relatively high + +On line 2148: + be hard to sell. If + borrowers were delinquent or + defaulted, investors + +On line 2148: + these tranches were out + of luck because of where they + sat in the payments + + waterfall. Wall Street + came up with a solution: + in the words of one + + banker, they "created + the investor."1 That is, they built + new securities + +On line 2150: + would buy the tranches + that had become harder to + sell. Bankers would take those + +On line 2150: + BBB or A, from many + mortgage-backed securities and + repackage them into + +On line 2150: + Approximately + of these CDO tranches would be + rated triple-A despite + +On line 2150: + lower-rated tranches + of mortgage-backed securities. + CDO securities + +On line 2150: + be sold with their own + waterfalls, with the risk-averse + investors, again, paid first + +On line 2150: + they did in the case + of mortgage-backed securities, + the rating agencies + +On line 2150: + highest, triple-A ratings + to the securities at + the top (see figure + +On line 2152: + be transformed into + a new security that + is mostly rated + + triple-A. But math made it + so. *Throughout this book, unless + otherwise noted, + +On line 2154: + term "CDOs" to refer + to cash CDOs backed by asset-backed + securities (such + +On line 2156: + also known as ABS + CDOs. The securities firms + argued—and the rating + +On line 2156: + significant—that + if one security went + bad, the second had + + only a very small + chance of going bad at the + same time. And as long + +On line 2156: + limited, only + those investors at the bottom + would lose money. They + + would absorb the blow, + and the other investors would + continue to get + + paid. Relying on + that logic, the CDO machine + gobbled up the BBB + +On line 2158: + lower-rated tranches + of mortgage-backed securities, + growing from a bit + +On line 2158: + Between and as house + prices rose nationally and + trillion in mortgage-backed + +On line 2160: + securities were + created, Wall Street issued + nearly billion in + + CDOs that included + mortgage-backed securities as + collateral.2 With + +On line 2160: + demand loans for their + pools, and hundreds of billions + of dollars flooded + + the mortgage world. In + effect, the CDO became the + engine that powered + +On line 2160: + mortgage supply chain. + "There is a machine going," + Scott Eichel, a senior + +On line 2160: + at Bear Stearns, told a + financial journalist in + May "There is a lot + + of brain power to + keep this going."3 Everyone + involved in keeping + +On line 2162: + machine humming—the CDO + managers and underwriters + who packaged and sold + + the securities, + the rating agencies that gave + most of them sterling + +On line 2162: + protection against their + defaulting—collected fees + based on the dollar + +On line 2162: + of securities + sold. For the bankers who had put + these deals together, + +On line 2162: + the executives + of their companies, volume + equaled fees equaled bonuses. + + And those fees were in + the billions of dollars across + the market. But when + +On line 2164: + market went south, the + models on which CDOs were based + proved tragically + +On line 2164: + would default in large + numbers. This was not how it + was supposed to work. + +On line 2164: + in one region were + supposed to be offset by + successful loans in + + another region. + In the end, CDOs turned out to + be some of the most + +On line 2164: + financial crisis. + The greatest losses would be + experienced by + +On line 2164: + Lynch, and UBS, and by + financial guarantors such + as AIG, Ambac, and + + MBIA. These players had + believed their own models and + retained exposure + +On line 2164: + were understood to + be the least risky tranches of + the CDOs: those rated + +On line 2166: + or even "super-senior," + which were assumed to be safer + than triple-A-rated tranches. "The + +On line 2166: + ABS CDOs had been an + abomination," Patrick Parkinson, + currently the head + +On line 2168: + and regulation + at the Federal Reserve + Board, told the FCIC.4 CDOS: + +On line 2170: + assembled the first + rated collateralized + debt obligation in + +On line 2170: + The strategy made + sense—pooling many bonds reduced + investors’ exposure + +On line 2172: + enabled investors to + pick their preferred level of + risk and return. For + +On line 2172: + who created CDOs, + the key to profitability + of the CDO was the + +On line 2172: + the spread—the difference + between the interest that + the CDO received on + + the bonds or loans that + it held and the interest + that the CDO paid to + +On line 2172: + market bonds and bank + loans. When the liquidity + crisis of drove up + +On line 2172: + Securities saw + an opportunity and + launched a series of + +On line 2172: + "multisector" or + "ABS" securities were backed + by mortgages, mobile + +On line 2172: + leases, mutual + fund fees, and other asset + classes with predictable + +On line 2172: + The diversity + was supposed to provide yet + another layer + +On line 2174: + safety for investors. + Multisector CDOs went through + a tough patch when some + +On line 2174: + securities in + which they invested started + to perform poorly + +On line 2174: + 2002—particularly + those backed by mobile home loans + (after borrowers + +On line 2174: + leases (after and + mutual fund fees (after + the dot-com bust).5 The + +On line 2174: + many investment banks, + investors, and rating agencies + was that the wide range + +On line 2174: + had actually + contributed to the problem; + according to this + +On line 2174: + asset managers who + selected the portfolios + could not be experts + +On line 2176: + as aircraft leases + and mutual funds. So the + CDO industry turned + +On line 2176: + CDO managers believed + they understood, which seemed to + have a record of good + +On line 2176: + was considered a + safe investment. "Everyone + looked at the sector + +On line 2176: + construct works, but we + just need to find more stable + collateral," said + + Wing Chau, who ran two + firms, Maxim Group and Harding + Advisory, that + +On line 2176: + industry looked at + residential mortgage–backed + securities, Alt-A, + +On line 2178: + mortgages, and saw the + relative stability."6 + CDOs quickly became + + ubiquitous in the + mortgage business.7 Investors liked + the combination + +On line 2178: + bankers liked having a + new source of demand for the + lower tranches of + +On line 2178: + created. "We told + you these [BBB-rated securities] + were a great deal, and + +On line 2178: + great spreads, but nobody + stepped up," the Credit Suisse + banker Joe Donovan told + + a Phoenix conference + of securitization + bankers in February + +On line 2180: + we created the + investor."8 By creators of CDOs + were the dominant + +On line 2180: + tranches of mortgage-backed + securities, and their bids + significantly + +On line 2182: + By they were buying + "virtually all" of the + BBB tranches.9 Just as + +On line 2182: + provided the cash + to originate mortgages, now + CDOs would provide the + +On line 2182: + Also by mortgage-backed + securities accounted + for more than half of + +On line 2182: + collateral in + CDOs, up from in Sales of these + CDOs more than doubled + +On line 2184: + hundreds of billions + of dollars of subprime and + Alt-A mortgages. "It was + +On line 2186: + of effort" Five key + types of players were involved + in the construction + +On line 2186: + agencies, investors, and + financial guarantors. Each + took varying degrees + + of risk and, for a + time, profited handsomely. + Securities firms + +On line 2188: + the selection of + collateral, structured the + notes into tranches, + +On line 2188: + were responsible + for selling them to investors. + Three firms—Merrill Lynch, Goldman + +On line 2188: + the securities + arm of Citigroup—accounted + for more than of CDOs + +On line 2190: + were also major + participants.12 "We had sales + representatives + +On line 2190: + were to sell structured + products," Nestor Dominguez, the co-head + of Citigroup’s CDO + + desk, told the FCIC. "We + spent a lot of effort to + have people in place + +On line 2190: + educate, to pitch + structured products. So, it was + a lot of effort, + +On line 2192: + deals that they could sell. + Underwriting did entail + risks, however. The + + securities firm + had to hold the assets, such + as the BBB-rated tranches + +On line 2192: + CDOs. Typically, + during that period, the + securities firm + + took the risk that the + assets might lose value. "Our + business was to make + +On line 2194: + issue fees, [and to] + make sure that if the market + did have a downturn, + + we were somehow hedged," + Michael Lamont, the former + co-head for CDOs at + +On line 2194: + Bank, told the FCIC.14 Chris + Ricciardi, formerly + head of the CDO desk + +On line 2194: + Merrill Lynch, likewise + told the FCIC that he did not + track the performance + +On line 2194: + underwriting them.15 + Moreover, Lamont said it + was not his job to + +On line 2194: + agencies’ models had + the correct underlying + assumptions. That "was + +On line 2194: + brought to the table," + he said.16 In many cases, though, + underwriters helped + + CDO managers select + collateral, leading to + potential conflicts + +On line 2196: + on that later). The + role of the CDO manager + was to select the + + collateral, such + as mortgage-backed securities, + and in some cases + +On line 2196: + such as Chau’s to units + of large asset management + companies such as + +On line 2198: + Blackrock. CDO managers + received periodic fees + based on the dollar + + amount of assets in + the CDO and in some cases + on performance. On + +On line 2198: + percentage basis, + these may have looked small—sometimes + measured in tenths of + +On line 2198: + percentage point—but + the amounts were far from trivial. + For CDOs that focused + +On line 2198: + tended to be in + the range of to a million + dollars per year for + +On line 2198: + billion dollar deal. + For CDOs that focused on the + more junior tranches, + +On line 2200: + were often smaller, + fees would be to million per + year for a million + + deal.17 As managers did + more deals, they generated + more fees without much + +On line 2200: + "You’d hear statements like, + ‘Everybody and his uncle + now wants to be a + +On line 2200: + a structured finance + analyst at Nomura + Securities and + +On line 2200: + credit officer + at S&P, told the FCIC. "That was + an observation + +On line 2200: + several of the + industry conferences around + those times—the enormous + +On line 2202: + proliferation + of CDO managers— because it + was very lucrative."18 + +On line 2204: + industry-wide earned at + least billion in management + fees between and The + +On line 2204: + basic guidelines on + the collateral and the + structure of the CDOs—that + +On line 2204: + the sizes and returns + of the various tranches—in + close consultation + +On line 2204: + the riple-A rating made + those products appropriate + investments. Rating + +On line 2204: + for CDOs.20 For most deals, + at least two rating agencies + would provide ratings + + and receive those fees—although + the views tended to be in + sync. The CDO investors, + +On line 2206: + investors in mortgage-backed + securities, focused on + different tranches + +On line 2206: + for risk and return. + CDO underwriters such as + Citigroup, Merrill + + Lynch, and UBS often + retained the super-senior triple-A + tranches for reasons + +On line 2206: + also sold them to + commercial paper programs + that invested in + +On line 2208: + CDOs became the most + important class of investor + for the mezzanine + +On line 2208: + of the mezzanine + tranches—including those rated + A—and, especially, + +On line 2208: + BBB, the lowest and + riskiest investment-grade + rating—to other + + CDO managers, to be + packaged into other CDOs.22 + It was common for + +On line 2208: + to be structured with + or of their cash invested + in other CDOs; CDOs + +On line 2208: + as to of their cash + invested in other CDOs + were typically + +On line 2208: + notably AIG, played a + central role by issuing + swaps to investors in + +On line 2210: + reimburse them for + any losses on the tranches + in exchange for a + +On line 2210: + of premium-like + payments. This credit default + swap protection made + +On line 2210: + more attractive to + potential investors because + they appeared to be + + virtually risk + free, but it created huge + exposures for the + + credit default swap + issuers if significant + losses did occur. + +On line 2212: + the creation of CDOs, + as is customary on Wall + Street, was reflected + +On line 2212: + products soared during + the liquidity boom at + the beginning of + + the 21st century, + pretax profit for the five + largest investment banks + +On line 2212: + billion to billion; + total compensation at + these investment banks + +On line 2212: + for their employees + across the world rose from billion + to billion.23 A part + +On line 2212: + could be credited + to mortgage-backed securities, + CDOs, and various + +On line 2212: + mortgage and asset-backed + securities salespeople + should especially + +On line 2214: + for investment banks + reported in To see in + more detail how the + +On line 2214: + security, CMLTI + 2006-NC2. Earlier, we described + how most of the below-triple-A + + bonds issued in this + deal went into CDOs. One such + CDO was Kleros Real + + Estate Funding III, + which was underwritten by + UBS, a Swiss bank.25 The + +On line 2218: + Cohen Company; + that investment company + was headed by Chris + + Ricciardi, who + had earlier built Merrill’s + CDO business.26 Kleros III, + +On line 2218: + in purchased and held + million in securities + from the A-rated M5 + +On line 2220: + of other mortgage-backed + securities. In total, + it owned million of + +On line 2220: + of which were rated + BBB or lower, A, and the + rest higher than A. + +On line 2220: + fund those purchases, + Kleros III issued billion of + bonds to investors. As + +On line 2220: + was typical for + this type of CDO at the time, + roughly of the Kleros + + III bonds were triple-A-rated. At + least half of the below-triple-A tranches + issued by Kleros III + +On line 2224: + into other CDOs.27 + "Mother’s milk to the market" + The growth of CDOs had + +On line 2224: + the mortgage market + itself. CDO managers who were + eager to expand + +On line 2224: + assets that they were + managing—on which their income + was based—were willing + +On line 2224: + tranches of mortgage-backed + securities. This "CDO bid" + pushed up market prices + +On line 2226: + securities were + typically protected + from losses by bond + + insurers, who had + analyzed the deals as well. + Beginning in the + +On line 2228: + securities that + were structured with six or more + tranches and other + + features to protect + the triple-A investors became more + common, replacing + +On line 2228: + on bond insurance + to protect investors. By the + earlier forms of + +On line 2228: + had essentially + vanished, leaving the market + increasingly to + +On line 2230: + was a critical + development, given that + the focus of CDO + +On line 2230: + differed from that of + traditional investors. "The + CDO manager and + +On line 2230: + are not the same kind + of folks [as the monoline bond + insurers], who just + +On line 2234: + folks."28 Indeed, Chau, the + CDO manager, portrayed his + job as creating + +On line 2234: + that rating agencies + would approve and investors would + buy, and making sure + +On line 2234: + industry standards." + He said that he relied on + the rating agencies. + + "Unfortunately, + what lulled a lot of investors, + and I’m in that camp + + as well, what lulled us + into that sense of comfort + was that the rating + + stability was + so solid and that it was + so consistent. I + +On line 2234: + making everything + consistent."29 CDO production + was effectively + +On line 2238: + speak lovingly of + ‘the CDO bid.’ It is mother’s + milk to the market," + +On line 2238: + wrote in "Without it, + fewer asset-backed structures could + be built, and those that + + were would have to meet + a much more conservative + standard of design. + + The resulting pangs + of credit withdrawal would + certainly be felt + +On line 2240: + UBS’s Global CDO Group + agreed, noting that CDOs "have now + become bullies in + +On line 2240: + volume and the price + of mortgage-backed securities, + bids from CDOs had "an + +On line 2240: + economy that goes + well beyond the CDO market."31 + Without the demand + +On line 2240: + securities from + CDOs, lenders would have been able to + sell ewer mortgages, + + and thus they would have + had less reason to push so + hard to make the loans + +On line 2244: + inherent in CDOs" + The mortgage pipeline also + introduced leverage + + at every step. Most + financial institutions + thrive on leverage—that + +On line 2244: + investing borrowed + money. Leverage increases + profits in good times, + +On line 2244: + is of the low down + payment, high loan-to-value + ratio variety. + +On line 2244: + and CDOs created + further leverage because they + were financed with debt. + +On line 2244: + the CDOs were often + purchased as collateral + by those creating + +On line 2244: + of debt. Synthetic + CDOs consisting of credit + default swaps, described + + below, amplified + the leverage. The CDO, backed by + securities that + + were themselves backed by + mortgages, created leverage + on leverage, as Dan + +On line 2244: + mortgage department + head at Goldman Sachs, explained + to the FCIC.32 "People + +On line 2244: + either take leverage + individually, as + an institution, + +On line 2246: + take leverage within + the structure," Citigroup’s Dominguez + told the FCIC.33 Even the + +On line 2246: + bought the CDOs could use + leverage. Structured investment + vehicles—a type + +On line 2246: + triple-Arated securities—were + leveraged an average of + just under 14-to-1: in + +On line 2246: + these SIVs would hold in + assets for every dollar + of capital.34 The + +On line 2246: + would be financed with + debt. Hedge funds, which were common + purchasers, were also + +On line 2246: + highly leveraged in + the repo market, as we + will see. But it would + + become clear during + the crisis that some of the + highest leverage was + +On line 2246: + by companies such + as Merrill, Citigroup, and + AIG when they retained + + or purchased the triple-A + and super-senior tranches of + CDOs with little or + +On line 2248: + backing. Thus, in when + the homeownership rate was + peaking, and when new + +On line 2248: + refinancings, by + investors and speculators, + and by second home + +On line 2248: + trillions of dollars + of securities rested + on just two things: the + +On line 2248: + homeowners to make + the payments on their subprime + and Alt-A mortgages and + + the stability + of the market value of + homes whose mortgages were + + the basis of the + securities. Those dangers + were understood all + +On line 2248: + is inherent in + [asset-backed securities] CDOs," + Mark Klipsch, a banker + +On line 2248: + Raton conference + of securitization + bankers in October + +On line 2250: + While it was good for + short-term profits, losses could + be large later on. + +On line 2254: + "We’ll see some problems + down the road."35 BEAR STEARNS’S HEDGE FUNDS: + "IT FUNCTIONED FINE UP + + UNTIL ONE DAY IT + JUST DIDN’ T FUNCTION" Bear Stearns, + the smallest of the + +On line 2256: + started its asset + management business in when + it established Bear + +On line 2260: + Asset Management + (BSAM). Asset management brought + in steady fee income, + +On line 2262: + customers and required + little capital. BSAM played + a prominent role + + in the CDO business + as both a CDO manager + and a hedge fund that + +On line 2262: + and CDOs. At BSAM, by + the end of Ralph Cioffi was + managing CDOs with + +On line 2264: + billion in assets + and hedge funds with billion in + assets.36 Although Bear + +On line 2264: + supervision over + its business.37 The eventual + failure of Cioffi’s + +On line 2264: + mortgage-focused hedge + funds would be an important + event in early in + +On line 2266: + crisis. In Cioffi + launched his first fund at BSAM, the + High-Grade Structured Credit + +On line 2266: + and in he added the + High-Grade Structured Credit Strategies + Enhanced Leverage Fund. + +On line 2266: + funds purchased mostly + mortgage-backed securities or + CDOs, and used leverage + +On line 2268: + returns. The target + was for of assets to be + rated either AAA + +On line 2268: + AA. As Cioffi told + the FCIC, "The thesis behind + the fund was that the + +On line 2268: + markets offered yield + over and above what their ratings + suggested they should + +On line 2268: + Cioffi targeted + a leverage ratio of to + for the first High-Grade fund. + + For Enhanced Leverage, + Cioffi upped the ante, touting + the Enhanced Leverage + +On line 2268: + of the [High Grade] fund" + that targeted leverage of + to At the end of + +On line 2270: + the High-Grade fund contained + billion in assets (using + billion of his hedge + +On line 2270: + investors’ money and + billion in borrowed money). + The Enhanced Leverage + +On line 2274: + money).40 BSAM financed + these asset purchases by + borrowing in the + +On line 2274: + the FCIC identified + at least billion of repo + borrowing as of + +On line 2274: + funds that responded. + The respondents invested + at least billion in + +On line 2274: + or CDOs as of June + The ability to borrow + using the AAA and + + AA tranches of CDOs + as repo collateral + facilitated + +On line 2276: + securities. But + repo borrowing carried + risks: it created + +On line 2276: + leverage and it had + to be renewed frequently. + For example, an + +On line 2276: + stock on margin—meaning + with borrowed money—might have to + put up cents on the + +On line 2278: + other cents loaned by + his or her stockbroker, for + a leverage ratio + +On line 2278: + to A homeowner + buying a house might make a + down payment and take + +On line 2278: + out a mortgage for + the rest, a leverage ratio + of to By contrast, + +On line 2278: + allowed an investor + to buy a security + for much less out of + + pocket—in the case of + a Treasury security, + an investor may have + +On line 2278: + only borrowing + from a securities firm + to In the case of + +On line 2282: + security, an + investor might pay to With this + amount of leverage, a + +On line 2282: + the value of that + mortgage-backed security can + double the investor’s + +On line 2284: + the underlying + collateral could be sold + easily. But when + +On line 2284: + private-label mortgage-backed + securities would prove to + be very different + + from U.S. Treasuries. he + short-term nature of repo + money also makes + +On line 2288: + inherently risky + and unreliable: funding + that is offered at + +On line 2288: + terms today could be + gone tomorrow. Cioffi’s funds, + for example, took + +On line 2290: + that its repo lenders + would decide not to extend, + or "roll," the repo + +On line 2290: + on any given day. + Yet more and more, repo lenders + were loaning money + + to funds like Cioffi’s, + rolling the debt nightly, and not + worrying very much + +On line 2292: + real quality + of the collateral. The + firms loaning money + + to Cioffi’s hedge funds + were often also selling + them mortgage-related + +On line 2292: + and the hedge funds pledged + those same securities to + secure the loans.43 If + + the market value + of the collateral fell, + the repo lenders could + +On line 2292: + hedge fund to back the + repo loan. This dynamic + would play a pivotal + +On line 2292: + of many hedge funds in + 2007—most spectacularly in + the case of Cioffi’s + +On line 2292: + "The repo market, + I mean it functioned fine up + until one day it + + just didn’t function," + Cioffi told the FCIC. Up to + that point, his hedge funds + + could buy billions of + dollars of CDOs on borrowed + money because of + +On line 2292: + the market’s bullishness + about mortgage assets, he said. + "It became a more + +On line 2292: + more repo lenders, more + investors obviously. [It + had a] much broader + +On line 2296: + CDOs were a market + opportunity because + they were complex and + +On line 2296: + in the general + marketplace. In this was a + promising market with + +On line 2298: + risks. Cioffi and his + team not only bought CDOs, they + also created + +On line 2298: + managed other CDOs. + Cioffi would purchase mortgage-backed + securities, CDOs, + +On line 2298: + securities for + his hedge funds. When he had reached + his firm’s internal + +On line 2298: + he would repackage those + securities and sell CDO + securities to + + other customers. With + the proceeds, Cioffi would pay + off his repo lenders, + +On line 2300: + at the same time he + would acquire the equity + tranche of a new CDO.45 + +On line 2302: + created CDOs that + selected collateral + from his own hedge funds,46 + +On line 2302: + positioned on both + sides of the transaction. The + structure created + +On line 2302: + interest between + Cioffi’s obligation to his + hedge fund investors and + + his obligation to + his CDO investors; this was not + unique on Wall Street, and + +On line 2302: + the structure, and the + conflict of interest, to + potential investors.47 + + For example, a + critical question was at + what price the CDO should + + purchase assets from + the hedge fund: if the CDO paid + above-market prices for + +On line 2304: + the hedge fund investors + and disadvantage the CDO + investors. BSAM’s flagship + +On line 2304: + and III—were created + in rapid succession over and + with Citigroup as + +On line 2304: + composed of mortgage- + and asset-backed securities + that BSAM already owned, + + and BSAM retained the + equity position in + all three; all three were + +On line 2304: + asset-backed commercial + paper.48 Typical for the + industry at the + +On line 2304: + managing assets + and holding the equity + tranche, was between and + +On line 2304: + the underlying + collateral.49 Thanks to the + combination of + +On line 2304: + securities, CDOs, + and leverage, Cioffi’s funds earned + healthy returns for a + +On line 2304: + time: the High-Grade fund had + returns of in in and in + after fees.50 Cioffi + +On line 2304: + millions before the + hedge funds collapsed in Cioffi + was rewarded with + +On line 2304: + compensation worth + more than million from to In + the year the two hedge + +On line 2304: + made more than million + in total compensation. + Matt Tannin, his lead + +On line 2304: + compensation of + more than million from to Both + managers invested + +On line 2304: + of their own money + in the funds, and used this as + a selling point when + + pitching the funds to + others.52 But when house prices fell + and investors started + +On line 2306: + question the value + of mortgage-backed securities + in the same short-term + +On line 2306: + amplify losses + and quickly put his two hedge + funds out of business. + +On line 2312: + LIQUIDITY PUTS: + "A POTENTIAL CONFLICT OF + INTEREST" By the + + middle of the decade, + Citigroup was a market + leader in selling + +On line 2312: + types of trouble with + its regulators, and then-CEO + Charles Prince told the FCIC + +On line 2312: + those troubles took up + more than half his time.53 After + paying the million + +On line 2312: + to subprime mortgage + lending, Citigroup again got + into trouble, charged + +On line 2312: + company filed for + bankruptcy in 2001—use structured + finance transactions + +On line 2312: + to manipulate + its financial statements. In + July Citigroup + +On line 2314: + allegations and + also agreed, under formal + enforcement actions + + by the Federal + Reserve and Office of the + Comptroller of the + +On line 2316: + to overhaul its risk + management practices.54 By March + the Fed had seen enough: + +On line 2316: + legal compliance. + According to Prince, he had + already decided + +On line 2318: + growth."55 Robert Rubin, a + former treasury secretary + and former Goldman + +On line 2318: + time chairman of the + Executive Committee + of Citigroup’s board + +On line 2318: + recommended that + Citigroup increase its risk + taking—assuming, he told + +On line 2320: + was a natural + area for growth after the Fed + and then Congress had + +On line 2320: + commercial banks. One + opportunity among many + was the CDO business, + +On line 2322: + was just then taking + off amid the booming mortgage + market. In Citi’s CDO + +On line 2322: + was a tiny unit in + the company’s investment + banking arm, "eight guys + +On line 2322: + a Bloomberg" terminal, + in the words of Nestor Dominguez, then + co-head of the desk.57 + + Nevertheless, this + tiny operation under + the command of homas + + Maheras, co-CEO of the + investment bank, had become + a leader in the + +On line 2324: + for CDOs, creating + more than billion in and 2004—close + to one-fifth of the + + market in those years. + The eight guys had picked up on + a novel structure + +On line 2326: + by Goldman Sachs and + WestLB, a German bank. Instead + of issuing the + +On line 2326: + of the CDOs as long-term + debt, Citigroup structured them + as short-term asset-backed + + commercial paper.58 + Of course, using commercial + paper introduced + +On line 2326: + risk (not present when the + tranches were sold as long-term debt), + because the CDO would + +On line 2326: + days or weeks—for the + life of the CDO. But asset-backed + commercial paper + + was a cheap form of + funding at the time, and it + had a large base of + +On line 2326: + funds. To mitigate + the liquidity risk and + to ensure that the + +On line 2326: + their top ratings, Citibank + (Citigroup’s national bank + subsidiary) provided + +On line 2326: + puts. In selling the + liquidity put, for an + ongoing fee the + + bank would be on the + hook to step in and buy the + commercial paper + +On line 2326: + there were no buyers + when it matured or if the + cost of funding rose + +On line 2328: + predetermined amount.59 + The CDO team at Citigroup + had jumped into the + +On line 2328: + in July with a + billion CDO named Grenadier Funding + that included a + +On line 2328: + billion tranche backed by + a liquidity put from + Citibank.60 Over the next three + +On line 2328: + liquidity puts + on billion of commercial + paper issued by + +On line 2328: + more than any other + company. BSAM’s three Klio CDOs, + which Citigroup had + +On line 2328: + accounted for just + over billion of this total,62 + a large number that + + would not bode well for + the bank. But initially, this + "strategic initiative," + +On line 2330: + Dominguez called it, was very + profitable for Citigroup. The + CDO desk earned roughly + +On line 2330: + in structuring fees + for Citigroup’s investment + banking arm, or about + +On line 2330: + for a billion deal. + In addition, Citigroup + would generally + +On line 2330: + annually for + the liquidity puts.63 In + other words, for a + +On line 2330: + Citibank would receive to + million annually on + the liquidity + +On line 2330: + alone—practically free + money, it seemed, because the + trading desk believed + +On line 2332: + these puts would never + be triggered.64 In effect, the + liquidity put + +On line 2332: + another highly + leveraged bet: a contingent + liability + +On line 2332: + that would be triggered + in some circumstances. Prior + to the change in the + +On line 2332: + (discussed earlier), + Citigroup did not have to + hold any capital + +On line 2332: + contingencies. Rather, + it was permitted to use + its own risk models + + to determine the + appropriate capital + charge. But Citigroup’s + +On line 2332: + only a remote + possibility that the + puts would be triggered. + +On line 2332: + Following the rule + change, Citibank was required to hold + in capital against + +On line 2332: + amount of commercial + paper supported by the + liquidity put, + +On line 2332: + fee for the put, the + annual return on that + capital could still + +On line 2332: + Dominguez told the FCIC, the + triple-A or similar ratings, + the multiple fees, + +On line 2332: + requirements made the + liquidity puts "a much + better trade" for Citi’s + +On line 2334: + sheet.65 The events of would + reveal the fallacy of + those assumptions and + +On line 2334: + commercial paper + straight onto the bank’s balance + sheet, requiring it + +On line 2334: + with billion in cash + as well as more capital + to satisfy bank + +On line 2336: + liquidity puts + were approved by Citigroup’s + Capital Markets + + Approval Committee, + which was charged with reviewing + all new financial + +On line 2336: + Deeming them to be + low risk, the company based + its opinions on the + +On line 2336: + failed to consider + the liquidity risk posed + by a general + + market disruption.67 + The OCC, the supervisor + of Citigroup’s largest + +On line 2338: + bank sub - sidiary, was + aware that the bank had issued + the liquidity + +On line 2338: + terms of the OCC’s post-Enron + enforcement action focused + only on whether Citibank + + had a process in place + to review the product, and + not on the risks of + +On line 2340: + few large financial + institutions, such as AIG + Financial Products, + + BNP, WestLB of Germany, + and Société Générale of France, + wrote significant + +On line 2340: + of liquidity + puts on commercial paper + issued by CDOs.70 Bank + + of America, the + biggest commercial bank in + the United States, wrote + +On line 2342: + small deals through but did + billion worth in just before + the market crashed.71 When + +On line 2342: + participants were + not writing liquidity + puts, Dominguez stated that + + Société Générale and + BNP were big players in that + market. "You needed + + to be a bank with + a strong balance sheet, access + to collateral, + +On line 2346: + relationships with + collateral managers," he + said.72 The CDO desk stopped + +On line 2346: + liquidity puts + in early when it reached its + internal limits. + +On line 2346: + Citibank’s treasury function + had set a billion cap on + liquidity puts;74 + +On line 2346: + bringing the total + to billion.75 Risk management + had also set a + +On line 2346: + which included the + liquidity puts. Later, + in an October + +On line 2346: + Group criticized the + firm’s pricing of the puts, which + failed to consider + + the risk that investors + would not buy the commercial + paper protected + +On line 2346: + it came due, thereby + creating a billion cash + demand on Citibank.76 An + +On line 2346: + (believed to have been + drafted in also questioned + one of the practices + +On line 2346: + investment bank, which + paid traders on its CDO desk for + generating the + +On line 2348: + without regard to + later losses: "There is a + potential conflict + + of interest in + pricing the liquidity + put cheep [sic] so that + +On line 2348: + and more structuring + fee to be generated."77 + The result would be + +On line 2348: + severe that they would + help bring the huge financial + conglomerate to + + the brink of failure, + as we will see. AIG: "GOLDEN + GOOSE FOR THE ENTIRE + +On line 2352: + STREET" In American + International Group was + the largest insurance + +On line 2352: + as measured by stock + market value: a massive + conglomerate with + +On line 2354: + billion in assets, + employees in countries, and3 + subsidiaries. But to Wall + +On line 2354: + most valuable asset + was its credit rating: that + it was awarded the + +On line 2354: + possible rating—Aaa by + Moody’s since AAA by S&P since 983—was + crucial, because these + +On line 2354: + cheaply and deploy + the money in lucrative + investments. Only + +On line 2356: + in early carried + those ratings.78 Starting in AIG + Financial Products, + + a Connecticut-based unit + with major operations + in London, figured + + out a new way to + make money from those ratings. + Relying on the + + guarantee of its + parent, AIG, AIG Financial + Products became a + +On line 2356: + in notional amount. + Among other derivatives + activities, the + + unit issued credit + default swaps guaranteeing + debt obligations held + +On line 2356: + agreed to reimburse + the investor in such a debt + obligation in the + + event of any default. + The credit default swap (CDS) + is often compared + +On line 2356: + insurance, but when + an insurance company + sells a policy, + +On line 2356: + set aside a reserve + in case of a loss. Because + credit default swaps + +On line 2356: + such requirement was + applicable. In this case, + the unit predicted + +On line 2356: + with confidence that + there would be no realized + economic loss on + +On line 2356: + CDOs on which they wrote + CDS protection, and failed to + make any provisions + +On line 2358: + losses—a decision + that would prove fatal to AIG + in AIG Financial + +On line 2358: + huge business selling + CDS to European banks on + a variety of + +On line 2358: + assets, including + bonds, mortgage-backed securities, + CDOs, and other debt + +On line 2358: + For AIG, the fee for + selling protection via the + swap appeared well worth + + the risk. For the banks + purchasing protection, the + swap enabled them to + +On line 2358: + and thereby hold less + capital against its assets. + Purchasing credit + +On line 2358: + AIG could reduce the + amount of regulatory + capital that the + +On line 2360: + needed to hold against + an asset from to By AIG + had written billion + +On line 2360: + regulatory + capital benefits; most + were with European + +On line 2360: + for a variety + of asset types. That total + would rise to billion + +On line 2362: + The same advantages + could be enjoyed by banks in + the United States, where + +On line 2362: + capital standards + for banks’ holdings of mortgage-backed + securities and + +On line 2362: + investments under + the Recourse Rule in So a + credit default swap + +On line 2364: + could also lower + American banks’ capital + requirements. In and + +On line 2366: + AIG sold protection + on super-senior CDO tranches + valued at billion, + +On line 2368: + billion in In an + interview with the FCIC, one + AIG executive + +On line 2370: + Financial Products’ + principal swap salesman, Alan + Frost, as "the golden + +On line 2372: + for the entire Street."83 + AIG’s biggest customer in this + business was always + +On line 2372: + billions of dollars + of protection for Merrill + Lynch, Société Générale, + +On line 2372: + other firms. AIG "looked + like the perfect customer for + this," Craig Broderick, + +On line 2372: + chief risk officer, + told the FCIC. "They really + ticked all the boxes. + +On line 2372: + among the highest-rated + [corporations] around. They had + what appeared to be + +On line 2376: + this space, backed by a + long history of trading + in it."84 AIG also + +On line 2376: + imprimatur of its + pristine credit rating on + commercial paper + +On line 2376: + liquidity puts, + similar to the ones that + Citigroup’s bank wrote + +On line 2376: + many of its own deals, + guaranteeing it would buy + commercial paper + +On line 2376: + one else wanted it. + It entered this business in + by it had written + +On line 2378: + of liquidity + puts on commercial paper + issued by CDOs. AIG + +On line 2378: + also wrote more than + billion in CDS to protect + Société Générale against + +On line 2378: + on liquidity + puts that the French bank itself + wrote on commercial + +On line 2378: + issued by CDOs.85 "What + we would always try to do + is to structure a + +On line 2378: + where the transaction + was virtually riskless, + and get paid a small + +On line 2378: + director at AIG + Financial Products, told the + FCIC. "And we’re one of + + the few guys who can + do that. Because if you think + about it, no one wants + + to buy disaster + protection from someone who + is not going to + +On line 2380: + be around. That was AIGFP’s + sales pitch to the Street or to + banks."86 AIG’s business of + + offering credit + protection on assets of + many sorts, including + +On line 2380: + grew from billion in + to billion in and billion + in This business was + +On line 2380: + small part of the AIG + Financial Services business + unit, which included + +On line 2382: + billion in or of + AIG’s total. AIG did not post + any collateral + +On line 2382: + but unlike monoline + insurers, AIG Financial + Products agreed to post + +On line 2382: + the underlying + securities dropped, or if + the rating agencies + +On line 2382: + guarantors—insurance + companies such as MBIA and + Ambac that focused + +On line 2384: + paying out until + actual losses occurred. + The collateral + + posting terms in AIG’s + credit default swap contracts + would have an enormous + +On line 2386: + on the crisis about + to unfold. But during the + boom, these terms didn’t + +On line 2386: + The investors got their + triple-Arated protection, AIG got its + fees for providing + +On line 2386: + that insurance—about + of the notional amount of + the swap per year88—and the + +On line 2386: + In the case of the + London subsidiary that ran the + operation, the + +On line 2386: + bonus pool was of new + earnings.89 Financial Products + CEO Joseph J. Cassano + +On line 2386: + at the end of the + year.90 Between and the least amount + Cassano paid himself + +On line 2386: + the later years, his + compensation was sometimes + double that of the + +On line 2388: + By November the + company had reduced its + reported earnings + +On line 2388: + the five-year period + by billion.92 The board forced out + Maurice "Hank" Greenberg, + +On line 2388: + been CEO for years. New + York Attorney General + Eliot Spitzer prepared to + + bring fraud charges against him. + Greenberg told the FCIC, "When the + AAA credit rating + +On line 2392: + in spring it would have + been logical for AIG to + have exited or + + reduced its business + of writing credit default + swaps."93 But that didn’t + +On line 2392: + Financial Products + wrote another billion in + credit default swaps + +On line 2394: + tranches of DOs in + The company wouldn’t make + the decision to + +On line 2400: + THE EFFECTS OF THE + COLLAPSE IN SUBPRIME" Henry + Paulson, the CEO of + +On line 2400: + until he became + secretary of the Treasury + in testified to + + the FCIC that by the + time he became secretary + many bad loans already + + had been issued—"most + of the toothpaste was out of + the tube"— and that "there + +On line 2402: + Paulson provided + examples: "Subprime mortgages + went from accounting + +On line 2402: + originators from + the risk of the products they + originated." The + +On line 2402: + housing bubble that + eventually burst in far + more spectacular + +On line 2404: + bubbles."97 Under Paulson’s + leadership, Goldman Sachs had + played a central role + +On line 2404: + creation and sale of + mortgage securities. From + through the company + +On line 2404: + billions of dollars + in loans to mortgage lenders; most + went to the subprime + +On line 2404: + Long Beach, Fremont, New + Century, and Countrywide + through warehouse lines of + + credit, often in + the form of repos.98 During + the same period, + +On line 2404: + billion of loans from + these and other subprime loan + originators, which + +On line 2406: + totaling billion + (about a quarter were subprime), + and CDOs totaling + +On line 2406: + issued synthetic + or hybrid CDOs with a face + value of billion + +On line 2408: + Synthetic CDOs were + complex paper transactions + involving credit + +On line 2410: + cash CDO, synthetic + CDOs contained no actual + tranches of mortgage-backed + + securities, or + even tranches of other CDOs. + Instead, they simply + +On line 2410: + and thus were bets on + whether borrowers would pay their + mortgages. In the place + +On line 2410: + default swaps and did + not finance a single home + purchase. Investors in + +On line 2410: + included "funded" + long investors, who paid cash to + purchase actual + +On line 2410: + issued by the CDO; + "unfunded" long investors, who + entered into swaps + +On line 2410: + if the reference + securities performed; and + "short" investors, who bought + +On line 2410: + default swaps on the + reference securities, + making money if + +On line 2410: + securities failed. + While funded investors received + interest if the + +On line 2412: + if the reference + securities defaulted. + Unfunded investors, + +On line 2412: + waterfall, received + premium-like payments from + the CDO as long as + +On line 2412: + beyond a certain + point and if the CDO did not + have sufficient funds + +On line 2412: + the short investors. Short + investors, often hedge funds, bought + the credit default + +On line 2412: + the CDOs and paid those + premiums. Hybrid CDOs were + a combination + +On line 2414: + CDOs. Firms like Goldman + found synthetic CDOs cheaper + and easier to + +On line 2414: + than traditional + CDOs at the same time as the + supply of mortgages + + was beginning to + dry up. Because there were no + mortgage assets to + + collect and finance, + creating synthetic CDOs + took a fraction of + +On line 2418: + time. They also were + easier to customize, + because CDO managers + + and underwriters + could reference any mortgage-backed + security—they were + +On line 2418: + limited to the + universe of securities + available for them to + +On line 2420: + Figure provides an + example of how such a + deal worked. In Goldman + +On line 2420: + launched its first major + synthetic CDO, Abacus 2004-1—a + deal worth billion. About + +On line 2420: + the rest, commercial + mortgage–backed securities + (made up of bundled + +On line 2422: + real estate loans) + and other securities. + Goldman was the short + +On line 2422: + entire billion deal: + it purchased credit default + swap protection on + +On line 2422: + securities from + the CDO. The funded investors—IKB (a + German bank), the TCW + +On line 2424: + Wachovia—put up + a total of million to + purchase mezzanine + +On line 2426: + assets performed. If + the referenced assets did + not perform, Goldman, + +On line 2426: + as the short investor, + would receive the million.102 In + this sense, IKB, TCW, and + +On line 2426: + "long" investors, betting + that the referenced assets + would perform well, and + + Goldman was a "short" + investor, betting that they would + fail. The unfunded + + investors—TCW and GSC Partners + (asset management firms that + managed both hedge funds + +On line 2430: + up any money up + front; they received annual + premiums from the + +On line 2430: + pay the CDO if the + reference securities + failed and the CDO did + +On line 2432: + have enough funds to pay + the short investors.103 Goldman was + the largest unfunded + +On line 2432: + Goldman’s billion short + position more than offset + that exposure; about + +On line 2432: + long position by + buying credit protection + from AIG, in return + +On line 2432: + for an annual + payment of million.104 As a + result, by AIG was + +On line 2432: + unfunded investor + in the super-senior tranches + of the Abacus deal. + +On line 2434: + told, long investors in + Abacus 2004-1 stood to receive + millions of dollars + + if the reference + securities performed (just + as a bond investor + + makes money when a + bond performs). On the other + hand, Goldman stood to + +On line 2436: + gain nearly billion + if the assets failed. In the + end, Goldman, the short + +On line 2436: + in the Abacus 2004-1 + CDO, has received about million + while the long investors + +On line 2438: + lost just about all of + their investments. In April GSC + paid Goldman million + + as a result of + CDS protection sold by GSC + to Goldman on the + +On line 2440: + received million from + AIG Financial Products as + a result of the + +On line 2440: + protection it had + purchased against the super-senior + tranche. The same month it + +On line 2440: + received million from + TCW as a result of the + CDS purchased against the + +On line 2440: + junior mezzanine + tranches, and million from IKB + because of the CDS + +On line 2440: + purchased against the C + tranche. In April IKB paid Goldman + another million + +On line 2442: + as a result of + the CDS against the B tranche. Through + May Goldman received + +On line 2442: + from IKB, Wachovia, and + TCW as a result of the + credit default swaps + +On line 2442: + the A tranche. As was + common, some of the tranches + of Abacus 2004-1 found + +On line 2442: + way into other + funds and CDOs; for example, + TCW put tranches of + +On line 2444: + of its own CDOs. In + total, between July and + May Goldman packaged + +On line 2444: + and sold synthetic + CDOs, with an aggregate face + value of billion.105 + +On line 2444: + underwriting fee + was to of the deal totals, + Dan Sparks, the former + +On line 2444: + Goldman’s mortgage desk, + told the FCIC.106 Goldman would earn + profits from shorting + + many of these deals; on + others, it would profit by + facilitating + +On line 2444: + transaction between + the buyer and the seller + of credit default + +On line 2446: + protection. As we + will see, these new instruments + would yield substantial + + profits for investors + that held a short position + in the synthetic + +On line 2446: + is, investors betting + that the housing boom was a + bubble about to burst. + +On line 2446: + losses when housing + prices collapsed. When borrowers + defaulted on their + +On line 2446: + expecting cash from + the mortgage payments lost. And + investors betting on + +On line 2446: + securities via + synthetic CDOs also lost + (while those betting against + +On line 2446: + mortgages would gain).107 As + a result, the losses from + the housing collapse + +On line 2448: + Citigroup mortgage-backed + securities deal, CMLTI 2006-NC2. + Credit default swaps + +On line 2448: + it possible for + new market participants + to bet for or against + +On line 2448: + significantly + increased the demand for such + bets. For example, + +On line 2448: + about million worth of + bonds in the M9 (BBB-rated) tranche—one + of the mezzanine + +On line 2448: + Auriga, Volans, and + Neptune CDO IV all contained + credit default swaps + + in which the M9 tranche + was referenced. As long as + the M9 bonds performed, + + investors betting that + the tranche would fail (short investors) + would make regular + +On line 2448: + into the CDO, which + would be paid out to other + investors banking on + +On line 2448: + succeed (long investors). + If the M9 bonds defaulted, + then the long investors + + would make large payments + to the short investors. That is + the bet—and there were + +On line 2450: + more than million in + such bets in early on the + M9 tranche of this deal. + +On line 2450: + the basis of the + performance of million in + bonds, more than million + + could potentially + change hands. Goldman’s Sparks put it + succinctly to the + +On line 2450: + if there’s a problem + with a product, syn thetics + increase the impact.108 + +On line 2452: + amplification + of the M9 tranche was not unique. + A million tranche of + +On line 2452: + Glacier Funding CDO 2006-4A, + rated A, was referenced + in million worth of + +On line 2452: + synthetic CDOs. A + million tranche of the Soundview + Home Equity Loan + +On line 2454: + also rated A, + was referenced in million + worth of synthetic + +On line 2456: + A million tranche of + the Soundview Home Equity + Loan Trust 2006-EQ1, rated + +On line 2458: + worth of synthetic + CDOs.109 In total, synthetic + CDOs created by + +On line 2458: + Goldman referenced + mortgage securities, some + of them multiple + +On line 2458: + were referenced twice. + Indeed, one single mortgage-backed + security was + +On line 2460: + DOs created by + Goldman Sachs.110 Because of such + deals, when the housing + +On line 2462: + they also maintained + that their creation had "social + utility" because + +On line 2462: + enabled investors to + customize the exposures + they wanted in their + +On line 2462: + President and Chief + Operating Officer + Gary Cohn argued: "This + + is no different + than the tens of thousands of + swaps written every + +On line 2462: + U.S. dollar versus + another currency. Or, + more importantly, + +On line 2464: + U.S. Treasuries This is + the way that the financial + markets work."112 Others, + +On line 2464: + these deals. Patrick Parkinson, + the current director of + the Division of + +On line 2464: + Federal Reserve + Board, noted that synthetic + CDOs "multiplied the + +On line 2466: + of the collapse in + subprime."113 Other observers were + even harsher in their + + assessment. "I don’t + think they have social value," + Michael Greenberger, a + +On line 2466: + the University + of Maryland School of Law and + former director + + of the Division + of Trading and Markets at + the Commodity + +On line 2466: + Commission, told the + FCIC. He characterized the + credit default swap + +On line 2466: + a "casino." And he + testified that "the concept + of lawful betting + +On line 2466: + the question of whether + a homeowner would default + on a mortgage that + +On line 2466: + by either party, + has had a profound effect + on the American + +On line 2470: + taxpayers."114 MOODY’S: "ACHIEVED + THROUGH SOME ALCHEMY" The machine + churning out CDOs would + + not have worked without + the stamp of approval given + to these deals by the + +On line 2470: + often relied on + the rating agencies’ views rather + than conduct their own + + credit analysis. + Moody’s was paid according to + the size of each deal, + +On line 2470: + set at a half-million + dollars for a "standard" CDO + in and and as much + +On line 2474: + for a "complex" CDO.115 + In rating both synthetic + and cash CDOs, Moody’s faced + +On line 2474: + by the CDO (or its + synthetic equivalent) and, + second, gauging the + +On line 2474: + is, the likelihood + that the securities would + default at the same + + time.116 Imagine flipping + a coin to see how many times + it comes up heads. Each + +On line 2474: + others; that is, the + flips are uncorrelated. + Now, imagine a loaf + +On line 2474: + sliced bread. When there is + one moldy slice, there are likely + other moldy slices. The + +On line 2474: + each slice is highly + correlated with that of + the other slices. As + +On line 2474: + now understand, the + mortgage-backed securities in + CDOs were less like coins + +On line 2476: + bread. To estimate + the probability of + default, Moody’s relied + +On line 2476: + its own ratings of + the mortgage-backed securities + purchased by the CDOs.117 + +On line 2476: + did the agencies "look + through" the securities to + the underlying + +On line 2478: + been assigned by the + [mortgage-backed securities] group," + Gary Witt, formerly + +On line 2478: + for the CDO unit, told + the FCIC. This approach would lead + to problems for Moody’s—and + +On line 2478: + disintegrated + below us and we didn’t + react and we should + +On line 2478: + have. We had to be + looking for a problem. And + we weren’t looking."118 + + To determine the + likelihood that any given + security in + + the CDO would default, + Moody’s plugged in assumptions based + on those original + + ratings. This was no + simple task. Meanwhile, if the + initial ratings turned + +On line 2480: + poor underwriting, + fraud, or any other cause—to + poorly reflect the + +On line 2480: + blindly compounded + when mortgage-backed securities + were packaged into + +On line 2482: + securities in + the portfolio—always tricky, but + particularly + +On line 2482: + of CDOs consisting + of subprime and Alt-A mortgage-backed + securities that + +On line 2482: + history. So the + firm explicitly relied + on the judgment of + + its analysts. "In + the absence of meaningful + default data, it + +On line 2482: + based on actual + observations of defaults," + Moody’s acknowledged in + +On line 2484: + explanation of + its process.119 In plainer English, + Witt said, Moody’s didn’t + +On line 2484: + them up." He recalled, + "They went to the analyst + in each of the groups + +On line 2484: + they said, ‘Well, you know, + how related do you think + these types of [mortgage-backed + + securities] are1’"120 + This problem would become more + serious with the + +On line 2486: + CDOs in the middle + of the decade. Witt felt strongly + that Moody’s needed to + +On line 2488: + CDOs.121 He undertook + two initiatives to address + this issue. First, in + +On line 2488: + incorporated + correlation into the + model. However, + +On line 2488: + not applied to CDO + ratings for another year.122 + Second, he proposed + +On line 2490: + research initiative + in early to "look through" a + few CDO deals at the + +On line 2490: + securities and + to see if "the assumptions + that we’re making for + +On line 2490: + consistent with the + correlation assumptions + that we’re making for + +On line 2490: + received approval from + his superiors for this + investigation, + +On line 2492: + buying the software + he needed to conduct the + look-through analysis.123 In + +On line 2492: + based the new model + on trends from the previous + years, a period + +On line 2492: + prices were rising and + mortgage delinquencies were very + low—and a period + +On line 2492: + nontraditional + mortgage products had been a + very small niche. Then, Moody’s + +On line 2492: + adjustments based on + factors such as region, year + of origination, + +On line 2492: + For example, if + two mortgage-backed securities + were issued in the + +On line 2494: + region—say, Southern + California— Moody’s boosted + the correlation; + +On line 2494: + they shared a common + mortgage servicer, Moody’s boosted + it further. But at + +On line 2494: + the estimated + correlation of default, + which would improve the + +On line 2494: + estimated that + two mortgage-backed securities + would be less closely + +On line 2496: + card or auto loans.124 + The other major rating + agencies followed a + +On line 2496: + be dangerous. "The + complexity of structured + finance transactions + +On line 2496: + to situations + where investors tend to rely + more heavily on + +On line 2496: + than for other types + of rated securities. + On this basis, the + +On line 2496: + number of questions + with important potential + implications. One + +On line 2496: + question is whether tranched + instruments might result in + unanticipated + +On line 2498: + sponsored by the world’s + regulators and central + banks, warned in June CDO + +On line 2498: + and underwriters + relied on the ratings to + promote the bonds. For + +On line 2498: + CDO, they created + marketing material, + including a pitch + + book that investors used + to decide whether to subscribe + to a new CDO. Each + +On line 2498: + described the types of + assets that would make up the + portfolio without + + providing details.127 + Without exception, every + pitch book examined + +On line 2500: + the historical + "stability" of these new + products’ ratings with + +On line 2500: + of corporate bonds. + Statistics that made this case + included the fact + +On line 2500: + of these new products + did not experience any + rating changes over a + +On line 2500: + of corporate bonds + maintained their ratings. Over a + longer time period, + +On line 2500: + however, structured + finance ratings were not so + stable. Between and + +On line 2500: + triple-A-rated structured finance + securities retained their + original rating + +On line 2502: + sell CDOs using these + statistics in their pitch books + during and after + + mortgage defaults had + started to rise but before + the rating agencies + +On line 2502: + numbers of mortgage-backed + securities. Of course, each + pitch book did include + +On line 2502: + that "past performance + is not a guarantee of + future performance" + +On line 2504: + testified before + the House Financial Services + Committee, CDOs that + +On line 2504: + lower-rated tranches + of mortgage-backed securities + "are arcane structured + + finance products that + were designed specifically + to make dangerous, + +On line 2504: + through some alchemy and + some negligence in adapting + unrealistic + +On line 2506: + on behalf of the + ratings agencies. They convinced + investors that of a + +On line 2506: + subprime tranches were + the ratings equivalent of + U.S. Government bonds."129 + +On line 2508: + to fall nationwide + and defaults increased, it turned + out that the mortgage-backed + +On line 2508: + were in fact much more + highly correlated than + the rating agencies + + had estimated—that + is, they stopped performing at + roughly the same time. + +On line 2510: + of the CDOs. In of + U.S. CDO securities would + be downgraded. In + +On line 2514: + In late Moody’s would throw + out its key CDO assumptions + and replace them with + +On line 2516: + to three times higher + than used before the crisis.131 + In retrospect, it + +On line 2518: + that the agencies’ CDO + models made two key mistakes. + First, they assumed that + +On line 2518: + these securities + weren’t that different to + begin with. "There were + +On line 2520: + [the credit rating + agencies] did wrong," Federal + Reserve Chairman Ben + + Bernanke told the FCIC. "They + did not take into account + the appropriate + +On line 2522: + the categories of + mortgages."132 Second, the agencies + based their CDO ratings + +On line 2522: + the underlying + collateral. "The danger + with CDOs is when they + + are based on structured + finance ratings," Ann Rutledge, + a structured finance + + expert, told the FCIC. + "Ratings are not predictive + of future defaults; + +On line 2522: + only describe a + ratings management process, and + a mean and static + + expectation of + security loss."133 Of course, + rating CDOs was a + +On line 2524: + the rating agencies. + Including all types of CDOs—not + just those that were mortgage-related—Moody’s + +On line 2526: + deals in in in and + in the value of those deals + rose from billion in + +On line 2526: + in and billion in + The reported revenues of + Moody’s Investors Service + +On line 2528: + products—which included + mortgage-backed securities and + CDOs—grew from million in + +On line 2530: + corporate revenue. + The rating of asset-backed CDOs + alone contributed more + +On line 2530: + of the revenue from + structured finance.135 The boom years + of structured finance + +On line 2530: + company-wide surge in + revenue and profits. From to + the corporation’s + +On line 2534: + to billion and its + profit margin climbed from to + Yet the increase in + +On line 2534: + CDO group’s workload and + revenue was not paralleled + by a staffing increase. + +On line 2534: + were always playing + catch-up," Witt said.136 Moody’s "penny-pinching" + and "stingy" management + +On line 2534: + was insoluble. + Investment banks often hired + away our best people. + + As far as I can + remember, we were never + allocated funds + + to make counter offers," + Witt said. "We had almost no + ability to do + +On line 2534: + Kolchinsky, a former + team managing director + at Moody’s, told the FCIC + +On line 2534: + in the number of + deals rated was "huge but our + personnel did not + +On line 2534: + up accordingly." + By Kolchinsky recalled, "My role + as a team leader + +On line 2534: + crisis management. + Each deal was a crisis."138 When + personnel worked to + +On line 2534: + new methodology, + Witt said, "We had to kind of + do it in our spare + +On line 2536: + agencies worked closely + with CDO underwriters and + managers as each new + +On line 2536: + was devised. And the + rating agencies now relied + for a substantial + +On line 2536: + number of players. + Citigroup and Merrill alone + accounted for more + +On line 2538: + The ratings agencies’ + correlation assumptions + had a direct and + +On line 2538: + ow CDOs were structured: + assumptions of a lower + correlation made + +On line 2538: + easy-to-sell triple-A tranches + and smaller harder-to-sell BBB + tranches. Thus, as is + +On line 2538: + because issuers could + choose which rating agencies to + do business with, and + +On line 2538: + on the issuers for + their revenues, rating agencies + felt pressured to give + +On line 2540: + that they might remain + competitive. The pressure + on rating agency + +On line 2540: + was also intense + as a result of the high + turnover—a revolving door + + that often left raters + dealing with their old colleagues, + this time as clients. In + +On line 2540: + Yoshizawa, a Moody’s team + managing director for + U.S. derivatives + +On line 2540: + in was presented + with an organization + chart from July She + +On line 2542: + identified out of + analysts—about of the staff— who + had left Moody’s to work + +On line 2544: + or commercial banks.141 + Brian Clarkson, who oversaw + the structured finance + +On line 2544: + always a challenge, + for the simple reason that + the banks paid more. As + +On line 2544: + Moody’s employees were + prohibited from rating + deals by a bank or + +On line 2544: + institution, but + the responsibility + for notifying + + management of the + interview rested on the + employee. After + +On line 2544: + former employees + were barred from interacting + with Moody’s on the same + +On line 2544: + they had rated while + in its employ, but there were + no bans against working + + on other deals with + Moody’s.142 SEC: "IT’S GOING TO BE + AN AWFULLY BIG + +On line 2548: + The five major U.S. + investment banks expanded + their involvement in + +On line 2548: + mortgage and mortgage + securities industries + in the early 21st + +On line 2548: + formal government + regulation beyond their + broker-dealer subsidiaries. + +On line 2548: + In the European + Union told U.S. financial firms + that to continue + +On line 2548: + in Europe, they would + need a "consolidated" + supervisor by + +On line 2548: + company. The U.S. + commercial banks already met + that criterion— + +On line 2550: + supervisor was + the Federal Reserve—and + the Office of Thrift + +On line 2550: + oversight of AIG would + later also satisfy + the Europeans. The + + five investment banks, + however, did not meet the + standard: the SEC was + + supervising their + securities arms, but no + one supervisor + +On line 2550: + of these companies + on a consolidated + basis. Thus all five + + faced an important + decision: what agency would + they prefer as their + +On line 2552: + combined assets at + the five firms totaled trillion, + more than half of the + +On line 2552: + trillion of assets + held by the five largest U.S. bank + holding companies. + +On line 2552: + In the next three years + the investment banks’ assets + would grow to trillion. + +On line 2554: + the largest, followed by + Morgan Stanley and Merrill, + then Lehman and Bear. These + +On line 2554: + international + firms had transformed their business + models over the years. + +On line 2554: + activities on + top of their traditional + investment banking + +On line 2554: + Recall that at Bear + Stearns, trading and investments + accounted for more + +On line 2556: + some years after The + investment banks also owned + depository + +On line 2556: + they could provide FDIC-insured + accounts to their brokerage + customers; the deposits + +On line 2556: + limited funding. + These depositories took + the form of a thrift + +On line 2556: + an industrial + loan company (supervised + by the Federal + +On line 2556: + and Lehman, which had among + the largest of these subsidiaries, used + them to finance their + +On line 2558: + subsidiaries suggested + two obvious choices when + they found themselves in + +On line 2558: + If a firm chartered + its depository as + a commercial bank, + +On line 2558: + would be its holding + company supervisor; + if as a thrift, the + +On line 2558: + would do the job. But + the investment banks came up + with a third option. + + They lobbied the SEC + to devise a system of + regulation that + +On line 2560: + Consolidated + Supervised Entity (CSE) + program to oversee + +On line 2560: + holding companies + of investment banks and all + their subsidiaries. The CSE + +On line 2560: + large U.S. broker-dealer + subsidiaries already subject to + SEC regulation. + + However, this was + the SEC’s first foray into + supervising firms + +On line 2560: + soundness. The SEC did + not have express legislative + authority to + +On line 2560: + it proposed that the + CSE program be voluntary; + the SEC crafted the + +On line 2560: + program out of its + authority to make rules + for the broker-dealer + +On line 2560: + banks. The program would + apply to broker-dealers that + volunteered to be + +On line 2560: + consolidated + supervision under the + CSE program, or those + +On line 2560: + already were subject + to supervision by the + Fed at the holding + +On line 2560: + as JP Morgan and + Citigroup. The CSE program + would introduce a + +On line 2560: + of supervision + by SEC examiners. CSE + firms were allowed to + +On line 2560: + were holding against their + securities portfolios—a + methodology based + +On line 2560: + the "alternative + net capital rule," would be + similar to the + +On line 2562: + on the Market Risk + Amendment to the Basel rules—that large + commercial banks and + +On line 2564: + The traditional + net capital rule that had + governed broker-dealers + +On line 2564: + asset classes and + credit ratings, a bright-line + approach that gave firms + +On line 2564: + rules would allow the + investment banks to create + their own proprietary + + Value at Risk (VaR) + models to calculate their + regulatory + + capital—that is, the + capital each firm would have + to hold to protect + +On line 2564: + customers’ assets should + it experience losses + on its ecurities + +On line 2564: + SEC estimated + that the proposed new reliance + on proprietary VaR + +On line 2564: + reduce average + capital charges by The firms + would be required to + +On line 2564: + SEC an early-warning + notice if their tentative + net capital (net + +On line 2566: + capital minus + hard-to-sell assets) fell below + billion at any time. + +On line 2568: + securities firms + and argued that it therefore + was the natural + + supervisor of + their holding companies. In + a letter to the + +On line 2568: + the OTS was harshly + critical of the agency’s + proposal, which it + +On line 2570: + over savings and loan + holding companies that would + also be CSEs. The + + OTS argued that the + SEC was interfering with + the intentions of + +On line 2570: + Act, "carefully kept + the responsibility + for supervision + +On line 2570: + holding company + itself with the OTS or the + Federal Reserve + +On line 2570: + depending upon + whether the holding company + was a [thrift holding + + company] or a + bank holding company. This + was in recognition + + of the expertise + developed over the years by + these regulators + +On line 2570: + and the federal + deposit insurance funds by + depository + +On line 2570: + their affiliates." + The OTS declared: "We believe + that the SEC’s proposed + +On line 2570: + holding companies] + is unfounded and could pose + significant risks + +On line 2572: + and the federal + deposit insurance funds."144 In + contrast, the response + + from the financial + services industry to the + SEC proposal was + +On line 2572: + computation. Lehman + Brothers, for example, wrote + that it "applauds and + +On line 2572: + the Commission." JP + Morgan was supportive of + what it saw as an + +On line 2572: + rule that still governed + securities subsidiaries of + the commercial banks: + +On line 2572: + overstates the amount of + capital a broker-dealer + needs," the company + + wrote. Deutsche Bank found it + to be "a great stride towards + consistency with + +On line 2572: + executives at + the investment banks stated + that the firms preferred + +On line 2574: + familiar with their + core securities-related + businesses. In an + +On line 2574: + adopt the CSE program + and the new net capital + calculations that + +On line 2574: + banks volunteered for + this supervision, although + Merrill’s and Lehman’s thrifts + +On line 2574: + to be supervised + by the OTS. Several firms + delayed entry to + +On line 2576: + price movements. Harvey + Goldschmid, SEC commissioner + from to told FCIC staff + +On line 2576: + the CSE program was + created, SEC staff members + were concerned about how + +On line 2576: + had over the Wall Street + firms, including their hedge funds + and overseas subsidiaries. + + Once the CSE program + was in place, the SEC had "the + authority to + + look at everything."146 + SEC commissioners discussed + at the time the risks + + they were taking by + allowing firms to reduce + their capital. "If + +On line 2576: + goes wrong it’s going + to be an awfully big + mess," Goldschmid said at + +On line 2576: + we feel secure if + these drops in capital and + other things [occur] + + we really will + have investor protection1" In + response, Annette Nazareth, + + the SEC official + who would be in charge of the + program, assured the + + commissioners that + her division was up to + the challenge.147 The new + +On line 2578: + the SEC’s Office of + Prudential Supervision + and Risk Analysis, + +On line 2578: + staff of to within + the Division of Market + Regulation.148 In + +On line 2578: + CSE program had grown + to Still, only "monitors" + were responsible + +On line 2578: + the five investment + banks; monitors were assigned + to each firm, with some + +On line 2580: + CSE program was based + on the bank supervision + model, but the SEC + +On line 2580: + to do exactly + what bank examiners did.151 + For one thing, unlike + +On line 2580: + SEC never assigned + on-site examiners under + the CSE program; by + +On line 2582: + alone assigned more than + examiners full-time + at Citibank. According + + to Erik Sirri, the + SEC’s former director of + trading and markets, + +On line 2584: + a securities + firm traditionally had + no access to a + +On line 2584: + resort.152 (Of course, that + would change during the crisis.) + The investment banks + +On line 2584: + examinations, + during which staff reviewed the + firms’ systems and records + + and verified that + the firms had instituted + control processes. + +On line 2586: + from the start. The SEC + conducted an exam for + each investment bank + + when it entered the + program. The result of Bear + Stearns’s entrance exam, + +On line 2586: + deficiencies. For + example, examiners + were concerned that there + +On line 2586: + VaR limits and that + contingency funding plans + relied on overly + +On line 2586: + was aware of the firm’s + concentration of mortgage + securities and + +On line 2586: + SEC did not ask Bear + to change its asset balance, + decrease its leverage, + +On line 2588: + to SEC officials.154 + Then, because the CSE program + was preoccupied + +On line 2588: + its next annual + exam, during which the SEC + was supposed to be + +On line 2590: + did meet monthly with + all CSE firms, including Bear,155 + and it did conduct + +On line 2592: + worried that Bear was + too reliant on unsecured + commercial paper + +On line 2592: + and Bear reduced its + exposure to unsecured + commercial paper + +On line 2592: + increased its reliance + on secured repo lending.156 + Unfortunately, + +On line 2592: + billions of dollars + of that repo lending was + overnight funding that could + + disappear with no + warning. Ironically, in + the second week of + +On line 2594: + firm went into its + four-day death spiral, the SEC + was on-site conducting + +On line 2594: + first CSE exam since + Bear’s entrance exam more than + two years earlier.157 + +On line 2596: + at the investment + banks increased from to growth that + some critics have blamed + +On line 2596: + the SEC’s change in the + net capital rules. Goldschmid + told the FCIC that the + +On line 2598: + had been higher at + the five investment banks in + the late 1990s, then dropped + +On line 2598: + over the life of the + CSE program—a history + hat suggests that the + +On line 2598: + responsible for + the changes.159 In Sirri noted + that under the CSE + +On line 2598: + and, in some cases, + increased significantly" + over the program.160 Still, + +On line 2598: + Goldschmid, who left the + SEC in argued that the SEC + had the power to + +On line 2598: + in the investment + banks. He insisted, "There was + much more than enough moral + +On line 2600: + suasion and kind of + practical power that was + involved. The SEC has + +On line 2602: + ability to do + a lot if it uses its + power."161 Overall, the + +On line 2602: + was widely viewed as + a failure. From until the + financial crisis, + +On line 2602: + their spectacular + growth, relying heavily + on short-term funding. + +On line 2602: + "fundamentally + flawed from the beginning."162 Mary + Schapiro, the current SEC + +On line 2602: + "was not successful + in providing prudential + supervision."163 And, + +On line 2602: + chapters ahead, the SEC’s + inspector general would + be quite critical, + +On line 2602: + all five of the largest + independent investment + banks had either closed + + down (Lehman Brothers), merged + into other entities + (Bear Stearns and Merrill + + Lynch), or converted + to bank holding companies + to be supervised + +On line 2604: + Reserve (Goldman Sachs + and Morgan Stanley). For the + Fed, there would be a + +On line 2604: + shrinking over the course + of the decade, as JP Morgan + switched the charter of + + its banking subsidiary + to the OCC164 and as the OTS + and SEC promoted + +On line 2604: + "The OTS and SEC were + very aggressive in trying + to promote themselves + +On line 2604: + a regulator + in that environment and + wanted to be the + +On line 2604: + a Fed governor + from to "There was a lot of + competitiveness + +On line 2604: + January Fed staff + had prepared an internal + study to find out why + +On line 2604: + the investment banks + had chosen the Fed as its + consolidated + +On line 2604: + interviewed five firms + that already were supervised + by the Fed and four + +On line 2604: + had chosen the SEC. + According to the report, + the biggest reason + +On line 2608: + riskier portions (or + tranches) of mortgage-related + securities led + +On line 2608: + an enormous volume + of collateralized debt + obligations (CDOs). These + +On line 2608: + for nonprime mortgage + securitization and + contributed to the + +On line 2608: + important role in + doing so, including CDOs + squared, credit default + +On line 2608: + that invested in + mortgage-backed securities and + CDOs. Many of these risky + +On line 2608: + systemically + important institutions + and contributed to + +On line 2610: + near failure in the + financial crisis. Credit + default swaps, sold to + + provide protection + against default to purchasers of + the top-rated tranches + +On line 2610: + facilitated + the sale of those tranches by + convincing investors + +On line 2610: + low risk, but greatly + increased the exposure of + the sellers of the + +On line 2612: + swap protection to + the housing bubble’s collapse. + Synthetic CDOs, which + +On line 2612: + to continue and + expand even as the mortgage + market dried up and + +On line 2612: + speculators with + a means of betting on the + housing market. By + +On line 2612: + spread and amplified + exposure to losses when + the housing market + +On line 2614: + the continuing + securitization of + nonprime mortgages. There + + was a clear failure + of corporate governance + at Moody’s, which did not + +On line 2614: + of its ratings on + tens of thousands of mortgage-backed + securities and + +On line 2616: + The Securities + and Exchange Commission’s poor + oversight of the five + +On line 2616: + banks failed to restrict + their risky activities and + did not require them + +On line 2616: + failure or need for + government bailouts of all five + of the supervised + +On line 2626: + financial crisis. + ALL IN CONTENTS The bubble: + "A credit-induced boom".................................................................157 + +On line 2630: + and due diligence: "A + quality control issue + in the factory" + +On line 2636: + loans and commercial + real estate: "You’ve got + to get up and dance" + +On line 2642: + "moving" to "storage" + Fannie Mae and Freddie Mac: + "Two stark choices"............................................178 In + +On line 2642: + Warren Peterson + was paying as little as + for a 10,000-square-foot lot, + + about the size of three + tennis courts. The next year the + cost more than tripled to + +On line 2642: + had built between and + custom and semi-custom homes + a year. For a while, + +On line 2644: + was building as many + as And then came the crash. "I + have built exactly + +On line 2646: + new home since late he + told the FCIC five years later.1 + In the average + +On line 2646: + of California’s + agricultural center, the + San Joaquin Valley. That + +On line 2646: + jumped to almost by + June "By money seemed to be + coming in very fast + +On line 2646: + everywhere," said Lloyd + Plank, a Bakersfield real + estate broker. "They + + would purchase a house + in Bakersfield, keep it for + a short period + +On line 2646: + resell it. Sometimes + they would flip the house while it + was still in escrow, + +On line 2648: + and would still make to + Nationally, housing prices + jumped between and their + +On line 2650: + in more than in any + decade since at least It would be + catastrophically + +On line 2650: + machine kept churning + well into apparently + indifferent to + + the fact that housing + prices were starting to fall and + lending standards to + +On line 2650: + Newspaper stories + highlighted the weakness in + the housing market— + + even suggesting this + was a bubble that could burst + anytime. Checks were in + +On line 2658: + their own due diligence + on what they were buying. The + Federal Reserve + +On line 2658: + easier access + to credit were common in + other markets, too. + +On line 2658: + was flowing into + commercial real estate + and corporate loans. + + How to react to + what increasingly appeared + to be a credit + +On line 2660: + enterprises, such + as Lehman Brothers and Fannie + Mae, pushed deeper. All + + along the assembly + line, from the origination + of the mortgages to + +On line 2660: + marketing of the + mortgage-backed securities and + collateralized + +On line 2660: + (CDOs), many understood + and the regulators at + least suspected that + +On line 2662: + which would not perform + as advertised. THE BUBBLE: + "A CREDITINDUCED BOOM" + +On line 2664: + own loan quality + was deteriorating + and stripped power from + +On line 2664: + June presentation, + the Quality Assurance + staff reported they + +On line 2664: + errors, including + evidence of predatory + lending, legal and + +On line 2664: + violations, and + credit issues, in of the + loans they audited + +On line 2666: + December In Chief + Operating Officer + and later CEO Brad + +On line 2666: + recommended these + results be removed from the + statistical tools + +On line 2666: + performance, and in + the department was dissolved + and its personnel + +On line 2666: + deficiencies in + loan files; out of nine reviews + it conducted in + +On line 2666: + cut the department’s + budget, saying in a memo + that the "group was out + + of control and tries + to dictate business practices + instead of audit."6 + +On line 2668: + company struggled + with increasing requests that + it buy back soured loans + +On line 2668: + almost of its loans + were going into default + within the first three + +On line 2668: + with increasing loan + originations, without due + regard to the risks + +On line 2670: + securitizers, + and investors met at the ABS + East conference in + +On line 2670: + Raton, Florida, + to play golf, do deals, and talk + about the market. The + +On line 2670: + was still good, but even + the most optimistic could read + the signs. Panelists had + +On line 2672: + by "fundamentals" + such as increased demand1 Would + rising interest + + rates halt the arket1 + And was the CDO, because of + its ratings-driven + +On line 2674: + mortgage market18 The + numbers were stark. Nationwide, + house prices had never + +On line 2676: + national indices + masked important variations. + House prices in the four + +On line 2676: + California, had + dramatically larger + spikes—and subsequent + +On line 2676: + did the nation. If + there was a bubble, perhaps, + as Fed Chairman Alan + +On line 2676: + said, it was only + in certain regions. He told + a congressional + +On line 2676: + committee in June + that growth in nonprime mortgages + was helping to push + +On line 2676: + prices in some markets + to unsustainable levels, + "although a ‘bubble’ + +On line 2678: + prices for the nation + as a whole does not appear + likely."9 Globally, + +On line 2678: + jumped in many countries + around the world during the 2000s. + As Christopher Mayer, + +On line 2678: + to the Commission, + "What really sticks out is + how unremarkable + +On line 2678: + is relative to + our European peers."10 From to + price increases in + + the United Kingdom + and Spain were above those in the + United States, while price + +On line 2678: + France were just below. + In an International + Monetary Fund study + +On line 2678: + from more than one half + of the developed countries + analyzed had greater + +On line 2678: + appreciation + than the United States from late + through the third quarter + +On line 2678: + and yet some of these + countries did not suffer sharp + price declines.11 Notably, + +On line 2678: + home price increases + followed by a modest and + temporary decline + +On line 2678: + in Researchers at the + Federal Reserve Bank of + Cleveland attributed + + Canada’s experience + to tighter lending standards than + in the United States + +On line 2680: + structural differences + in the financial system.12 + Other countries, such + +On line 2682: + steep house price declines. + American economists and + policy makers + +On line 2682: + to explain the house + price increases. The good news + was the economy + +On line 2684: + and unemployment + was low. But, a Federal + Reserve study in May + +On line 2684: + cost of owning rather + than renting was much higher + than had been the case + +On line 2684: + historically: + home prices had risen from times the + annual cost of + +On line 2684: + times.13 In some cities, the + change was particularly + dramatic. From to + +On line 2684: + prices to rents rose in + Los Angeles, Miami, + and New York City by + +On line 2684: + index—which measures whether + a typical family + could qualify for + + a mortgage on a + typical home— had reached a + record low.15 But that was + +On line 2686: + based on the cost of + a traditional mortgage + with a down payment,16 + +On line 2686: + was no longer required. + Perhaps such measures were no + longer relevant, when + +On line 2686: + could make lower down + payments and obtain loans such + as payment-option + +On line 2686: + and interest-only + mortgages, with reduced initial + mortgage payments. Or + +On line 2688: + given homeowners’ + expectations of further + price gains. During a + +On line 2688: + Market Committee + (FOMC), composed of Federal + Reserve governors, + +On line 2688: + presidents, and the + Federal Reserve Bank of + New York president, + +On line 2688: + presentations on + mortgage risks and the housing + market. Members and + +On line 2688: + developing a + consensus on whether housing + prices were overvalued + +On line 2688: + and "it was hard for + many FOMC participants to + ascribe substantial + +On line 2688: + to the proposition + that overvaluation in + the housing market + +On line 2688: + the major systemic + risks that we now know it did," + according to a + +On line 2688: + Fed Chairman Ben Bernanke + to the FCIC. "The national + mortgage system might + +On line 2690: + not break," and "neither + borrowers nor lenders appeared + particularly + +On line 2690: + according to the + letter. In discussions about + nontraditional + +On line 2690: + mortgages are not an + especially sinister + development," and + +On line 2690: + cushioned by large down + payments." The presentation + also noted that + +On line 2690: + were rising on a + portion of interest-only + loans, the ratios for + +On line 2690: + that housing market + activity could be the + result of "solid + + fundamentals." Yet + another presentation + concluded that the + + impact of changes in + household wealth on spending would + be "perhaps only + + half as large as that + of the 1990s stock bubble." Most + FOMC participants + +On line 2692: + were "agnostics" on + housing, unwilling to risk + their reputations + +On line 2692: + finding support in + economic theory.18 Fed + Vice Chairman Donald + +On line 2694: + "Identification + [of a bubble] is a tricky + proposition because + +On line 2694: + driving asset prices + are directly observable," + Kohn said in a speech, + + citing research by + the European Central Bank. + "For this reason, any + +On line 2694: + by a central bank + that stocks or homes are overpriced + is inherently + +On line 2696: + to sound a louder + alarm. "The situation is + beginning to look + + like a credit-induced + boom in housing that could very + well result in a + +On line 2696: + Federal Deposit + Insurance Corporation + Chief Economist Richard + +On line 2698: + Brown wrote in a March + report. "During the past five + years, the average + +On line 2700: + U.S. home has risen in + value by while homes in the + fastest-growing markets + +On line 2700: + approximately + doubled in value." While this + increase might have been + +On line 2700: + fundamentals, "the + dramatic broadening of + the housing boom in + +On line 2700: + the influence of + systemic factors, including + the low cost and wide + + availability of + mortgage credit."20 A couple + of months later, Fed + +On line 2702: + that housing prices were + overvalued, but downplayed the + potential impacts + + of a downturn. Even + in the face of a large price + decline, they argued, + +On line 2702: + would not be widespread, + given the large equity + that many borrowers + +On line 2702: + in their homes. Structural + changes in the mortgage market + made a crisis less + +On line 2702: + financial system + seemed well capitalized. "Even + historically + +On line 2702: + declines in house prices + would be small relative to + the recent decline + +On line 2702: + wealth owing to the + stock market," the economists + concluded. "From a + +On line 2710: + only company + that ignored concerns about poor + loan quality. Across + +On line 2710: + mortgage industry, + with the bubble at its peak, + standards had declined, + +On line 2710: + no longer verified, + and warnings from internal + audit departments + +On line 2710: + patterns during the + savings and loan crisis, told + the Commission that + +On line 2710: + by one estimate, + in the mid-2000s, at least million + loans annually + + contained "some sort of + fraud," in part because of the + large percentage of + +On line 2712: + housing can entail + a borrower’s lying or + intentionally + +On line 2712: + deception to gain + financially from the sale + of a house. Illinois + +On line 2714: + mortgage products to + borrowers."24 In of cases, + according to the + +On line 2714: + involves industry + insiders.25 For example, + property flipping + +On line 2714: + real estate agents, + appraisers, and complicit + closing agents. In a + +On line 2714: + second," the buyer, + with the collusion of a + loan officer and + +On line 2714: + the knowledge of the + first mortgage lender, disguises + the existence of + + a second mortgage + to hide the fact that no down + payment has been made. + + "Straw buyers" allow + their names and credit scores to + be used, for a fee, + + by buyers who want + to conceal their ownership.26 + In one instance, two + +On line 2716: + South Florida were + indicted in for placing + ads between and in + +On line 2716: + were accused of then + stealing the identities of + hundreds of people + + who came for help and + using the information + to buy properties, + +On line 2716: + A. Ferrer told the + Commission it was "one of + the cruelest schemes" he + + had seen.27 Estimates + vary on the extent of fraud, + as it is seldom + +On line 2720: + business relations + at Inter - thinx, a fraud + detection service, + +On line 2720: + the FCIC that her firm + analyzed a large sample + of all loans from to + +On line 2720: + and found contained lies + or omissions significant + enough to rescind the + +On line 2720: + worth of fraudulent + loans from to resulted in + foreclosures, leading + +On line 2720: + losses of billion + for the holders. According + to Fulmer, experts + +On line 2720: + the percentage of + transactions involving less + significant forms + +On line 2724: + the radar, because many + borrowers made payments on + time. Ed Parker, the + + head of mortgage fraud + investigation at Ameriquest, + the largest subprime lender + +On line 2724: + FCIC that fraudulent + loans were very common at the + company. "No one + +On line 2724: + watching. The volume + was up and now you see the + fallout behind the + +On line 2724: + Markets at Fannie + Mae, told the Commission that + in one package of + +On line 2724: + his analysts found + one purchaser who had bought + properties, falsely + +On line 2724: + time as the owner + of only one property, + while another had + + bought five properties.30 + Fannie Mae’s detection of + fraud increased steadily + +On line 2724: + the housing bubble + and accelerated in + late according to + +On line 2724: + current director + of the company’s mortgage + fraud program. He said + +On line 2724: + seeing evidence + of fraud, Fannie demanded + that lenders such as Bank + +On line 2724: + Citigroup, and JP + Morgan Chase repurchase about + million in mortgages + +On line 2724: + million in "Lax or + practically non-existent + government oversight + +On line 2724: + thrive," said Henry N. + Pontell, a professor of + criminology + +On line 2724: + the University + of California, Irvine, in + testimony to + + the Commission.32 The + responsibility to + investigate and + +On line 2726: + to local, state and + federal law enforcement + officials. On the + + federal level, + the Federal Bureau of + Investigation + +On line 2726: + prosecution to + U.S. Attorneys, who are part + of the Department + + of Justice. Cases + may also involve other + agencies, including + +On line 2726: + U.S. Postal Inspection + Service, the Department of + Housing and Urban + +On line 2726: + The FBI, which has the + broadest jurisdiction of + any federal law + +On line 2726: + Chris Swecker began + noticing a rise in mortgage + fraud while he was the + +On line 2726: + charge of the Charlotte, + North Carolina, office from + to In that office + +On line 2726: + Mortgage for selling + fraudulent loans to Fannie + Mae, leading to the + +On line 2726: + prosecution of + the company’s owner, James + Edward McLean Jr., and + +On line 2728: + but then—without any + interference from Fannie—resold + them to Ginnie Mae.34 + +On line 2730: + Ginnie, Fannie paid + million of restitution to + the government. McLean + +On line 2730: + to the attention + of the FBI after buying + a luxury yacht + +On line 2730: + after Swecker was + promoted to assistant + FBI director for + +On line 2730: + turned a spotlight on + mortgage fraud. "The potential + impact of mortgage + +On line 2730: + clear," Swecker told a + congressional committee + in "If fraudulent + +On line 2730: + fraud is allowed to + become unrestrained, it will + ultimately place + +On line 2730: + institutions at + risk and have adverse effects + on the stock market."36 + +On line 2732: + Swecker pointed out + the inadequacies of + data regarding + +On line 2732: + that Congress mandate + a reporting system and + other remedies and + +On line 2732: + not. For example, + suspicious activity + reports, also known + +On line 2732: + reports filed by FDIC-insured + banks and their affiliates + to the Financial + +On line 2732: + Enforcement Network + FinCEN), a bureau within the + Treasury Department + +On line 2734: + and works closely with + law enforcement to combat + financial crimes. SARs + +On line 2734: + in a financial + transaction. But many mortgage + originators, such + +On line 2734: + New Century, and + Option One, were outside FinCEN’s + jurisdiction—and + +On line 2734: + investment banks, were + not subject to FinCEN review. + William Black testified + +On line 2734: + to the Commission + that an estimated of + nonprime mortgage loans + +On line 2734: + SARs. And as for those + institutions required to + do so, he believed + + he saw evidence + of underreporting in + that, he said, only + +On line 2734: + filed even a single + criminal referral for + alleged mortgage fraud + +On line 2736: + in the first half of + Countrywide, the nation’s largest + mortgage lender at the + +On line 2738: + activity in + its mortgage business in in + and in according + + to Francisco San + Pedro, the former senior + vice president of + +On line 2740: + investigations + at the company.38 But it + filed only SARs in + +On line 2742: + in Similarly, + in examining Bank of + America in its + +On line 2742: + regulator, the + Office of the Comptroller + of the Currency + +On line 2742: + activity for + which no report had been filed + with FinCEN. All met the + +On line 2742: + required management + to refine its processes + to ensure that SARs + +On line 2744: + and fraud analyst + at Wells Fargo, the second + largest mortgage lender from + +On line 2744: + the largest in told the + Commission that "hundreds and + hundreds and hundreds + +On line 2744: + identified within + Wells Fargo’s home equity + loan division were + + not reported to + FinCEN. And, she added, at least half + the loans she flagged for + +On line 2746: + objections.41 Despite + the underreporting, the + jump in mortgage fraud + +On line 2748: + drew attention. FinCEN + in November reported + a 20-fold increase in + +On line 2748: + SARs related to + mortgage fraud between and It + noted that two-thirds of + +On line 2748: + were originated + by mortgage brokers who were + not subject to any + +On line 2748: + standard or oversight.42 + Swecker unsuccessfully + asked legislators + + to compel all lenders + to forward information + about criminal fraud + + to regulators + and law enforcement agencies.43 + Swecker attempted + +On line 2750: + gain more funding to + combat mortgage fraud but was + resisted. Swecker + +On line 2750: + cut at either the + director level at the + FBI, at the Justice + + Department, or at + the Office of Management + and Budget. He called + +On line 2752: + his struggle for more + resources an "uphill slog."44 In + SARs related to + +On line 2754: + mortgage fraud were filed; + in there were The number kept + climbing, to in in + +On line 2756: + At the same time, top + FBI officials, focusing + on terrorist threats, + +On line 2758: + to white-collar crime + from in the fiscal year to + fewer than by That + +On line 2758: + mortgage fraud program + had only agents at any one + time to review more + +On line 2758: + than SARs filed with FinCEN. + In response to inquiries from + the FCIC, the FBI said + + that to compensate + for a lack of manpower, + it had developed + +On line 2758: + methods to detect + and combat mortgage fraud," such + as a computer + +On line 2760: + property flipping.46 + Robert Mueller, the FBI’s director + since said mortgage fraud + +On line 2760: + priorities," such + as terrorism. He told the + Commission that he + + hired additional + resources to fight fraud, but that + "we didn’t get what + + we had requested" + during the budget process. He + also said that the + + FBI allocated + additional resources to + reflect the growth in + +On line 2760: + fraud, but acknowledged + that those resources may have been + insufficient. "I + +On line 2760: + not going to tell + you that that is adequate + for what is out there," + + he said. In the wake + of the crisis, the FBI is + continuing to + + investigate fraud, + and Mueller suggested that some + prosecutions may + +On line 2762: + nation’s attorney + general from February + to September told + +On line 2762: + that while he might have + done more on mortgage fraud, in + hindsight he believed + +On line 2762: + more pressing: "I don’t + think anyone can credibly + argue that [mortgage + +On line 2762: + more important than + the war on terror. Mortgage + fraud doesn’t involve + + taking loss of life + so it doesn’t rank above the + priority of + +On line 2764: + Housing Enterprise + Oversight, the regulator + of the GSEs, released + + a report showing + a "significant rise in + the incidence of + +On line 2764: + in mortgage lending + in and the first half of OFHEO + stated it had been + + working closely with + law enforcement and was an + active member of + + the Department of + Justice Mortgage Fraud Working + Group.49 "The concern about + +On line 2764: + issue," Richard Spillenkothen, head + of banking supervision + and regulation + +On line 2764: + Fed from to told the + FCIC. "And we understood there + was an increasing + +On line 2766: + B. Mukasey, who served as + U.S. attorney general + from November to + +On line 2766: + the end of told the + Commission that he recalled + "receiving reports + +On line 2766: + mortgage failures and + of there being fraudulent + activity in + +On line 2766: + with flipping houses, + overvaluation, and the + like. I have a dim + + recollection of + outside people commenting + that additional + +On line 2766: + be devoted, and + there being speculation + about whether resources that + +On line 2766: + investigations + were somehow impeding fraud + investigations, + + which I thought was a + bogus issue." He said that + the department had + +On line 2768: + as terrorism, gang + violence, and southwestern + border issues.51 In + + letters to the FCIC, + the Department of Justice + outlined actions it + + undertook along with + the FBI to combat mortgage + fraud. For example, + +On line 2768: + Continued Action, + targeting a variety + of financial crimes, + +On line 2768: + the agency started + to publish an annual + mortgage fraud report. + +On line 2768: + following year, the + FBI and other federal + agencies announced a + +On line 2768: + produced indictments, + arrests, and convictions for + mortgage fraud. In the + +On line 2768: + cases and increased + personnel dedicated + to those efforts. And + +On line 2768: + Mortgage resulted + in mortgage fraud cases in + which defendants were + +On line 2770: + Attorneys offices + throughout the country.52 William Black + told the Commission + +On line 2770: + issue and allowed + it to worsen. "The FBI did + have severe limits," + +On line 2770: + and the problem was + compounded by the lack of + cooperation: + + "The terrible thing + that happened was that the FBI + got virtually + +On line 2770: + assistance from the + regulators, the banking + regulators and + +On line 2772: + FBI official, told + the Commission he had no + contact with banking + +On line 2774: + As mortgage fraud grew, + state agencies took action. In + Florida, Ellen Wilcox, + + a special agent with + the state Department of Law + Enforcement, teamed with + +On line 2774: + Agency to bring down + a criminal ring scamming + homeowners in the + +On line 2774: + Its key member was + Orson Benn, a New York–based + vice president of + +On line 2774: + of Ameriquest. Beginning + in investigators and + two prosecutors + +On line 2774: + repair contractors, + title companies, notaries, + and a convicted + +On line 2776: + case that involved some + loans.55 According to charging + documents in the + +On line 2776: + neighborhoods, looking + for elderly homeowners + they thought were likely + + to have substantial + equity in their homes. They + would suggest repairs + + or improvements to + the homes. The homeowners would + fill out paperwork, + + and insiders would + use the information to + apply for loans in + +On line 2776: + the ring would prepare + fraudulent loan documents, + including false W-2 + +On line 2776: + with information + about invented employment + and falsified salaries, + +On line 2776: + out home equity + loans in the homeowners’ names. + Each person involved + + in the transaction + would receive a fee for his + or her role; Benn, at + +On line 2776: + Argent, received a + kickback for each loan he helped + secure. When the loan + +On line 2776: + out to the bogus + home construction company + that had proposed the + +On line 2776: + would then disappear + with the proceeds. Some of the + homeowners never + + received a penny + from the refinancing on + their homes. Hillsborough + +On line 2776: + to say that scheduled + repairs had never been made + to their homes, and then + +On line 2776: + of equity as + well. Sixteen of defendants, + including Benn, have + +On line 2778: + or have pled guilty.56 Wilcox + told the Commission that the + "cost and length of these + + investigations + make them less attractive to + most investigative + +On line 2778: + their budgets based on + investigative statistics."57 + She said it has been + +On line 2778: + to follow up on + other cases because so + many of the subprime + +On line 2778: + of business, making + it difficult to track down + perpetrators and + +On line 2778: + Ameriquest, for example, + collapsed in although Argent, + and the company’s + + loan-servicing arm, were + bought by Citigroup that same + year. DISCLOSURE AND + +On line 2786: + QUALITY CONTROL + ISSUE IN THE FACTORY" + In addition to + +On line 2786: + the final years of + the bubble. After growing + for years, Alt-A lending + +On line 2786: + another from to + In particular, option + ARMs grew during that + +On line 2788: + for borrowers with + fixed-rate mortgages) grew Overall, by + no-doc or low-doc + +On line 2790: + loans made up of all + mortgages originated. Many + of these products would + + perform only if + prices continued to rise and + the borrower could + +On line 2792: + participant along + the securitization + pipeline should have had + +On line 2792: + in the quality + of every underlying + mortgage. In practice, + + their interests were + often not aligned. Two New York + Fed economists have + +On line 2792: + frictions" in mortgage + securitization—places + along the pipeline where + + one party knew more + than the other, creating + opportunities + + to take advantage.59 + For example, the lender who + originated the + +On line 2792: + for sale, earning a + commission, knew a great deal + about the loan and the + +On line 2792: + but had no long-term stake + in whether the mortgage was paid, + beyond the lender’s own + +On line 2794: + process. They described their + role as being "an umpire + in the market."60 But + +On line 2794: + security, nor + did they check to see that the + mortgages were what the + +On line 2796: + said they were. So the + integrity of the market + depended on two + +On line 2796: + First, firms purchasing + and securitizing the + mortgages would conduct + + due diligence reviews + of the mortgage pools, either + using third-party + +On line 2796: + rules, parties in the + securitization process + were expected to + + disclose what they were + selling to investors. Neither + of these checks performed + +On line 2800: + securitizers + undertook due diligence on + their own or through third + +On line 2800: + The originator + and the securitizer + negotiated + +On line 2800: + extent of the due + diligence investigation. + While the percentage + +On line 2802: + the pool examined + could be as high as it was + often much lower; + + according to some + observers, as the market grew + and originators + +On line 2802: + bargaining power + over the mortgage purchasers, and + samples were sometimes + +On line 2802: + requested that the + due diligence firm analyze + a random sample + +On line 2802: + mortgages from the pool; + others asked for a sampling + of those most likely + + to be deficient + in some way, in an effort + to efficiently + + detect more of the + problem loans. layton Holdings, + a Connecticut-based firm, + +On line 2804: + was a major provider + of third-party due diligence + services. As Clayton + +On line 2804: + Vicki Beal explained + to the FCIC, firms like hers were + "not retained by [their] + + clients to provide an + opinion as to whether a loan + is a good loan or + + a bad loan." Rather, they + were hired to identify, among + other things, whether the + +On line 2806: + to enable clients to + negotiate better prices + on pools of loans.63 The + +On line 2806: + the originator’s + standards, sometimes with overlays + or additional + +On line 2806: + provided by the + financial institutions + purchasing the loans)1 + +On line 2806: + values accurate164 + And, critically: to the + degree that a loan + + was deficient, did + it have any "compensating + factors" that offset + +On line 2806: + loan had a higher + loan-to-value ratio than + guidelines called for, did + +On line 2806: + as the borrower’s + higher income mitigate + that weakness1 The due + +On line 2806: + firm would then grade the + loan sample and forward the + data to its client. + +On line 2806: + securitizer + would negotiate a price + for the pool and could + +On line 2808: + loans that did not meet + the stated guidelines. Because + of the volume of + + loans examined by + Clayton during the housing + boom, the firm had a + + unique inside view of + the underwriting standards + that originators + +On line 2808: + willing to accept. + Loans were classified into + three groups: loans that met + +On line 2808: + (a Grade Event), those that + failed to meet guidelines but were + approved because of + +On line 2810: + (a Grade Event), and those + that failed to meet guidelines and + were not approved (a + +On line 2814: + Event). Overall, for the + months that ended June Clayton + rated of the loans + +On line 2814: + it analyzed as + Grade and another as Grade + 2—for a total of + +On line 2814: + guidelines outright or + with compensating factors. + The remaining of + +On line 2814: + the loans were Grade In + theory, the banks could have + refused to buy a + + loan pool, or, indeed, + they could have used the findings + of the due diligence + +On line 2814: + firm to probe the loans’ + quality more deeply. Over the + 18-month period, of + +On line 2814: + the loans that Clayton + found to be deficient—Grade 3—were "waived in" + by the banks. Thus of + + the loans sampled by + Clayton were accepted even + though the company + +On line 2816: + found a basis for + rejecting them (see figure + Referring to the + +On line 2816: + Keith Johnson, the + president of Clayton from + May to May told the + +On line 2816: + me says there [was] a + quality control issue + in the factory" + +On line 2816: + Johnson concluded + that his clients often waived in + loans to preserve their + +On line 2816: + of rejections might + lead the originator to + sell the loans to a + +On line 2816: + a sellers’ market. + "Probably the seller had + more power than the + +On line 2818: + FCIC.67 The high rate of + waivers following rejections + may not itself be + +On line 2818: + Beal testified. She + said that as originators’ + lending guidelines were + +On line 2818: + credit Rejected + Loans Waived in by Selected + Banks guidelines. "As you + + know, there was stated + income, they were telling us look + for reasonableness + +On line 2818: + one would expect more + rejections, and, after the + securitizer + +On line 2818: + at the rejected + loans, possibly more waivers. As + Moody’s Investors Service + +On line 2818: + a letter to the + FCIC, "A high rate of waivers from + an institution + + with extremely tight + underwriting standards could + result in a pool + + that is less risky than + a pool with no waivers from an + institution with + +On line 2818: + indicated that + the loans in the pools either + met guidelines outright + +On line 2818: + had compensating + factors, even though Clayton’s records + show that only a + + portion of the loans + were sampled, and that of those + that were sampled, a + +On line 2820: + percentage of Grade + Event loans were waived in. Johnson + said he approached the + +On line 2820: + agencies in and to + gauge their interest in the + exception-tracking + + product that Clayton + was developing. He said + he shared some of their + +On line 2820: + the agencies that the + data would benefit the + ratings process. "We went + +On line 2822: + and said, ‘Wouldn’t this + information be great for + you to have as you + + assign tranche levels + of isk1’" Johnson recalled. The + agencies thought the due + + diligence firm’s data + were "great," but they did not want + the information, + + Johnson said, because + it would presumably produce + lower ratings for + +On line 2828: + market was winding + down.70 When securitizers + did kick loans out of + +On line 2828: + some originators + simply put them into new + pools, presumably in + +On line 2828: + the next pool’s sampling. + The examiner’s report + for New Century + +On line 2828: + Investment Loan had + a policy of putting loans + into subsequent + +On line 2828: + they were kicked out three + times, the company’s former + regulatory + + compliance and risk + manager, Roger Ehrnman, told + the FCIC. As Johnson + + described the practice + to the FCIC, this was the "three + strikes, you’re out rule."72 Some + +On line 2830: + their own due diligence, + but seemed to devote only + limited resources + +On line 2830: + At Morgan Stanley, + the head of due diligence was + based not in New York + + but rather in Boca + Raton, Florida. He had, + at any one time, two + +On line 2830: + him directly—and they were + actually employees + of a personnel + + consultant, Equinox.73 Deutsche + Bank and JP Morgan likewise + also had only + +On line 2832: + diligence teams.74 Banks did + not necessarily have + better processes + + for monitoring + the mortgages that they purchased. + At an FCIC hearing + +On line 2832: + the mortgage business, + Richard Bowen, a whistleblower who + had been a senior + +On line 2832: + testified that his + team conducted quality + assurance checks on + +On line 2832: + Citigroup from a + network of lenders, including + both subprime mortgages + +On line 2832: + hold and prime mortgages + that it intended to sell + to Fannie Mae and + +On line 2834: + purchases, Bowen’s team + would review the physical + credit file of the + +On line 2834: + they were purchasing. + "During and I witnessed many + changes to the way the + +On line 2834: + evaluated for + these pools during the purchase + processes," Bowen said. + +On line 2834: + example, he said, + the chief risk officer in + Citigroup’s Consumer + +On line 2836: + business reversed large + numbers of underwriting + decisions from "turn + +On line 2838: + part of Bowen’s charge was + to supervise the purchase + of roughly billion + +On line 2838: + in prime loan pools, a + high percentage of which were + sold to Fannie Mae + + and Freddie Mac for + securitization. The + sampling provided + +On line 2838: + quality control + was supposed to include at + least of the loan pool + +On line 2838: + usually ignored." + Samples of were more likely, + and the loan samples + +On line 2838: + group did examine + showed extremely high rates of + noncompliance. "At + +On line 2838: + time that I became + involved, which was early to + mid-2006, we identified + +On line 2838: + to percent of the + files either had a ‘disagree’ + decision, or they + +On line 2840: + supervisor and + company executives + about the quality + + and underwriting + of mortgages that CitiMortgage purchased + and then sold to the + + GSEs. As discussed in + a later chapter, the GSEs + would later require + +On line 2840: + Citigroup to buy + back billion in loans as of + November finding + +On line 2842: + the loans Citigroup + had sold them did not conform + to GSE standards. SEC: + +On line 2846: + the room is that we + didn’t review the prospectus + supplements" By the + +On line 2846: + time the financial + crisis hit, investors held more + than trillion of non-GSE + +On line 2848: + billion of CDOs that + held mortgage-backed securities.77 + These securities + +On line 2850: + with practically + no SEC oversight. And only + a minority + +On line 2850: + ongoing public + reporting requirements. The + SEC’s mandate is to + +On line 2850: + disclosures so that + investors can make up their own + minds. In the case of + +On line 2850: + offerings of a + company’s shares, the work has + historically + +On line 2852: + other "offering + materials" prior to + sale.78 However, with + +On line 2852: + "shelf registration," + a method of registering + securities on + +On line 2852: + became much quicker + for mortgage-backed securities + ranked in the highest + +On line 2852: + the rating agencies. + The process allowed issuers to + file a base prospectus + +On line 2852: + issuer intended + to offer securities + in the future. The + +On line 2852: + offering’s terms. "The + elephant in the room is that + we didn’t review + +On line 2852: + in corporation + finance, Shelley Parratt, told + the FCIC.79 To improve + +On line 2852: + Regulation AB + in late The regulation + required that every + +On line 2852: + credit-granting or + underwriting criteria + used to originate + + or purchase the pool + assets, including, to the + extent known, any changes + +On line 2852: + criteria and the + extent to which such policies + and criteria are + +On line 2854: + be overridden."80 With + essentially no review + or oversight, how good + +On line 2854: + included disclaimers + to the effect that not all + mortgages would comply + +On line 2854: + the lending policies + of the originator: "On + a case-by-case basis + +On line 2854: + may determine that, + based upon compensating + factors, a prospective + + mortgage not strictly + qualifying under the + underwriting risk + +On line 2856: + an underwriting + exception."81 The disclosure + typically had + +On line 2858: + number" or perhaps + "a substantial portion of + the Mortgage Loans will + +On line 2858: + Bowen criticized the + extent of information + provided on loan + +On line 2858: + no disclosure made + to the investors with regard + to the quality + + of the files they were + purchasing."83 Such disclosures + were insufficient + +On line 2860: + know what criteria + the mortgages they were buying + actually did + +On line 2862: + meet. Only a small + portion—as little as to 3%—of + the loans in any deal + +On line 2862: + from Clayton shows that + a significant number + did not meet stated + +On line 2862: + have compensating + factors.84 On he loans in the + remainder of the + +On line 2864: + that were not sampled + (as much as Clayton and the + securitizers + +On line 2864: + information, but + one could reasonably expect + them to have many of + +On line 2864: + at the same rate, as + the sampled loans. Prospectuses + for the ultimate + +On line 2864: + this information, + or information on how + few loans were reviewed, + + raising the question + of whether the disclosures were + materially + +On line 2866: + violation of + the securities laws. CDOs + were issued under + +On line 2866: + framework from the one + that applied to many mortgage-backed + securities, and + +On line 2866: + rules. Underwriters + typically issued CDOs + under the SEC’s Rule + +On line 2868: + so-called qualified + institutional buyers + (QIBs); these included + + investors as diverse + as insurance companies + like MetLife, pension funds + +On line 2868: + California State + Teachers’ Retirement System, + and investment banks + +On line 2870: + U.S. investment banks + more competitive with their + foreign counterparts; + +On line 2870: + participants viewed + U.S. disclosure requirements + as more onerous than + +On line 2870: + significantly + expanded the market for + these securities + +On line 2870: + distributions which + complied with the rule would no + longer be considered + +On line 2870: + exemption with the + National Securities + Markets Improvements + +On line 2870: + that Denise Voigt Crawford, + a commissioner on the + Texas Securities + +On line 2870: + prohibit[ing] the states + from taking preventative + actions in areas + +On line 2870: + the current crisis."86 + Under this legislation, + state securities + + regulators were + preempted from overseeing + private placements such + +On line 2870: + In the absence of + registration requirements, + a new debt market + +On line 2870: + Rule 144A. This market + was liquid, since qualified + investors could freely trade + +On line 2872: + securities. But + debt securities when Rule + 144A was enacted + +On line 2872: + corporate bonds, very + different from the CDOs that + dominated the + +On line 2874: + been adequate, filed + numerous lawsuits under + federal and state + +On line 2878: + new mortgage products + had been on regulators’ + radar screens in the years + +On line 2880: + banks’ own internal + risk management systems.88 "As + internal systems + +On line 2880: + the basic thrust of + the examination process + should shift from largely + +On line 2880: + feedback that the bank + can use to enhance further + the quality of + +On line 2880: + its risk-management + systems," Chairman Greenspan had said + in Across agencies, there + +On line 2880: + approach, that a lighter + hand at regulation was + the appropriate + + way to regulate," + Eugene Ludwig, comptroller + of the currency + +On line 2880: + from to told the FCIC, + referring to the Gramm-Leach-Bliley Act + in The New York Fed, + +On line 2882: + "lessons-learned" analysis + after the crisis, pointed + to the mistaken + + belief that "markets + will always self-correct." + "A deference to + +On line 2882: + supervisors from + imposing prescriptive views + on banks," the report + +On line 2886: + capital standards. + Banks had complained for years that + the original Basel + +On line 2886: + did not allow them + sufficient latitude to + base their capital + +On line 2886: + with strong support from + the Fed, introduced the Basel + II capital regime + +On line 2886: + which would allow banks + to lower their capital + charges if they could show + +On line 2886: + sophisticated + approaches that it allowed, + Basel II reflected + + and reinforced the + supervisors’ risk-focused + approach. Spillenkothen said that + +On line 2886: + "acceptance of Basel + II premises," which he described + as displaying "an + +On line 2886: + accuracy of + complex quantitative risk + measurement techniques, + +On line 2886: + willingness (at least + in the early days of Basel + II) to tolerate + +On line 2886: + regulatory + capital in return for + the prospect of better + +On line 2888: + Regulators had + been taking notice of the + mortgage market for + +On line 2888: + mortgage products and + borrowers had changed during + and following the + + refinancing boom + of the previous year, and + they began work on + +On line 2888: + guidance to banks and + thrifts. But too little was done, + and too late, because + +On line 2888: + interagency + discord, industry pushback, + and a widely held + +On line 2890: + participants had + the situation well in + hand. "Within the board, + +On line 2890: + many of these loan types + had gotten to an extreme," + Susan Bies, then a + +On line 2890: + governor and chair + of the Federal Reserve + Board’s subcommittees + + on both safety and + soundness supervision and + consumer protection + + supervision, told + the FCIC. "So the main debate + within the board was + + how tightly [should we] + rein in the abuses that we + were seeing. So it + +On line 2894: + was more of ‘to a + degree.’"93 Indeed, in the same + June Federal Open + +On line 2894: + Committee meeting + described earlier, one FOMC + member noted that + +On line 2894: + and untested credit + default instruments had caused + some market turmoil." + +On line 2894: + participant was + concerned "that subprime lending + was an accident + +On line 2894: + third participant + noted the risks in mortgage + securities, the + +On line 2894: + information on + borrowers," adding, however, + that record profits and + +On line 2894: + capital levels + allayed those concerns. A fourth + participant said + +On line 2894: + "we could be seeing + the final gasps of house price + appreciation." + + The participant + expressed concern about "creative + financing" and was + +On line 2894: + of default ould be + higher than suggested by + the securities + +On line 2894: + backed, "could be making + the books of GSEs look better + than they really + + were." Fed staff replied that + the GSEs were not large purchasers + of private label + +On line 2896: + securities.94 In + the spring of the FOMC would again + discuss risks in the + +On line 2896: + markets and express + nervousness about the growing + "ingenuity" of + +On line 2896: + amortization loans + had the per-nicious effect of + stripping equity + +On line 2896: + and raised concerns about + nontraditional lending + practices that seemed based + + on the presumption + of continued increases + in home prices. John Snow, + +On line 2900: + treasury secretary, + told the FCIC that he called a + meeting in late or + +On line 2900: + proliferation + of poor lending practices. He + said he was struck that + +On line 2900: + to see a problem + at their own institutions. + "Nobody had a full + +On line 2900: + regulators was, + ‘Well, there may be a problem. + But it’s not in my + +On line 2900: + view,’" Snow told the FCIC. + Regulators responded + to Snow’s questions by + +On line 2900: + rates are very low. Our + institutions are very well + capitalized. Our + + institutions [have] + very low delinquencies. So we + don’t see any real + +On line 2904: + problem."95 In May the + banking agencies did issue + guidance on the risks + +On line 2904: + and home equity + loans. It cautioned financial + institutions about + +On line 2904: + loan-to-value and + debt-to-income ratios, lower + credit scores, greater use + +On line 2904: + and the increase in + transactions generated + through a loan broker + +On line 2904: + third party. While this + guidance identified many of + the problematic + +On line 2904: + engaged in by bank + lenders, it was limited to + home equity loans. + +On line 2906: + to first mortgages.96 In + examiners from the Fed + and other agencies + +On line 2908: + confidential "peer + group" study of mortgage practices + at six companies + +On line 2908: + that together had + originated trillion in + mortgages in almost + +On line 2908: + national total. + In the group were five banks whose + holding companies + +On line 2908: + and Wells Fargo—as well + as the largest thrift, Washington + Mutual.97 The study + +On line 2908: + in the volume of + these irresponsible loans, + very risky loans," Sabeth + +On line 2908: + head of credit risk + at the Federal Reserve + Board’s Division of + +On line 2908: + Supervision and + Regulation, told the FCIC.98 + A large percentage + +On line 2908: + their loans issued were + subprime and Alt-A mortgages, and + the underwriting + +On line 2910: + for these products had + deteriorated.99 Once + the Fed and other + +On line 2910: + had identified the + mortgage problems, they agreed to + express those concerns + + to the industry + in the form of nonbinding + guidance. "There was among + +On line 2912: + Board of Governors + folks, you know, some who felt that + if we just put out + + guidance, the banks would + get the message," Bies said.100 The + federal agencies + +On line 2914: + drafted guidance on + nontraditional mortgages + such as option ARMs, + +On line 2914: + comment in late The + draft guidance directed lenders + to consider a + +On line 2914: + the loan payment when + rates adjusted, rather than just + the lower starting + +On line 2916: + loans should be "used with + caution."101 Immediately, + the industry was + +On line 2916: + The American Bankers + Association said the + guidance "overstate[d] + +On line 2916: + the guidance required + them to assume "a worst case + scenario," that is, the + +On line 2916: + which borrowers would + have to make the full payment + when rates adjusted.103 + +On line 2916: + that "almost any form + of documentation can + be appropriate."104 + +On line 2918: + denied that better + disclosures were required to + protect borrowers + +On line 2918: + nontraditional + mortgages, arguing that they + were "not aware of any + +On line 2920: + supports the need for + further consumer protection + standards."105 The need for + +On line 2920: + was controversial + within the agencies, too. "We + got tremendous pushback + +On line 2920: + industry as well + as Congress as well as, you + know, internally," + +On line 2920: + the FCIC. "Because it + was stifling innovation, + potentially, and + +On line 2922: + American dream to + many people."106 The pressures to + weaken and delay + +On line 2922: + were strong and came from + many sources. Opposition by + the Office of Thrift + + Supervision helped + delay the mortgage guidance + for almost a year.107 + + Bies said, "There was some + real concern about if the + Fed tightened down on + +On line 2922: + regulated], whether + that would create an un-level + playing field [for] stand-alone + +On line 2922: + the mortgage market + was Congress. She recalled an + occasion when she + + testified about a + proposed rule and "members of + Congress [said] that we + +On line 2922: + going to deny + the dream of homeownership + to Americans if + + we put this new stronger + standard in place."108 When guidance + was put in place in + +On line 2926: + institutions switched + regulators in search of + more lenient treatment. + +On line 2926: + Countrywide applied + to switch regulators from + the Fed and OCC to + +On line 2926: + OTS. Countrywide’s move + came after several months + of evaluation + +On line 2926: + the benefits of + OTS regulation, many of + which were promoted + +On line 2926: + OTS itself over the + course of an "outreach effort" + initiated in + +On line 2928: + John Reich became + director of the agency. + Publicly, Countrywide + +On line 2928: + the decision to + switch to the OTS was driven + by the desire to + +On line 2930: + holding company.109 + However, other factors + came into play as + +On line 2930: + OCC’s top Countrywide + examiner told the FCIC + that Countrywide CEO + + Angelo Mozilo + and President and COO David + Sambol thought the OCC’s + +On line 2932: + property appraisals + would be "killing the business."110 An + internal July + +On line 2934: + OTS regulation + of holding companies is + not as intrusive + +On line 2934: + of the Federal + Reserve. In particular, + the OTS rarely conducts + + extensive onsite + examinations and when + they do conduct an + +On line 2934: + regulator than + the Federal Reserve."111 In + August Mozilo wrote + +On line 2934: + his executive + team, "It appears that the Fed + is now troubled by + +On line 2934: + the OTS is not. Since + pay options are a major + component of both + +On line 2934: + and profitability + the Fed may force us into + a decision faster + +On line 2934: + would like." Countrywide + Chief Risk Officer John McMurray + responded that "based + +On line 2934: + with the FRB and OTS, + the OTS appears to be both + more familiar and + +On line 2936: + ARMs."112 The OTS approved + Countrywide’s application + for a thrift charter + +On line 2942: + March LEVERAGED LOANS AND + COMMERCIAL REAL ESTATE: + "YOU’VE GOT TO GET + +On line 2944: + AND DANCE" The credit + bubble was not confined to + the residential + +On line 2944: + (typically loans + to below-investment-grade + companies to aid + +On line 2944: + dynamics, although + the effects were not as large + and damaging as + +On line 2944: + in residential + real estate. From to these + other two markets + +On line 2944: + by structured finance + products—commercial mortgage–backed + securities and + +On line 2944: + loan obligations (CLOs), + respectively—which were in + many ways similar + + to residential + mortgage-backed securities and + CDOs. And just as in + +On line 2944: +