The Financial Collapse - Professional Education Services

The Financial
How and Why
Course #6375/QAS6375
Course Material
Table of Contents
(Course #6375/QAS6375)
Chapter 1: Before Our Very Eyes
I. Introduction
II. Warning Signs
III. Housing Bubble
IV. Mortgage Backed Securities
V. Poor Loan Choices
VI. Growing Mortgage Indebtedness
VII. Complexity Grows
Review Questions & Solutions
Chapter 2: Shadow Banking
I. Introduction
II. Commercial Paper and Repos: “Unfettered Markets”
III. The Savings and Loan Crisis: They Put a Lot of Pressure on
Their Regulators
Review Questions & Solutions
Chapter 3: Securitization and Derivatives
I. Fannie and Freddie
II. Structured Finance: “It Wasn’t Reducing the Risk”
III. The Growth of Derivatives: “By Far the Most Significant
Event in Finance During the Past Decade”
Review Questions & Solutions
Chapter 4: Deregulation Redux
I. Expansion of Banking Activities
II. Dot-Com Crash: “Lay on More Risk”
III. The Wages of Finance: “Well, This One’s Doing It, So How
Can I Not Do It?”
IV. Financial Sector Growth: “I Think We Overdid Finance
Versus the Real Economy”
Review Questions & Solutions
Chapter 5: Subprime Lending
I. Mortgage Securitization: “This Stuff Is So Complicated How Is
Anybody Going to Know?”
II. Greater Access to Lending: “A Business Where We Can Make
Some Money”
III. Subprime Lenders in Turmoil: “Adverse Market Conditions”
IV. The Regulators: “Oh, I See”
Review Questions & Solutions
Table of Contents
Table of Contents (cont.)
Chapter 6: Credit Expansion
I. Housing: “A Powerful Stabilizing Force”
II. Subprime Loans
III. Citigroup
IV. Federal Rules Revisited
V. States’ Position
VI. Community-Lending Pledges
VII. Bank Capital Standards
Review Questions & Solutions
Chapter 7: The Mortgage Machine
I. Foreign Investors: “An Irresistible Profit Opportunity”
II. Mortgages: “A Good Loan”
III. 2/28s and 3/27s: “Adjust for the Affordability”
IV. Option ARMs: “Our Most Profitable Mortgage Loan”
V. Underwriting Standards: “We’re Going to Have to Hold
Our Nose”
VI. Federal Regulators: “Immunity From Many State Laws Is a
Significant Benefit”
VII. Mortgage Securities Players: “Wall Street Was Very
Hungry for Our Product”
VIII. The Investors in the Deal
IX. “Compensated Very Well”
X. Moody’s: “Given a Blank Check”
XI. “In the Business Forevermore”
XII. “Everything but the Elephant Sitting on the Table”
XIII. Fannie Mae and Freddie Mac: “Less Competitive in
the Marketplace
Review Questions & Solutions
Chapter 8: The CDO Machine
I. Introduction to Collateralized Debt Obligations
II. CDOs: “We Created the Investor”
III. “It Was a Lot of Effort”
IV. “Mother’s Milk to the…Market”
V. “Leverage Is Inherent in CDOs”
VI. Three Large Firms’ Experiences with CDOs
VII. Moody’s: “Achieved through Some Alchemy”
VIII. SEC: “It’s Going to Be an Awfully Big Mess”
Review Questions & Solutions
Table of Contents
Table of Contents (cont.)
Chapter 9: All In
I. The Bubble: “A Credit-Induced Boom”
II. Mortgage Fraud: “Crime-Facilitative Environments”
III. Disclosure and Due Diligence: “A Quality Control Issue
in the Factory”
IV. Due Diligence Firms: “Waived In”
V. SEC: “The Elephant in the Room Is That We Didn’t Review
the Prospectus Supplements”
VI. Regulators: “Markets Will Always Self-Correct”
Review Questions & Solutions
Chapter 10: The Madness
I. CDO Managers: “We Are Not a Rent-A-Manager”
II. Credit Default Swaps: “Dumb Question”
III. Regulators: “Are Undue Concentrations of Risk Developing?”
IV. Moody’s: “It Was All About Revenue”
Review Questions & Solutions
Chapter 11: The Bust
I. Delinquencies: “The Turn of the Housing Market”
II. Rating Downgrades: “Never Before”
III. CDOs: “Climbing the Wall of Subprime Worry”
IV. Legal Remedies: “On the Basis of the Information”
V. Losses: “Who Owns Residential Credit Risk?”
Review Questions & Solutions
Chapter 12: Early 2007 – Spreading Subprime Worries
I. Goldman: “Let’s Be Aggressive Distributing Things”
II. Bear Stearns’s Hedge Funds: “Looks Pretty Damn Ugly”
III. “19% Is Doomsday”
IV. “Canary in the Mine Shaft”
V. Rating Agencies: “It Can’t Be…All of a Sudden”
VI. AIG: “Well Bigger Than We Ever Planned For”
Review Questions & Solutions
Chapter 13: Summer 2007 – Disruptions in Funding
I. IKB of Germany: “Real Money Investors”
II. Countrywide: “That’s Our 9/11”
III. BNP Paribas: “The Ringing of the Bell”
IV. SIVs: “An Oasis of Calm”
V. Money Funds and Other Investors: “Drink[ing] from a
Fire Hose”
Review Questions & Solutions
Table of Contents
Table of Contents (cont.)
Chapter 14: Late 2007 to Early 2008 – Billions in Subprime Losses
I. Merrill Lynch: “Dawning Awareness Over the Course of
the Summer
II. Citigroup: “That Would Not in Any Way Have Excited My
III. “That Has Never Happened Since The Depression
IV. “DEFCON Calls”
V. Federal Reserve: “The Discount Window Wasn’t Working”
VI. Monoline Insurers: “We Never Expected Losses”
Review Questions & Solutions
Chapter 15: The Fall of Bear Stearns
I. “I Requested Some Forbearance”
II. “We Were Suitably Skeptical”
III. “Turn Into a Death Spiral”
IV. “Duty to Protect Their Investors”
V. “The Government Would Not Permit a Higher Number”
VI. “It Was Heading to a Black Hole”
Review Questions & Solutions
Chapter 16: March to August 2008 – Systemic Risk Concerns
I. The Federal Reserve: “When People Got Scared”
II. JP Morgan: “Refusing to Unwind…Would Be Unforgivable”
III. The Fed and the SEC: “Weak Liquidity Position”
IV. Derivatives: “Early Stages of Assessing the Potential
Systemic Risk”
V. Banks: “The Markets Were Really, Really Dicey”
Review Questions & Solutions
Chapter 17: The Takeover of Fannie Mae and Freddie Mac
I. “A Good Time to Buy”
II. “The Only Game in Town”
III. “It’s a Time Game…Be Cool”
IV. “It Will Increase Confidence”
Review Questions & Solutions
Chapter 18: September 2008 – The Bankruptcy of Lehman
I. “Get More Conservatively Funded”
II. “This Is Not Sounding Good at All”
III. “Spook the Market”
IV. “Imagination Hat”
V. “Heads of Family”
VI. “Tell Those Sons of Bitches to Unwind”
VII. “This Doesn’t Seem Like it Is Going to End Pretty”
VIII. “The Only Alternative Was That Lehman Had to Fail”
IX. “A Calamity”
Review Questions & Solutions
Table of Contents
Table of Contents (cont.)
Chapter 19: The Bailout of AIG
I. “Current Liquidity Position Is Precarious”
II. “Spillover Effect”
III. “Like a Gnat on an Elephant”
Review Questions & Solutions
Chapter 20: Crisis and Panic
I. Money Market Funds: “Dealers Weren’t Even Picking Up
Their Phones”
II. Morgan Stanley: “Now We’re the Next in Line”
III. Over-the-Counter Derivatives: “A Grinding Halt”
IV. Washington Mutual: “It’s Yours”
V. Wachovia: “At the Front End of the Dominoes as Other
Dominoes Fell”
VI. TARP: “Comprehensive Approach”
Review Questions & Solutions
Chapter 21: The Economic Fallout
I. Households: “I’m Not Eating. I’m Not Sleeping”
II. Businesses: “Squirrels Storing Nuts”
III. Commercial Real Estate: “Nothing’s Moving”
IV. Government: “States Struggled to Close Shortfalls”
V. The Financial Sector: “Almost Triple the Level of Three
Years Earlier”
Review Questions & Solutions
Chapter 22: The Foreclosure Crisis
I. Foreclosure on the Rise: “Hard to Talk About Any Recovery”
II. Initiatives to Stem Foreclosure: “Persistently Disregard”
III. Flaws in the Process: Speculation and Worst-Case Scenarios
IV. Neighborhood Effects: “I’m Not Leaving”
Review Questions & Solutions
Table of Contents
The Financial Crisis Inquiry Commission was created to "examine the causes, domestic
and global, of the current financial and economic crisis in the United States." The
Commission was established as part of the Fraud Enforcement and Recovery Act
passed by Congress and signed by the President in May 2009. This independent, 10member panel was composed of private citizens with experience in areas such as
housing, economics, finance, market regulation, banking and consumer protection. Six
members of the Commission were appointed by the Democratic leadership of Congress
and four by the Republican leadership. The Commission’s statutory instructions set out
22 specific topics for inquiry and called for the examination of the collapse of major
financial institutions that failed or would have failed if not for exceptional assistance from
the government. These included:
Fraud and abuse in the financial sector, including fraud and abuse toward
consumers in the mortgage sector;
Federal and state financial regulators, including the extent to which they
enforced, or failed to enforce statutory, regulatory, or supervisory requirements;
The global imbalance of savings, international capital flows, and fiscal
imbalances of various governments;
Monetary policy, and the availability and terms of credit;
Accounting practices, including, mark-to-market and fair value rules, and
treatment of off-balance sheet vehicles;
Tax treatment of financial products and investments;
Capital requirements and regulations on leverage and liquidity, including the
capital structures of regulated and non-regulated financial entities;
Credit rating agencies in the financial system, including reliance on credit ratings
by financial institutions and Federal financial regulators, the use of credit ratings
in financial regulation, and the use of credit ratings in the securitization markets;
Lending practices and securitization, including the originate-to-distribute model
for extending credit and transferring risk;
Affiliations between insured depository institutions and securities, insurance, and
other types of nonbanking companies;
The concept that certain institutions are 'too-big-to-fail' and its impact on market
Corporate governance, including the impact of company conversions from
partnerships to corporations;
Compensation structures;
Changes in compensation for employees of financial companies, as compared to
compensation for others with similar skill sets in the labor market;
The legal and regulatory structure of the United States housing market;
Derivatives and unregulated financial products and practices, including credit
default swaps;
Financial institution reliance on numerical models, including risk models and
credit ratings;
The legal and regulatory structure governing financial institutions, including the
extent to which the structure creates the opportunity for financial institutions to
engage in regulatory arbitrage;
The legal and regulatory structure governing investor and mortgagor protection;
Financial institutions and government-sponsored enterprises; and
The quality of due diligence undertaken by financial institutions.
On January 27, 2011 the Commission delivered its report to the President, Congress
and the American people. The operations of the Commission concluded on February 13,
In the course of its research and investigation, the Commission reviewed millions of
pages of documents, interviewed more than 700 witnesses, and held 19 days of public
hearings in New York, Washington, D.C., and communities across the country that were
hard hit by the crisis. The Commission also drew from a large body of existing work
about the crisis developed by congressional committees, government agencies,
academics, journalists, legal investigators, and many others.
The author of this course has reviewed and condensed the report to provide readers
with a more succinct version of the accounts of the crisis, its causes and its aftermath.
As you read through this course, there are a number of acronyms. To assist you, below
is chart of the acronyms that are commonly used.
Acronym Chart
asset-backed commercial paper
asset-backed security
A series of derivatives indices constructed
from the prices of 20 credit default swaps
that each reference individual subprime
mortgage backed securities; akin to an
index like the Dow Jones Industrial
adjustable-rate mortgage
auction rate securities
collateralized debt obligation
credit default swap
Commodity Futures Trading Commission
commercial paper
Capital Purchase Program
Community Reinvestment Act
Consolidated Supervised Entity
Financial Crisis Inquiry Commission
Federal Deposit Insurance Corporation
Federal Housing Administration
Federal Housing Finance Agency
Financial Crimes Enforcement Network
Federal Open Market Committee
government-sponsored enterprise
Home Ownership and Equity Protection Act
Department of Housing and Urban
London Interbank Offered Rate, an interest
rate at which banks are willing to lend to
each other in the London interbank market
LTV Ratio
loan-to-value ratio
net asset value
Office of the Comptroller of the Currency
Office of Federal Housing Enterprise
Office of Thrift Supervision.
Primary Dealer Credit Facility
private-label mortgage-backed securities
Securities and Exchange Commission
structured investment vehicle
special purpose vehicle
Term Auction Facility
Term Asset-Backed Securities Loan
Troubled Asset Relief Program
Term Securities Lending Facility
Below is a timeline that you may find helpful as you read through this course.
Congress passed the Glass-Steagall Act which established the
Fannie Mae (Federal National Mortgage Association) was
enacted to purchase mortgages that were insured by the Federal
Housing Administration (FHA)
Ginnie Mae (Government National Mortgage Association) was
developed to alleviate the debt of the federal government
created by Fannie Mae
Freddie Mac (Federal Home Loan Mortgage Corporation) was
created to assist the thrifts in selling their mortgages
The Community Reinvestment Act was adopted to ensure that
banks would lend to those who banked in their neighborhood
The Garn-St. Germain Act was created which expanded the
types of loans that banks and thrifts could construct
The Financial Institutions Reform, Recovery and Enforcement
Act (FIRREA) was enacted to create stricter requirements
concerning capital on thrifts
The Home Ownership and Equity Protection Act (HOEPA) was
created to protect homeowners from dishonest lending
November 1999
The Gramm-Leach Bliley Act was passed which removed most
of the restrictions from the Glass-Steagall Act
Spring of 2000
The technology bubble burst
December of 2000
The Commodity Futures Modernization Act of 2000 was
developed to deregulate the derivatives market and decrease
authority of the CFTC
March 2001
This marked the beginning of an 8 month recession. Interest
rates were decreased 11 times to a 40 year low of 1.75%
October 2001
The Recourse Rule was created to monitor how much capital a
bank needed to have against securitized assets
Spring of 2004
Homeownership peaked at 69.2% of households
Home loans were equally financed by Fannie Mae and Freddie
Mac and commercial and investment banks and thrifts
June 2005
The “pay as you go” credit default swap was initiated by
derivative dealers
April 2006
Housing prices hit an all time high of $227,100; the price of
homes increased 152% from 1997 to 2006
Fall 2006
Housing prices were decreasing and mortgage delinquencies
were increasing
Summer of 2007
The securitization markets came to a stand-still and the CDOs
were right behind
December 2007
This was the beginning of a recession
January 2008
Bank of America purchased Countrywide
February 2008
The OFHEO removed the limits on growth concerning portfolio
March 2008
The Term Securities Lending Facility (TSLF) was created so that
lenders would lend money to banks in exchange for Treasury
securities as collateral
March 2008
JP Morgan purchased Bear Stearns
July 2008
IndyMac Bank was closed by the Office of Thrift Supervision
July 2008
The Housing and Economic Recovery Act (HERA) was created
to broaden secured credit lines
September 2008
Fannie Mae and Freddie Mac were placed into conservatorships
September 15, 2008
Lehman Brothers filed for bankruptcy; Merrill Lynch was taken
September 16, 2008
The government rescued AIG
September 21, 2008
Morgan Stanley and Goldman Sachs applied to and became
supervised by the Feds
September 25, 2008
Washington Mutual was taken over by the government
October 2008
Commercial Paper Funding Facility was developed to enable the
Federal Reserve to loan money to nonfinancial entities. This
helped to stabilize the commercial paper market
March 2009
The Term Asset-Backed Securities Loan Facility (TALF)
initiated to help in the securitization of loans
Spring 2009
Home prices dropped 32% from their peak in 2006
June 2009
This marked the end of the recession
October 2009
Unemployment reached its highest number at 10.1%
Fall of 2010
1 in 11 mortgage loans had past due balances. Of those with
mortgages, 22.5% of them owed more on their mortgage than
what their home was worth. Office spaces were only 80%
The following are just some of the key players in the financial crisis who are discussed in
this course.
Who’s Who in the Financial Crisis
Sheila Bair
Chairwoman of the Federal Deposit
Insurance Corporation (FDIC)
Ben Bernanke
Current Chairman of the Federal Reserve
Board; assumed that role in 2006
Lloyd Blankfein
Chairman and Chief Executive Officer of
Goldman Sachs
Warren Buffet
Chairman and Chief Executive of Berkshire
Ralph Cioffi
Executive with Bear Sterns who created
CDOs for the firm
Brian Clarkson
Former President of Moody’s Investors
Christopher Cox
Former Chairman of the Securities and
Exchange Commission (SEC)
Andrew Cuomo
Secretary of the Department of Housing
and Urban Development (HUD) between
1997 and 2001; current Governor of New
Jamie Dimon
CEO of JP Morgan
William Dudley
President of the Federal Reserve Bank of
New York
Andrew Forster
Head of Credit Trading at AIG Financial
Timothy Geithner
Current Secretary of the Treasury; former
President of the New York Federal
Alberto Gonzalez
U.S. Attorney General under President
George W. Bush between 2005 and 2007
Lyle Gramley
Former Governor of the Federal Reserve
and former Director of Countrywide
Edward Gramlich
Federal Reserve Governor and
Chairperson of the Fed’s Consumer
Alan Greenspan
Chairman of the Federal Reserve Board for
two decades until 2006
Alphonso Jackson
Secretary of the Department of Housing
and Urban Development (HUD) from 2004
to 2008
Robert Levin
Former Chief Business Officer for Fannie
Arthur Levitt
Former Chairman of the Securities and
Exchange Commission (SEC)
Ken Lewis
Former CEO of Bank of America
Lawrence Lindsay
National Economic Council Director under
President George W. Bush; former Federal
Reserve Governor
James Lockhart
Director of the Federal Housing Finance
Glenn Loney
Deputy Director of the Federal Reserve’s
Consumer and Community Affairs Division
from 1998 to 2010
John Mack
CEO of Morgan Stanley
Paul McCulley
Managing Director at PIMCO, one of the
nation’s largest money management firms
Raymond McDaniel
Chairman and CEO of Moody’s
Angelo Mozilo
Former CEO of Countywide Financial, a
lender that was destroyed as a result of
risky mortgages
Daniel Mudd
CEO of Fannie Mae
Robert Mueller
Former Director of the FBI
Stan O’Neal
Former Chairman, Chief Executive and
President of Merrill Lynch
Vikram Pandit
CEO of Citigroup
Richard Parson
Chairman of the Board of Citigroup
Henry Paulson
CEO of Goldman Sachs until he became
Secretary of the Treasury under President
George W. Bush in 2006; he was
Secretary of the Treasury during the
financial crisis
Charles Prince
Former Chairman and Chief Executive
Officer of Citigroup
Robert Rubin
Former Secretary of the Treasury and
Executive with Citibank
David Sambol
President and COO of Countrywide
Alan Schwartz
Former Bear Sterns’s Co-President and
Mary Shapiro
Chairwoman of the Securities and
Exchange Commission (SEC)
John Snow
U.S. Treasury Secretary under George W.
Bush prior to Henry Paulsen
Peter Solomon
Former Partner with Lehman Brothers
Lawrence Summer
Deputy Treasury Secretary
Chris Swecker
Assistant Director of the FBI
Matthew Tannin
Executive at Bear Sterns who structured
Ken Thompson
Former CEO of Wachovia
Ira Wagner
Head of Bear Sterns CDO group
Sandy Weill
Former CEO of Citigroup
Mark Zandi
Chief Economist with Moody’s Analytics
Chapter 1: Before Our Very Eyes
I. Introduction
In examining the worst financial meltdown since the Great Depression, the Financial
Crisis Inquiry Commission (FCIC) reviewed millions of pages of documents and
questioned hundreds of individuals – financial executives, business leaders, policy
makers, regulators, community leaders, and people from all walks of life – to find out
how and why it happened.
In public hearings and interviews, many financial industry executives and top public
officials testified that they had been blindsided by the crisis, describing it as a dramatic
and mystifying turn of events. Even among those who worried that the housing bubble
might burst, few – if any – foresaw the magnitude of the crisis that would ensue.
Charles Prince, the former chairman and chief executive officer of Citigroup Inc., called
the collapse in housing prices “wholly unanticipated.” Warren Buffett, the chairman and
chief executive officer of Berkshire Hathaway Inc., told the Commission that “very, very
few people could appreciate the bubble,” which he called a “mass delusion” shared by
“300 million Americans.” Lloyd Blankfein, the chairman and chief executive officer of
Goldman Sachs Group, Inc., likened the financial crisis to a hurricane.
Regulators echoed a similar refrain. Ben Bernanke, the chairman of the Federal Reserve
Board since 2006, told the Commission a “perfect storm” had occurred that regulators
could not have anticipated; but when asked about whether the Fed’s lack of
aggressiveness in regulating the mortgage market during the housing boom was a
failure, Bernanke responded, “It was, indeed. I think it was the most severe failure of the
Fed in this particular episode.” Alan Greenspan, the Fed chairman during the two
decades leading up to the crash, told the Commission that it was beyond the ability of
regulators to ever foresee such a sharp decline. “History tells us [regulators] cannot
identify the timing of a crisis, or anticipate exactly where it will be located or how large
the losses and spillovers will be.”
II. Warning Signs
In fact, there were warning signs. In the decade preceding the collapse, there were
many signs that house prices were inflated, that lending practices had spun out of
control, that too many homeowners were taking on mortgages and debt they could ill
afford, and that risks to the financial system were growing unchecked. Alarm bells were
clanging inside financial institutions, regulatory offices, consumer service organizations,
state law enforcement agencies, and corporations throughout America, as well as in
neighborhoods across the country. Many knowledgeable executives saw trouble and
managed to avoid the train wreck. While countless Americans joined in the financial
euphoria that seized the nation, many others were shouting to government officials in
Washington and within state legislatures, pointing to what would become a human
disaster, not just an economic debacle.
“Everybody in the whole world knew that the mortgage bubble was there,” said Richard
Breeden, the former chairman of the Securities and Exchange Commission appointed by
President George H. W. Bush. “I mean, it wasn’t hidden. . . . You cannot look at any of
Before Our Very Eyes
this and say that the regulators did their job. This was not some hidden problem. It
wasn’t out on Mars or Pluto or somewhere. It was right here. . . . You can’t make trillions
of dollars’ worth of mortgages and not have people notice.”
Paul McCulley, a managing director at PIMCO, one of the nation’s largest money
management firms, told the Commission that he and his colleagues began to get worried
about “serious signs of bubbles” in 2005; they therefore sent out credit analysts to 20
cities to do what he called “old-fashioned shoe-leather research,” talking to real estate
brokers, mortgage brokers, and local investors about the housing and mortgage
markets. They witnessed what he called “the outright degradation of underwriting
standards,” McCulley asserted, and they shared what they had learned when they got
back home to the company’s Newport Beach, California, headquarters. “And when our
group came back, they reported what they saw, and we adjusted our risk accordingly,”
McCulley told the Commission. The company “severely limited” its participation in risky
mortgage securities.
Veteran bankers, particularly those who remembered the savings and loan crisis, knew
that age-old rules of prudent lending had been cast aside. Arnold Cattani, the chairman
of Bakersfield, California-based Mission Bank, told the Commission that he grew
uncomfortable with the “pure lunacy” he saw in the local home-building market, fueled by
“voracious” Wall Street investment banks; he thus opted out of certain kinds of
investments by 2005.
III. Housing Bubble
Unlike so many other bubbles – tulip bulbs in Holland in the 1600s, South Sea stocks in
the 1700s, Internet stocks in the late 1990s – this one involved not just another
commodity, but a building block of community and social life and a cornerstone of the
economy: the family home. Homes are the foundation upon which many of our social,
personal, governmental, and economic structures rest. Children usually go to schools
linked to their home addresses; local governments decide how much money they can
spend on roads, firehouses, and public safety based on how much property tax revenue
they have; house prices are tied to consumer spending. Downturns in the housing
industry can cause ripple effects almost everywhere.
When the Federal Reserve cut interest rates early in the new century and mortgage
rates fell, home refinancing surged, climbing from $460 billion in 2000 to $2.8 trillion in
2003, allowing people to withdraw equity built up over previous decades and to consume
more, despite stagnant wages. Home sales volume started to increase, and average
home prices nationwide climbed, rising 67% in eight years by one measure and hitting a
national high of $227,100 in early 2006. Home prices in many areas skyrocketed: prices
increased nearly two and one-half times in Sacramento, for example, in just five years,
and shot up by about the same percentage in Bakersfield, Miami, and Key West. Prices
about doubled in more than 110 metropolitan areas, including Phoenix, Atlantic City,
Baltimore, Ft. Lauderdale, Los Angeles, Poughkeepsie, San Diego, and West Palm
Housing starts nationwide climbed 53%, from 1.4 million in 1995 to more than 2 million in
2005. Encouraged by government policies, homeownership reached a record 69.2% in
the spring of 2004, although it wouldn’t rise an inch further even as the mortgage
machine kept churning for another three years. By refinancing their homes, Americans
Before Our Very Eyes
extracted $2.0 trillion in home equity between 2000 and 2007, including $334 billion in
2006 alone, more than seven times the amount they took out in 1996. Real estate
speculators and potential homeowners stood in line outside new subdivisions for a
chance to buy houses before the ground had even been broken. By the first half of 2005,
more than one out of every ten home sales was to an investor, speculator, or someone
buying a second home. Bigger was better, and even the structures themselves
ballooned in size; the floor area of an average new home grew by 15%, to 2,277 square
feet, in the decade from 1997 to 2007.
Money washed through the economy like water rushing through a broken dam. Low
interest rates and then foreign capital helped fuel the boom. Construction workers,
landscape architects, real estate agents, loan brokers, and appraisers profited on Main
Street, while investment bankers and traders on Wall Street moved even higher on the
American earnings pyramid and the share prices of the most aggressive financial service
firms reached all-time highs.
Homeowners pulled cash out of their homes to send their kids to college, pay medical
bills, install designer kitchens with granite counters, take vacations, or launch new
businesses. They also paid off credit cards, even as personal debt rose nationally.
Survey evidence shows that about 5% of homeowners pulled out cash to buy a vehicle
and over 40% spent the cash on a catchall category including tax payments, clothing,
gifts, and living expenses. Renters used new forms of loans to buy homes and to move
to suburban subdivisions, erecting swing sets in their backyards and enrolling their
children in local schools.
In an interview with the Commission, Angelo Mozilo, the longtime CEO of Countrywide
Financial – a lender brought down by its risky mortgages – said that a “gold rush”
mentality overtook the country during these years, and that he was swept up in it as well:
“Housing prices were rising so rapidly – at a rate that I’d never seen in my 55 years in
the business – that people, regular people, average people got caught up in the mania of
buying a house, and flipping it, making money. It was happening. They buy a house,
make $50,000 . . . and talk at a cocktail party about it. . . . Housing suddenly went from
being part of the American dream to house my family to settle down – it became a
commodity. That was a change in the culture. . . . It was sudden, unexpected.”
IV. Mortgage-Backed Securities
On the surface, it looked like prosperity. After all, the basic mechanisms making the real
estate machine hum – the mortgage-lending instruments and the financing techniques
that turned mortgages into investments called securities, which kept cash flowing from
Wall Street into the U.S. housing market – were tools that had worked well for many
But underneath, something was going wrong. Like a science fiction movie in which
ordinary household objects turn hostile, familiar market mechanisms were being
transformed. The time-tested 30-year fixed-rate mortgage, with a 20% down payment,
went out of style. There was a burgeoning global demand for residential mortgagebacked securities that offered seemingly solid and secure returns. Investors around the
world clamored to purchase securities built on American real estate, seemingly one of
the safest bets in the world.
Before Our Very Eyes
Wall Street labored mightily to meet that demand. Bond salesmen earned multimilliondollar bonuses packaging and selling new kinds of loans, offered by new kinds of
lenders, into new kinds of investment products that were deemed safe but possessed
complex and hidden risks. Federal officials praised the changes – these financial
innovations, they said, had lowered borrowing costs for consumers and moved risks
away from the biggest and most systemically important financial institutions. But the
nation’s financial system had become vulnerable and interconnected in ways that were
not understood by either the captains of finance or the system’s public stewards. In fact,
some of the largest institutions had taken on what would prove to be debilitating risks.
Trillions of dollars had been wagered on the belief that housing prices would always rise
and that borrowers would seldom default on mortgages, even as their debt grew. Shaky
loans had been bundled into investment products in ways that seemed to give investors
the best of both worlds – high-yield, risk-free – but instead, in many cases, would prove
to be high-risk and yield-free.
The securitization machine began to guzzle these once rare mortgage products with
their strange-sounding names: Alt-A, subprime, I-O (interest-only), low-doc, no-doc, or
ninja (no income, no job, no assets) loans; 2-28s and 3-27s; liar loans; piggy-back
second mortgages; payment-option or pick-a-pay adjustable rate mortgages. New
variants on adjustable-rate mortgages, called “exploding” ARMs, featured low monthly
costs at first, but payments could suddenly double or triple, if borrowers were unable to
refinance. Loans with negative amortization would eat away the borrower’s equity. Soon
there were a multitude of different kinds of mortgages available on the market,
confounding consumers who didn’t examine the fine print, baffling conscientious
borrowers who tried to puzzle out their implications, and opening the door for those who
wanted in on the action.
V. Poor Loan Choices
Many people chose poorly. Some people wanted to live beyond their means, and by
mid-2005, nearly one-quarter of all borrowers nationwide were taking out interest only
loans that allowed them to defer the payment of principal. Some borrowers opted for
nontraditional mortgages because that was the only way they could get a foothold in
areas such as the sky-high California housing market. Some speculators saw the
chance to snatch up investment properties and flip them for profit. Some were misled by
salespeople who came to their homes and persuaded them to sign loan documents on
their kitchen tables. Some borrowers naively trusted mortgage brokers who earned more
money placing them in risky loans than in safe ones. With these loans, buyers were able
to bid up the prices of houses even if they didn’t have enough income to qualify for
traditional loans.
Some of these exotic loans had existed in the past, used by high-income, financially
secure people as a cash-management tool. Some had been targeted to borrowers with
impaired credit, offering them the opportunity to build a stronger payment history before
they refinanced. But the instruments began to deluge the larger market in 2004 and
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VI. Growing Mortgage Indebtedness
At first not a lot of people really understood the potential hazards of these new loans.
They were new, they were different, and the consequences were uncertain. But it soon
became apparent that what had looked like newfound wealth was a mirage based on
borrowed money. Overall mortgage indebtedness in the United States climbed from $5.3
trillion in 2001 to $10.5 trillion in 2007. The mortgage debt of American households rose
almost as much in the six years from 2001 to 2007 as it had over the course of the
country’s more than 200-year history. The amount of mortgage debt per household rose
from $91,500 in 2001 to $149,500 in 2007. With a simple flourish of a pen on paper,
millions of Americans traded away decades of equity tucked away in their homes.
Under the radar, the lending and the financial services industry had mutated. In the past,
lenders had avoided making unsound loans because they would be stuck with them in
their loan portfolios. But because of the growth of securitization, it wasn’t even clear
anymore who the lender was. The mortgages would be packaged, sliced, repackaged,
insured, and sold as incomprehensibly complicated debt securities to an assortment of
hungry investors. Now, even the worst loans could find a buyer.
More loan sales meant higher profits for everyone in the chain. Business boomed for
Christopher Cruise, a Maryland-based corporate educator who trained loan officers for
companies that were expanding mortgage originations. He crisscrossed the nation,
coaching about 10,000 loan originators a year in auditoriums and classrooms. His clients
included many of the largest lenders – Countrywide, Ameriquest, and Ditech among
them. Most of their new hires were young, with no mortgage experience, fresh out of
school and with previous jobs “flipping burgers,” he told the FCIC. Given the right
training, however, the best of them could “easily” earn millions.
On Wall Street, where many of these loans were packaged into securities and sold to
investors around the globe, a new term was coined: IBGYBG, “I’ll be gone, you’ll be
gone.” It referred to deals that brought in big fees up front while risking much larger
losses in the future. And, for a long time, IBGYBG worked at every level.
Most home loans entered the pipeline soon after borrowers signed the documents and
picked up their keys. Loans were put into packages and sold off in bulk to securitization
firms – including investment banks such as Merrill Lynch, Bear Stearns, and Lehman
Brothers, and commercial banks and thrifts such as Citibank, Wells Fargo, and
Washington Mutual. The firms would package the loans into residential mortgage
backed securities that would mostly be stamped with triple-A ratings by the credit rating
agencies, and sold to investors. In many cases, the securities were repackaged again
into collateralized debt obligations (CDOs) – often composed of the riskier portions of
these securities – which would then be sold to other investors. Most of these securities
would also receive the coveted triple-A ratings that investors believed attested to their
quality and safety. Some investors would buy an invention from the 1990s called a credit
default swap (CDS) to protect against the securities’ defaulting. For every buyer of a
credit default swap, there was a seller: as these investors made opposing bets, the
layers of entanglement in the securities market increased.
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VII. Complexity Grows
The instruments grew more and more complex; CDOs were constructed out of CDOs,
creating CDOs squared. When firms ran out of real product, they started generating
cheaper-to-produce synthetic CDOs – composed not of real mortgage securities but just
of bets on other mortgage products. Each new permutation created an opportunity to
extract more fees and trading profits. And each new layer brought in more investors
wagering on the mortgage market – even well after the market had started to turn. So by
the time the process was complete, a mortgage on a home in south Florida might
become part of dozens of securities owned by hundreds of investors – or parts of bets
being made by hundreds more. Treasury Secretary Timothy Geithner, the president of
the New York Federal Reserve Bank during the crisis, described the resulting product as
“cooked spaghetti” that became hard to “untangle.”
Ralph Cioffi spent several years creating CDOs for Bear Stearns and a couple of more
years on the repurchase or “repo” desk, which was responsible for borrowing money
every night to finance Bear Stearns’s broader securities portfolio. In September 2003,
Cioffi created a hedge fund within Bear Stearns with a minimum investment of $1 million.
As was common, he used borrowed money – up to $9 borrowed for every $1 from
investors – to buy CDOs. Cioffi’s first fund was extremely successful; it earned 17% for
investors in 2004 and 10% in 2005 – after the annual management fee and the 20%
slice of the profit for Cioffi and his Bear Stearns team – and grew to almost $9 billion by
the end of 2005. In the fall of 2006, he created another, more aggressive fund. This one
would shoot for leverage of up to 12 to 1. By the end of 2006, the two hedge funds had
$18 billion invested, half in securities issued by CDOs centered on housing. As a CDO
manager, Cioffi also managed another $18 billion of mortgage-related CDOs for other
Cioffi’s investors and others like them wanted high-yielding mortgage securities. That, in
turn, required high-yielding mortgages. An advertising barrage bombarded potential
borrowers, urging them to buy or refinance homes. Direct-mail solicitations flooded
people’s mailboxes. Dancing figures, depicting happy homeowners, boogied on
computer monitors. Telephones began ringing off the hook with calls from loan officers
offering the latest loan products: One percent loan! (But only for the first year.) No
money down! (Leaving no equity if home prices fell.) No income documentation needed!
(Mortgages soon dubbed “liar loans” by the industry itself.) Borrowers answered the call,
many believing that with ever-rising prices, housing was the investment that couldn’t
In Washington, four intermingled issues came into play that made it difficult to
acknowledge the looming threats. First, efforts to boost homeownership had broad
political support – from Presidents Bill Clinton and George W. Bush and successive
Congresses – even though in reality the homeownership rate had peaked in the spring
of 2004. Second, the real estate boom was generating a lot of cash on Wall Street and
creating a lot of jobs in the housing industry at a time when performance in other sectors
of the economy was dreary. Third, many top officials and regulators were reluctant to
challenge the profitable and powerful financial industry. And finally, policy makers
believed that even if the housing market tanked, the broader financial system and
economy would hold up.
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As the mortgage market began its transformation in the late 1990s, consumer advocates
and front-line local government officials were among the first to spot the changes:
homeowners began streaming into their offices to seek help in dealing with mortgages
they could not afford to pay. They began raising the issue with the Federal Reserve and
other banking regulators. Bob Gnaizda, the general counsel and policy director of the
Greenlining Institute, a California-based nonprofit housing group, told the Commission
that he began meeting with Greenspan at least once a year starting in 1999, each time
highlighting to him the growth of predatory lending practices and discussing with him the
social and economic problems they were creating.
One of the first places to see the bad lending practices envelop an entire market was
Cleveland, Ohio. From 1989 to 1999, home prices in Cleveland rose 66%, climbing from
a median of $75,200 to $125,100, while home prices nationally rose about 49% in those
same years; at the same time, the city’s unemployment rate, ranging from 5.8% in 1990
to 4.2% in 1999, more or less tracked the broader U.S. pattern. James Rokakis, the
longtime county treasurer of Cuyahoga County, where Cleveland is located, told the
Commission that the region’s housing market was juiced by “flipping on mega-steroids,”
with rings of real estate agents, appraisers, and loan originators earning fees on each
transaction and feeding the securitized loans to Wall Street. City officials began to hear
reports that these activities were being propelled by new kinds of nontraditional loans
that enabled investors to buy properties with little or no money down and gave
homeowners the ability to refinance their houses, regardless of whether they could
afford to repay the loans. Foreclosures shot up in Cuyahoga County from 3,500 a year in
1995 to 7,000 a year in 2000. Rokakis and other public officials watched as families who
had lived for years in modest residences lost their homes. After they were gone, many
homes were ultimately abandoned, vandalized, and then stripped bare, as scavengers
ripped away their copper pipes and aluminum siding to sell for scrap.
“Securitization was one of the most brilliant financial innovations of the 20th century,”
Rokakis told the Commission. “It freed up a lot of capital. If it had been done responsibly,
it would have been a wondrous thing because nothing is more stable, there’s nothing
safer, than the American mortgage market. . . . It worked for years. But then people
realized they could scam it.”
Officials in Cleveland and other Ohio cities reached out to the federal government for
help. They asked the Federal Reserve, the one entity with the authority to regulate risky
lending practices by all mortgage lenders, to use the power it had been granted in 1994
under the Home Ownership and Equity Protection Act (HOEPA) to issue new mortgage
lending rules. In March 2001, Fed Governor Edward Gramlich, an advocate for
expanding access to credit but only with safeguards in place, attended a conference on
the topic in Cleveland. He spoke about the Fed’s power under HOEPA, declared some
of the lending practices to be “clearly illegal,” and said they could be “combated with
legal enforcement measures.”
In 2000, when Cleveland was looking for help from the federal government, other cities
around the country were doing the same. John Taylor, the president of the National
Community Reinvestment Coalition, with the support of community leaders from
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Nevada, Michigan, Maryland, Delaware, Chicago, Vermont, North Carolina, New Jersey,
and Ohio, went to the Office of Thrift Supervision (OTS), which regulated savings and
loan institutions, asking the agency to crack down on what they called “exploitative”
practices they believed were putting both borrowers and lenders at risk.
The California Reinvestment Coalition, a nonprofit housing group based in Northern
California, also begged regulators to act, CRC officials told the Commission. The
nonprofit group had reviewed the loans of 125 borrowers and discovered that many
individuals were being placed into high-cost loans when they qualified for better
mortgages and that many had been misled about the terms of their loans.
There were government reports, too. The Department of Housing and Urban
Development and the Treasury Department issued a joint report on predatory lending in
June 2000 that made a number of recommendations for reducing the risks to borrowers.
In December 2001, the Federal Reserve Board used the HOEPA law to amend some
regulations; among the changes were new rules aimed at limiting high interest lending
and preventing multiple refinancings over a short period of time, if they were not in the
borrower’s best interest. As it would turn out, those rules covered only 1% of subprime
loans. FDIC Chairman Sheila C. Bair, then an assistant treasury secretary in the
administration of President George W. Bush, characterized the action to the FCIC as
addressing only a “narrow range of predatory lending issues.” In 2002, Gramlich noted
again the “increasing reports of abusive, unethical and in some cases, illegal, lending
Bair told the Commission that this was when “really poorly underwritten loans, the
payment shock loans” were beginning to proliferate, placing “pressure” on traditional
banks to follow suit. She said that she and Gramlich considered seeking rules to rein in
the growth of these kinds of loans, but Gramlich told her that he thought the Fed, despite
its broad powers in this area, would not support the effort. Instead, they sought voluntary
rules for lenders, but that effort fell by the wayside as well.
In an environment of minimal government restrictions, the number of nontraditional loans
surged and lending standards declined. The companies issuing these loans made profits
that attracted envious eyes. New lenders entered the field. Investors clamored for
mortgage-related securities and borrowers wanted mortgages. The volume of subprime
and nontraditional lending rose sharply. In 2000, the top 25 nonprime lenders originated
$105 billion in loans. Their volume rose to $188 billion in 2002, and then $310 billion in
California, with its high housing costs, was a particular hotbed for this kind of lending. In
2001, nearly $52 billion, or 25% of all nontraditional loans nationwide, were made in that
state; California’s share rose to 35% by 2003, with these kinds of loans growing to $95
billion or by 84% in California in just two years. In those years, “subprime and option
ARM loans saturated California communities,” Kevin Stein, the associate director of the
California Reinvestment Coalition, testified to the Commission. “We estimated at that
time that the average subprime borrower in California was paying over $600 more per
month on their mortgage payment as a result of having received the subprime loan.”
Gail Burks, president and CEO of Nevada Fair Housing, Inc., a Las Vegas–based
housing clinic, told the Commission she and other groups took their concerns directly to
Greenspan at this time, describing to him in person what she called the “metamorphosis”
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in the lending industry. She told him that besides predatory lending practices such as
flipping loans or misinforming seniors about reverse mortgages, she also witnessed
examples of growing sloppiness in paperwork: not crediting payments appropriately or
miscalculating accounts.
Lisa Madigan, the attorney general in Illinois, also spotted the emergence of a troubling
trend. She joined state attorneys general from Minnesota, California, Washington,
Arizona, Florida, New York, and Massachusetts in pursuing allegations about First
Alliance Mortgage Company, a California-based mortgage lender. Consumers
complained that they had been deceived into taking out loans with hefty fees. The
company was then packaging the loans and selling them as securities to Lehman
Brothers, Madigan said. The case was settled in 2002, and borrowers received $50
million. First Alliance went out of business. But other firms stepped into the void.
State officials from around the country joined together again in 2003 to investigate
another fast-growing lender, California-based Ameriquest. It became the nation’s largest
subprime lender, originating $39 billion in subprime loans in 2003 – mostly refinances
that let borrowers take cash out of their homes, but with hefty fees that ate away at their
equity. Madigan testified to the FCIC, “Our multistate investigation of Ameriquest
revealed that the company engaged in the kinds of fraudulent practices that other
predatory lenders subsequently emulated on a wide scale: inflating home appraisals;
increasing the interest rates on borrowers’ loans or switching their loans from fixed to
adjustable interest rates at closing; and promising borrowers that they could refinance
their costly loans into loans with better terms in just a few months or a year, even when
borrowers had no equity to absorb another refinance.”
Ed Parker, the former head of Ameriquest’s Mortgage Fraud Investigations Department,
told the Commission that he detected fraud at the company within one month of starting
his job there in January 2003, but senior management did nothing with the reports he
sent. He heard that other departments were complaining he “looked too much” into the
loans. In November 2005, he was downgraded from “manager” to “supervisor,” and was
laid off in May 2006.
In late 2003, Prentiss Cox, then a Minnesota assistant attorney general, asked
Ameriquest to produce information about its loans. He received about 10 boxes of
documents. He pulled one file at random, and stared at it. He pulled out another and
another. He noted file after file where the borrowers were described as “antiques
dealers” – in his view, a blatant misrepresentation of employment. In another loan file, he
recalled in an interview with the FCIC, a disabled borrower in his 80s who used a walker
was described in the loan application as being employed in “light construction.”
“It didn’t take Sherlock Holmes to figure out this was bogus,” Cox told the Commission.
As he tried to figure out why Ameriquest would make such obviously fraudulent loans, a
friend suggested that he “look upstream.” Cox suddenly realized that the lenders were
simply generating product to ship to Wall Street to sell to investors. “I got that it had
shifted,” Cox recalled. “The lending pattern had shifted.”
Before Our Very Eyes
Ultimately, 49 states and the District of Columbia joined in the lawsuit against
Ameriquest, on behalf of “more than 240,000 borrowers.” The result was a $325 million
settlement. But during the years when the investigation was under way, between 2002
and 2005, Ameriquest originated another $217.9 billion in loans, which then flowed to
Wall Street for securitization.
Although the federal government played no role in the Ameriquest investigation, some
federal officials said they had followed the case. At the Department of Housing and
Urban Development, “we began to get rumors” that other firms were “running wild, taking
applications over the Internet, not verifying peoples’ income or their ability to have a job,”
recalled Alphonso Jackson, the HUD secretary from 2004 to 2008, in an interview with
the Commission. “Everybody was making a great deal of money . . . and there wasn’t a
great deal of oversight going on.” Although he was the nation’s top housing official at the
time, he placed much of the blame on Congress.
Cox, the former Minnesota prosecutor, and Madigan, the Illinois attorney general, told
the Commission that one of the single biggest obstacles to effective state regulation of
unfair lending came from the federal government, particularly the Office of the
Comptroller of the Currency (OCC), which regulated nationally chartered banks –
including Bank of America, Citibank, and Wachovia – and the OTS, which regulated
nationally chartered thrifts. The OCC and OTS issued rules preempting states from
enforcing rules against national banks and thrifts. Cox recalled that in 2001, Julie
Williams, the chief counsel of the OCC, had delivered what he called a “lecture” to the
states’ attorneys general, in a meeting in Washington, warning them that the OCC would
“quash” them if they persisted in attempting to control the consumer practices of
nationally regulated institutions.
Two former OCC comptrollers, John Hawke and John Dugan, told the Commission that
they were defending the agency’s constitutional obligation to block state efforts to
impinge on federally created entities. Because state-chartered lenders had more lending
problems, they said, the states should have been focusing there rather than looking to
involve themselves in federally chartered institutions, an arena where they had no
jurisdiction. However, Madigan told the Commission that national banks funded 21 of the
25 largest subprime loan issuers operating with state charters, and that those banks
were the end market for abusive loans originated by the state-chartered firms. She noted
that the OCC was “particularly zealous in its efforts to thwart state authority over national
lenders, and lax in its efforts to protect consumers from the coming crisis.”
Many states nevertheless pushed ahead in enforcing their own lending regulations, as
did some cities. In 2003, Charlotte, North Carolina–based Wachovia Bank told state
regulators that it would not abide by state laws, because it was a national bank and fell
under the supervision of the OCC. Michigan protested Wachovia’s announcement, and
Wachovia sued Michigan. The OCC, the American Bankers Association, and the
Mortgage Bankers Association entered the fray on Wachovia’s side; the other 49 states,
Puerto Rico, and the District of Columbia aligned themselves with Michigan. The legal
battle lasted four years. The Supreme Court ruled 5-3 in Wachovia’s favor on April 17,
2007, leaving the OCC its sole regulator for mortgage lending. Cox criticized the federal
government: “Not only were they negligent, they were aggressive players attempting to
stop any enforcement action[s]. . . . Those guys should have been on our side.”
Before Our Very Eyes
Nonprime lending surged to $730 billion in 2004 and then $1.0 trillion in 2005, and its
impact began to be felt in more and more places. Many of those loans were funneled
into the pipeline by mortgage brokers – the link between borrowers and the lenders who
financed the mortgages – who prepared the paperwork for loans and earned fees from
lenders for doing it. More than 200,000 new mortgage brokers began their jobs during
the boom, and some were less than honorable in their dealings with borrowers.
According to an investigative news report published in 2008, between 2000 and 2007, at
least 10,500 people with criminal records entered the field in Florida, for example,
including 4,065 who had previously been convicted of such crimes as fraud, bank
robbery, racketeering, and extortion. J. Thomas Cardwell, the commissioner of the
Florida Office of Financial Regulation, told the Commission that “lax lending standards”
and a “lack of accountability . . . created a condition in which fraud flourished.” Marc S.
Savitt, a past president of the National Association of Mortgage Brokers, told the
Commission that while most mortgage brokers looked out for borrowers’ best interests
and steered them away from risky loans, about 50,000 of the newcomers to the field
nationwide were willing to do whatever it took to maximize the number of loans they
made. He added that some loan origination firms, such as Ameriquest, were “absolutely”
In Bakersfield, California, where home starts doubled and home values grew even faster
between 2001 and 2006, the real estate appraiser Gary Crabtree initially felt pride that
his birthplace, 110 miles north of Los Angeles, “had finally been discovered” by other
Californians. The city, a farming and oil industry center in the San Joaquin Valley, was
drawing national attention for the pace of its development. Wide-open farm fields were
plowed under and divided into thousands of building lots. Home prices jumped 11% in
Bakersfield in 2002, 17% in 2003, 32% in 2004, and 29% more in 2005.
Crabtree, an appraiser for 48 years, started in 2003 and 2004 to think that things were
not making sense. People were paying inflated prices for their homes, and they didn’t
seem to have enough income to pay for what they had bought. Within a few years, when
he passed some of these same houses, he saw that they were vacant. “For sale” signs
appeared on the front lawns. And when he passed again, the yards were untended and
the grass was turning brown. Next, the houses went into foreclosure, and that’s when he
noticed that the empty houses were being vandalized, which pulled down values for the
new suburban subdivisions.
The Cleveland phenomenon had come to Bakersfield, a place far from the Rust Belt.
Crabtree watched as foreclosures spread like an infectious disease through the
community. Houses fell into disrepair and neighborhoods disintegrated.
Crabtree began studying the market. In 2006, he ended up identifying what he believed
were 214 fraudulent transactions in Bakersfield; some, for instance, were allowing
insiders to siphon cash from each property transfer. The transactions involved many of
the nation’s largest lenders. One house, for example, was listed for sale for $565,000,
and was recorded as selling for $605,000 with 100% financing, though the real estate
agent told Crabtree that it actually sold for $535,000. Crabtree realized that the gap
between the sales price and loan amount allowed these insiders to pocket $70,000. The
terms of the loan required the buyer to occupy the house, but it was never occupied. The
house went into foreclosure and was sold in a distress sale for $322,000.
Before Our Very Eyes
Crabtree began calling lenders to tell them what he had found; but to his shock, they did
not seem to care. He finally reached one quality assurance officer at Fremont
Investment & Loan, the nation’s eighth-largest subprime lender. “Don’t put your nose
where it doesn’t belong,” he was told.
Crabtree took his story to state law enforcement officials and to the Federal Bureau of
Investigation. “I was screaming at the top of my lungs,” he said. He grew infuriated at the
slow pace of enforcement and at prosecutors’ lack of response to a problem that was
wreaking economic havoc in Bakersfield.
At the Washington, D.C., headquarters of the FBI, Chris Swecker, an assistant director,
was also trying to get people to pay attention to mortgage fraud. “It has the potential to
be an epidemic,” he said at a news conference in Washington in 2004. “We think we can
prevent a problem that could have as much impact as the S&L crisis.”
Swecker called another news conference in December 2005 to say the same thing, this
time adding that mortgage fraud was a “pervasive problem” that was “on the rise.” He
was joined by officials from HUD, the U.S. Postal Service, and the Internal Revenue
Service. The officials told reporters that real estate and banking executives were not
doing enough to root out mortgage fraud and that lenders needed to do more to “police
their own organizations.”
Meanwhile, the number of cases of reported mortgage fraud continued to swell.
Suspicious activity reports, also known as SARs, are reports filed by banks to the
Financial Crimes Enforcement Network (FinCEN), a bureau within the Treasury
Department. In November 2006, the network published an analysis that found a 20-fold
increase in mortgage fraud reports between 1996 and 2005. According to FinCEN, the
figures likely represented a substantial underreporting, because two-thirds of all the
loans being created were originated by mortgage brokers who were not subject to any
federal standard or oversight. In addition, many lenders who were required to submit
reports did not in fact do so.
“The claim that no one could have foreseen the crisis is false,” said William K. Black, an
expert on white-collar crime and a former staff director of the National Commission on
Financial Institution Reform, Recovery and Enforcement, created by Congress in 1990
as the savings and loan crisis was unfolding.
Former attorney general Alberto Gonzales, who served from February 2005 to 2007, told
the FCIC he could not remember the press conferences or news reports about mortgage
fraud. Both Gonzales and his successor Michael Mukasey, who served as attorney
general in 2007 and 2008, told the FCIC that mortgage fraud had never been
communicated to them as a top priority. “National security . . . was an overriding”
concern, Mukasey said.
To community activists and local officials, however, the lending practices were a matter
of national economic concern. Ruhi Maker, a lawyer who worked on foreclosure cases at
the Empire Justice Center in Rochester, New York, told Fed Governors Bernanke,
Susan Bies, and Roger Ferguson in October 2004 that she suspected that some
investment banks – she specified Bear Stearns and Lehman Brothers – were producing
such bad loans that the very survival of the firms was put in question. “We repeatedly
see false appraisals and false income,” she told the Fed officials, who were gathered at
the public hearing period of a Consumer Advisory Council meeting. She urged the Fed
to prod the Securities and Exchange Commission to examine the quality of the firms’
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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.
Maker told the board that she feared an “enormous economic impact” could result from a
confluence of financial events: flat or declining incomes, a housing bubble, and
fraudulent loans with overstated values.
In an interview with the FCIC, Maker said that Fed officials seemed impervious to what
the consumer advocates were saying. The Fed governors politely listened and said little,
she recalled. “They had their economic models, and their economic models did not see
this coming,” she said. “We kept getting back, ‘This is all anecdotal.’”
Soon nontraditional mortgages were crowding other kinds of products out of the market
in many parts of the country. More mortgage borrowers nationwide took out interest-only
loans, and the trend was far more pronounced on the West and East Coasts. Because of
their easy credit terms, nontraditional loans enabled borrowers to buy more expensive
homes and ratchet up the prices in bidding wars. The loans were also riskier, however,
and a pattern of higher foreclosure rates frequently appeared soon after.
As home prices shot up in much of the country, many observers began to wonder if the
country was witnessing a housing bubble. On June 18, 2005, the Economist magazine’s
cover story posited that the day of reckoning was at hand, with the headline “House
Prices: After the Fall.” The illustration depicted a brick plummeting out of the sky. “It is
not going to be pretty,” the article declared. “How the current housing boom ends could
decide the course of the entire world economy over the next few years.”
That same month, Fed Chairman Greenspan acknowledged the issue, telling the Joint
Economic Committee of the U.S. Congress that “the apparent froth in housing markets
may have spilled over into the mortgage markets.” For years, he had warned that Fannie
Mae and Freddie Mac, bolstered by investors’ belief that these institutions had the
backing of the U.S. government, were growing so large, with so little oversight, that they
were creating systemic risks for the financial system. Still, he reassured legislators that
the U.S. economy was on a “reasonably firm footing” and that the financial system would
be resilient if the housing market turned sour.
“The dramatic increase in the prevalence of interest-only loans, as well as the
introduction of other relatively exotic forms of adjustable rate mortgages, are
developments of particular concern,” he testified in June:
To be sure, these financing vehicles have their appropriate uses. But to
the extent that some households may be employing these instruments to
purchase a home that would otherwise be unaffordable, their use is
beginning to add to the pressures in the marketplace. . . .
Although we certainly cannot rule out home price declines, especially in
some local markets, these declines, were they to occur, likely would not
have substantial macroeconomic implications. Nationwide banking and
widespread securitization of mortgages makes it less likely that financial
intermediation would be impaired than was the case in prior episodes of
regional house price corrections.
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Indeed, Greenspan would not be the only one confident that a housing downturn would
leave the broader financial system largely unscathed. As late as March 2007, after
housing prices had been declining for a year, Bernanke testified to Congress that “the
problems in the subprime market were likely to be contained” – that is, he expected little
spillover to the broader economy.
Some were less sanguine. For example, the consumer lawyer Sheila Canavan, of Moab,
Utah, informed the Fed’s Consumer Advisory Council in October 2005 that 61% of
recently originated loans in California were interest-only, a proportion that was more than
twice the national average. “That’s insanity,” she told the Fed governors. “That means
we’re facing something down the road that we haven’t faced before and we are going to
be looking at a safety and soundness crisis.”
On another front, some academics offered pointed analyses as they raised alarms. For
example, in August 2005, the Yale professor Robert Shiller, who along with Karl Case
developed the Case-Shiller Index, charted home prices to illustrate how precipitously
they had climbed and how distorted the market appeared in historical terms. Shiller
warned that the housing bubble would likely burst.
In that same month, a conclave of economists gathered at Jackson Lake Lodge in
Wyoming, in a conference center nestled in Grand Teton National Park. It was a “who’s
who of central bankers,” recalled Raghuram Rajan, who was then on leave from the
University of Chicago’s business school while serving as the chief economist of the
International Monetary Fund. Greenspan was there, and so was Bernanke. Jean-Claude
Trichet, the president of the European Central Bank, and Mervyn King, the governor of
the Bank of England, were among the other dignitaries.
Rajan presented a paper with a provocative title: “Has Financial Development Made the
World Riskier?” He posited that executives were being overcompensated for short-term
gains but let off the hook for any eventual losses – the IBGYBG syndrome. Rajan added
that investment strategies such as credit default swaps could have disastrous
consequences if the system became unstable, and that regulatory institutions might be
unable to deal with the fallout.
He recalled to the FCIC that he was treated with scorn. Lawrence Summers, a former
U.S. treasury secretary who was then president of Harvard University, called Rajan a
“Luddite,” implying that he was simply opposed to technological change. “I felt like an
early Christian who had wandered into a convention of half-starved lions,” Rajan wrote
Susan M. Wachter, a professor of real estate and finance at the University of
Pennsylvania’s Wharton School, prepared a research paper in 2003 suggesting that the
United States could have a real estate crisis similar to that suffered in Asia in the 1990s.
When she discussed her work at another Jackson Hole gathering two years later, it
received a chilly reception, she told the Commission. “It was universally panned,” she
said, and an economist from the Mortgage Bankers Association called it “absurd.”
In 2005, news reports were beginning to highlight indications that the real estate market
was weakening. Home sales began to drop, and Fitch Ratings reported signs that
mortgage delinquencies were rising. That year, the hedge fund manager Mark Klipsch of
Before Our Very Eyes
Orix Credit Corp. told participants at the American Securitization Forum, a securities
trade group, that investors had become “over optimistic” about the market. “I see a lot of
irrationality,” he added. He said he was unnerved because people were saying, “It’s
different this time” – a rationale commonly heard before previous collapses.
Some real estate appraisers had also been expressing concerns for years. From 2000 to
2007 a coalition of appraisal organizations circulated and ultimately delivered to
Washington officials a public petition; signed by 11,000 appraisers and including the
name and address of each, it charged that lenders were pressuring appraisers to place
artificially high prices on properties. According to the petition, lenders were “blacklisting
honest appraisers” and instead assigning business only to appraisers who would hit the
desired price targets. “The powers that be cannot claim ignorance,” the appraiser Dennis
J. Black of Port Charlotte, Florida, testified to the Commission.
The appraiser Karen Mann of Discovery Bay, California, another industry veteran, told
the Commission that lenders had opened subsidiaries to perform appraisals, allowing
them to extract extra fees from “unknowing” consumers and making it easier to inflate
home values. The steep hike in home prices and the unmerited and inflated appraisals
she was seeing in Northern California convinced her that the housing industry was
headed for a cataclysmic downturn. In 2005, she laid off some of her staff in order to cut
her overhead expenses, in anticipation of the coming storm; two years later, she shut
down her office and began working out of her home.
Despite all the signs that the housing market was slowing, Wall Street just kept going
and going – ordering up loans, packaging them into securities, taking profits, earning
bonuses. By the third quarter of 2006, home prices were falling and mortgage
delinquencies were rising, a combination that spelled trouble for mortgage-backed
securities. But from the third quarter of 2006 on, banks created and sold some $1.3
trillion in mortgage-backed securities and more than $350 billion in mortgage related
Not everyone on Wall Street kept applauding, however. Some executives were urging
caution, as corporate governance and risk management were breaking down. Reflecting
on the causes of the crisis, Jamie Dimon, CEO of JP Morgan testified to the FCIC, “I
blame the management teams 100% and . . . no one else.”
At too many financial firms, management brushed aside the growing risks to their firms.
At Lehman Brothers, for example, Michael Gelband, the head of fixed income, and his
colleague Madelyn Antoncic warned against taking on too much risk in the face of
growing pressure to compete aggressively against other investment banks. Antoncic,
who was the firm’s chief risk officer from 2004 to 2007, was shunted aside: “At the senior
level, they were trying to push so hard that the wheels started to come off,” she told the
Commission. She was reassigned to a policy position working with government
regulators. Gelband left; Lehman officials blamed Gelband’s departure on “philosophical
At Citigroup, meanwhile, Richard Bowen, a veteran banker in the consumer lending
group, received a promotion in early 2006 when he was named business chief under
writer. He would go on to oversee loan quality for over $90 billion a year of mortgages
underwritten and purchased by CitiFinancial. These mortgages were sold to Fannie
Before Our Very Eyes
Mae, Freddie Mac, and others. In June 2006, Bowen discovered that as much as 60% of
the loans that Citi was buying were defective. They did not meet Citigroup’s loan
guidelines and thus endangered the company – if the borrowers were to default on their
loans, the investors could force Citi to buy them back. Bowen told the Commission that
he tried to alert top managers at the firm by “email, weekly reports, committee
presentations, and discussions”; but though they expressed concern, it “never translated
into any action.” Instead, he said, “there was a considerable push to build volumes, to
increase market share.” Indeed, Bowen recalled, Citi began to loosen its own standards
during these years up to 2005: specifically, it started to purchase stated-income loans.
“So we joined the other lemmings headed for the cliff,” he said in an interview with the
He finally took his warnings to the highest level he could reach – Robert Rubin, the
chairman of the Executive Committee of the Board of Directors and a former U.S.
treasury secretary in the Clinton administration, and three other bank officials. He sent
Rubin and the others a memo with the words “URGENT – READ IMMEDIATELY” in the
subject line. Sharing his concerns, he stressed to top managers that Citi faced billions of
dollars in losses if investors were to demand that Citi repurchase the defective loans.
Rubin told the Commission in a public hearing in April 2010 that Citibank handled the
Bowen matter promptly and effectively. “I do recollect this and that either I or somebody
else, and I truly do not remember who, but either I or somebody else sent it to the
appropriate people, and I do know factually that that was acted on promptly and actions
were taken in response to it.” According to Citigroup, the bank undertook an investigation
in response to Bowen’s claims and the system of underwriting reviews was revised.
Bowen told the Commission that after he alerted management by sending emails, he
went from supervising 220 people to supervising only 2, his bonus was reduced, and he
was downgraded in his performance review.
Some industry veterans took their concerns directly to government officials. J. Kyle
Bass, a Dallas-based hedge fund manager and a former Bear Stearns executive,
testified to the FCIC that he told the Federal Reserve that he believed the housing
securitization market to be on a shaky foundation. “Their answer at the time was, and
this was also the thought that was – that was homogeneous throughout Wall Street’s
analysts – was home prices always track income growth and jobs growth. And they
showed me income growth on one chart and jobs growth on another, and said, ‘We don’t
see what you’re talking about because incomes are still growing and jobs are still
growing.’ And I said, well, you obviously don’t realize where the dog is and where the tail
is, and what’s moving what.”
Even those who had profited from the growth of nontraditional lending practices said
they became disturbed by what was happening. Herb Sandler, the co-founder of the
mortgage lender Golden West Financial Corporation, which was heavily loaded with
option ARM loans, wrote a letter to officials at the Federal Reserve, the FDIC, the OTS,
and the OCC warning that regulators were “too dependent” on ratings agencies and
“there is a high potential for gaming when virtually any asset can be churned through
securitization and transformed into a AAA-rated asset, and when a multi-billion dollar
industry is all too eager to facilitate this alchemy.”
Before Our Very Eyes
Similarly, Lewis Ranieri, a mortgage finance veteran who helped engineer the Wall
Street mortgage securitization machine in the 1980s, said he didn’t like what he called
“the madness” that had descended on the real estate market. Ranieri told the
Commission, “I was not the only guy. I’m not telling you I was John the Baptist. There
were enough of us, analysts and others, wandering around going ‘look at this stuff,’ that
it would be hard to miss it.” Ranieri’s own Houston-based Franklin Bank Corporation
would itself collapse under the weight of the financial crisis in November 2008.
Other industry veterans inside the business also acknowledged that the rules of the
game were being changed. “Poison” was the word famously used by Countrywide’s
Mozilo to describe one of the loan products his firm was originating. “In all my years in
the business I have never seen a more toxic [product],” he wrote in an internal email.
Others at the bank argued in response that they were offering products “pervasively
offered in the marketplace by virtually every relevant competitor of ours.” Still, Mozilo
was nervous. “There was a time when savings and loans were doing things because
their competitors were doing it,” he told the other executives. “They all went broke.”
In late 2005, regulators decided to take a look at the changing mortgage market. Sabeth
Siddique, the assistant director for credit risk in the Division of Banking Supervision and
Regulation at the Federal Reserve Board, was charged with investigating how broadly
loan patterns were changing. He took the questions directly to large banks in 2005 and
asked them how many of which kinds of loans they were making. Siddique found the
information he received “very alarming,” he told the Commission. In fact, nontraditional
loans made up 59% percent of originations at Countrywide, 58% percent at Wells Fargo,
51% at National City, 31% at Washington Mutual, 26.5% at CitiFinancial, and 18.3% at
Bank of America. Moreover, the banks expected that their originations of nontraditional
loans would rise by 17% in 2005, to $608.5 billion. The review also noted the “slowly
deteriorating quality of loans due to loosening underwriting standards.” In addition, it
found that two-thirds of the nontraditional loans made by the banks in 2003 had been of
the stated-income, minimal documentation variety known as liar loans, which had a
particularly great likelihood of going sour.
The reaction to Siddique’s briefing was mixed. Federal Reserve Governor Bies recalled
the response by the Fed governors and regional board directors as divided from the
beginning. “Some people on the board and regional presidents . . . just wanted to come
to a different answer. So they did ignore it, or the full thrust of it,” she told the
The OCC was also pondering the situation. Former comptroller of the currency John C.
Dugan told the Commission that the push had come from below, from bank examiners
who had become concerned about what they were seeing in the field.
The agency began to consider issuing “guidance,” a kind of nonbinding official warning
to banks, that nontraditional loans could jeopardize safety and soundness and would
invite scrutiny by bank examiners. Siddique said the OCC led the effort, which became a
multiagency initiative.
Bies said that deliberations over the potential guidance also stirred debate within the
Fed, because some critics feared it both would stifle the financial innovation that was
bringing record profits to Wall Street and the banks and would make homes less
affordable. Moreover, all the agencies – the Fed, the OCC, the OTS, the FDIC, and the
Before Our Very Eyes
National Credit Union Administration – would need to work together on it, or it would
unfairly block one group of lenders from issuing types of loans that were available from
other lenders. The American Bankers Association and Mortgage Bankers Association
opposed it as regulatory overreach.
“The bankers pushed back,” Bies told the Commission. “The members of Congress
pushed back. Some of our internal people at the Fed pushed back.”
The Mortgage Insurance Companies of America, which represents mortgage insurance
companies, weighed in on the other side. “We are deeply concerned about the contagion
effect from poorly underwritten or unsuitable mortgages and home equity loans,” the
trade association wrote to regulators in 2006. “The most recent market trends show
alarming signs of undue risk-taking that puts both lenders and consumers at risk.”
In congressional testimony about a month later, William A. Simpson, the group’s vice
president, pointedly referred to past real estate downturns. “We take a conservative
position on risk because of our first loss position,” Simpson informed the Senate
Subcommittee on Housing, Transportation and Community Development and the Senate
Subcommittee on Economic Policy. “However, we also have a historical perspective. We
were there when the mortgage markets turned sharply down during the mid-1980s
especially in the oil patch and the early 1990s in California and the Northeast.”
Within the Fed, the debate grew heated and emotional, Siddique recalled. “It got very
personal,” he told the Commission. The ideological turf war lasted more than a year,
while the number of nontraditional loans kept growing and growing.
Consumer advocates kept up the heat. In a Fed Consumer Advisory Council meeting in
March 2006, Fed Governors Bernanke, Mark Olson, and Kevin Warsh were specifically
and publicly warned of dangers that nontraditional loans posed to the economy. Stella
Adams, the executive director of the North Carolina Fair Housing Center, raised
concerns that nontraditional lending “may precipitate a downward spiral that starts on the
coast and then creates panic in the east that could have implications on our total
economy as well.”
At the next meeting of the Fed’s Consumer Advisory Council, held in June 2006 and
attended by Bernanke, Bies, Olson, and Warsh, several consumer advocates described
to the Fed governors alarming incidents that were now occurring all over the country.
Edward Sivak, the director of policy and evaluation at the Enterprise Corp. of the Delta,
in Jackson, Mississippi, spoke of being told by mortgage brokers that property values
were being inflated to maximize profit for real estate appraisers and loan originators.
Alan White, the supervising attorney at Community Legal Services in Philadelphia,
reported a “huge surge in foreclosures,” noting that up to half of the borrowers he was
seeing with troubled loans had been overcharged and given high interest rate mortgages
when their credit had qualified them for lower-cost loans. Hattie B. Dorsey, the president
and chief executive officer of Atlanta Neighborhood Development, said she worried that
houses were being flipped back and forth so much that the result would be
neighborhood “decay.” Carolyn Carter of the National Consumer Law Center in
Massachusetts urged the Fed to use its regulatory authority to “prohibit abuses in the
mortgage market.”
Before Our Very Eyes
The balance was tipping. According to Siddique, before Greenspan left his post as Fed
chairman in January 2006, he had indicated his willingness to accept the guidance.
Ferguson worked with the Fed board and the regional Fed presidents to get it done. Bies
supported it, and Bernanke did as well.
More than a year after the OCC had begun discussing the guidance, and after the
housing market had peaked, it was issued in September 2006 as an interagency
warning that affected banks, thrifts, and credit unions nationwide. Dozens of states
followed, directing their versions of the guidance to tens of thousands of state-chartered
lenders and mortgage brokers.
Then, in July 2008, long after the risky, nontraditional mortgage market had disappeared
and the Wall Street mortgage securitization machine had ground to a halt, the Federal
Reserve finally adopted new rules under HOEPA to curb the abuses about which
consumer groups had raised red flags for years – including a requirement that borrowers
have the ability to repay loans made to them.
By that time, however, the damage had been done. The total value of mortgage-backed
securities issued between 2001 and 2006 reached $13.4 trillion. There was a mountain
of problematic securities, debt, and derivatives resting on real estate assets that were far
less secure than they were thought to have been.
Just as Bernanke thought the spillovers from a housing market crash would be
contained, so too policymakers, regulators, and financial executives did not understand
how dangerously exposed major firms and markets had become to the potential
contagion from these risky financial instruments. As the housing market began to turn,
they scrambled to understand the rapid deterioration in the financial system and respond
as losses in one part of that system would ricochet to others.
By the end of 2007, most of the subprime lenders had failed or been acquired, including
New Century Financial, Ameriquest, and American Home Mortgage. In January 2008,
Bank of America announced it would acquire the ailing lender Countrywide. It soon
became clear that risk – rather than being diversified across the financial system, as had
been thought – was concentrated at the largest financial firms. Bear Stearns, laden with
risky mortgage assets and dependent on fickle short term lending, was bought by JP
Morgan with government assistance in the spring.
Before the summer was over, Fannie Mae and Freddie Mac would be put into
conservatorship. Then, in September, Lehman Brothers failed and the remaining
investment banks, Merrill Lynch, Goldman Sachs, and Morgan Stanley, struggled as
they lost the market’s confidence. AIG, with its massive credit default swap portfolio and
exposure to the subprime mortgage market, was rescued by the government. Finally,
many commercial banks and thrifts, which had their own exposures to declining
mortgage assets and their own exposures to short-term credit markets, teetered.
IndyMac had already failed over the summer; in September, Washington Mutual became
the largest bank failure in U.S. history. In October, Wachovia struck a deal to be
acquired by Wells Fargo. Citigroup and Bank of America fought to stay afloat. Before it
was over, taxpayers had committed trillions of dollars through more than two dozen
extraordinary programs to stabilize the financial system and to prop up the nation’s
largest financial institutions.
Before Our Very Eyes
The crisis that befell the country in 2008 had been years in the making. In testimony to
the Commission, former Fed chairman Greenspan defended his record and said most of
his judgments had been correct. “I was right 70% of the time but I was wrong 30% of the
time,” he told the Commission. Yet the consequences of what went wrong in the run-up
to the crisis would be enormous.
The economic impact of the crisis has been devastating. And the human devastation is
continuing. The officially reported unemployment rate hovered at almost 10% in
November 2010, but the underemployment rate, which includes those who have given
up looking for work and part-time workers who would prefer to be working full-time, was
above 17%. And the share of unemployed workers who have been out of work for more
than six months was just above 40%. Of large metropolitan areas, Las Vegas, Nevada,
and Riverside – San Bernardino, California, had the highest unemployment – their rates
were above 14%.
The loans were as lethal as many had predicted, and it has been estimated that
ultimately as many as 13 million households in the United States may lose their homes
to foreclosure. As of 2010, foreclosure rates were highest in Florida and Nevada; in
Florida, nearly 14% of loans were in foreclosure, and Nevada was not very far behind.
Nearly one-quarter of American mortgage borrowers owed more on their mortgages than
their home was worth. In Nevada, the percentage was nearly 70%. Households have
lost $11 trillion in wealth since 2006.
As Mark Zandi, the chief economist of Moody’s, testified to the
Commission, “The financial crisis has dealt a very serious blow to the U.S. economy.
The immediate impact was the Great Recession: the longest, broadest and most severe
downturn since the Great Depression of the 1930s. . . . The longer-term fallout from the
economic crisis is also very substantial. . . . It will take years for employment to regain its
pre-crisis level.”
Looking back on the years before the crisis, the economist Dean Baker said: “So much
of this was absolute public knowledge in the sense that we knew the number of loans
that were being issued with zero down. Now, do we suddenly think we have that many
more people – who are capable of taking on a loan with zero down who we think are
going to be able to pay that off than was true 10, 15, 20 years ago? I mean, what’s
changed in the world? There were a lot of things that didn’t require any investigation at
all; these were totally available in the data.”
Warren Peterson, a home builder in Bakersfield, felt that he could pinpoint when the
world changed to the day. Peterson built homes in an upscale neighborhood, and each
Monday morning, he would arrive at the office to find a bevy of real estate agents, sales
contracts in hand, vying to be the ones chosen to purchase the new homes he was
building. The stream of traffic was constant. On one Saturday in November 2005, he
was at the sales office and noticed that not a single purchaser had entered the building.
He called a friend, also in the home-building business, who said he had noticed the
same thing, and asked him what he thought about it.
“It’s over,” his friend told Peterson.
Before Our Very Eyes
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. The FCIC concluded that there were no warning signs prior to the recent economic
a) true
b) false
2. In 2004, there were a record number of Americans who owned a home. What
percentage of Americans owned a home at that time:
3. What was the characteristic of the so-called “ARM”s, mortgages that became popular
during the housing boom:
high down payments
low monthly costs when first issued
rapidly increasing rates
both b and c above
4. Why did investors during the housing bubble purchase credit default swaps:
a) the SEC mandates that firms trading in mortgage-backed securities purchase
credit default swaps to limit market volatility
b) to protect against defaults
c) to look for large profits because the returns on these instruments were huge
d) none of the above
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1. A: True is incorrect. While it may not have seemed so at the time, the FCIC
concluded that there were indeed some advance signals.
B: False is correct. The FCIC concluded that there were a number of signals that
preceded the collapse, including escalating home prices, loose lending practices,
and a lack of oversight on the financial system as a whole.
(See page 1-1 of the course material.)
2. A: Incorrect. The actual percentage of Americans who owned homes at that time was
much higher.
B: Incorrect. Even more Americans than that owned homes during a period of record
new home starts.
C: Correct. This figure represents the peak of home ownership in American history.
D: Incorrect. The figure is under 70%.
(See page 1-2 of the course material.)
3. A: Incorrect. To the contrary, most of the new products that emerged during the
housing boom featured low, if not, no down payment.
B: Incorrect. Initially, these loans had low monthly payments. However, this is not the
best answer.
C: Incorrect. Consumers of these loans could sometimes see their payments
suddenly double or triple. However, this is not the best answer.
D: Correct. Both low monthly costs when first issued and rapidly increasing rates
were features of these loans.
(See page 1-4 of the course material.)
4. A: Incorrect. These instruments were created by financial firms to reduce risk. They
were not mandated by any governmental agency.
B: Correct. The idea was to reduce the risk in the event of default.
C: Incorrect. They were merely designed to reduce risk; they were not intended to
produce large returns.
D: Incorrect. One of the responses is correct.
(See page 1-5 of the course material.)
Before Our Very Eyes
Chapter 2: Shadow Banking
I. Introduction
The financial crisis of 2007 and 2008 was not a single event, but a series of crises that
rippled through the financial system and, ultimately, the economy. Distress in one area
of the financial markets led to failures in other areas by way of interconnections and
vulnerabilities that bankers, government officials, and others had missed or dismissed.
When subprime and other risky mortgages – issued during a housing bubble that many
experts failed to identify, and whose consequences were not understood – began to
default at unexpected rates, a once-obscure market for complex investment securities
backed by those mortgages abruptly failed. When the contagion spread, investors
panicked – and the danger inherent in the whole system became manifest. Financial
markets teetered on the edge, and brand-name financial institutions were left bankrupt
or dependent on the taxpayers for survival.
Federal Reserve Chairman Ben Bernanke now acknowledges that he missed the
systemic risks. “Prospective subprime losses were clearly not large enough on their own
to account for the magnitude of the crisis,” Bernanke told the Commission. “Rather, the
system’s vulnerabilities, together with gaps in the government’s crisis-response toolkit,
were the principal explanations of why the crisis was so severe and had such
devastating effects on the broader economy.”
This part of our report explores the origins of risks as they developed in the financial
system over recent decades. It is a fascinating story with profound consequences – a
complex history that could yield its own report. Instead, we focus on four key
developments that helped shape the events that shook our financial markets and
economy. Detailed books could be written about each of them; we stick to the essentials
for understanding our specific concern, which is the recent crisis.
First, we describe the phenomenal growth of the shadow banking system – the
investment banks, most prominently, but also other financial institutions – that freely
operated in capital markets beyond the reach of the regulatory apparatus that had been
put in place in the wake of the crash of 1929 and the Great Depression.
This new system threatened the once-dominant traditional commercial banks, and they
took their grievances to their regulators and to Congress, which slowly but steadily
removed long-standing restrictions and helped banks break out of their traditional mold
and join the feverish growth. As a result, two parallel financial systems of enormous
scale emerged. This new competition not only benefited Wall Street but also seemed to
help all Americans, lowering the costs of their mortgages and boosting the returns on
their 401(k)s. Shadow banks and commercial banks were codependent competitors.
Their new activities were very profitable – and, it turned out, very risky.
Second, we look at the evolution of financial regulation. To the Federal Reserve and
other regulators, the new dual system that granted greater license to market participants
appeared to provide a safer and more dynamic alternative to the era of traditional
banking. More and more, regulators looked to financial institutions to police themselves
– “deregulation” was the label. Former Fed chairman Alan Greenspan put it this way:
“The market-stabilizing private regulatory forces should gradually displace many
Shadow Banking
cumbersome, increasingly ineffective government structures.” In the Fed’s view, if
problems emerged in the shadow banking system, the large commercial banks – which
were believed to be well-run, well-capitalized, and well-regulated despite the loosening
of their restraints – could provide vital support. And if problems outstripped the market’s
ability to right itself, the Federal Reserve would take on the responsibility to restore
financial stability. It did so again and again in the decades leading up to the recent crisis.
And, understandably, much of the country came to assume that the Fed could always
and would always save the day.
Third, we follow the profound changes in the mortgage industry, from the sleepy days
when local lenders took full responsibility for making and servicing 30-year loans to a
new era in which the idea was to sell the loans off as soon as possible, so that they
could be packaged and sold to investors around the world. New mortgage products
proliferated, and so did new borrowers. Inevitably, this became a market in which the
participants – mortgage brokers, lenders, and Wall Street firms – had a greater stake in
the quantity of mortgages signed up and sold than in their quality. We also trace the
history of Fannie Mae and Freddie Mac, publicly traded corporations established by
Congress that became dominant forces in providing financing to support the mortgage
market while also seeking to maximize returns for investors.
Fourth, we introduce some of the most arcane subjects in our report: securitization,
structured finance, and derivatives – words that entered the national vocabulary as the
financial markets unraveled through 2007 and 2008. Put simply and most pertinently,
structured finance was the mechanism by which subprime and other mortgages were
turned into complex investments often accorded triple-A ratings by credit rating agencies
whose own motives were conflicted. This entire market depended on finely honed
computer models – which turned out to be divorced from reality – and on ever-rising
housing prices. When that bubble burst, the complexity bubble also burst: the securities
almost no one understood, backed by mortgages no lender would have signed 20 years
earlier, were the first dominoes to fall in the financial sector.
A basic understanding of these four developments will bring the reader up to speed in
grasping where matters stood for the financial system in the year 2000, at the dawn of a
decade of promise and peril.
II. Commercial Paper and Repos: “Unfettered Markets”
For most of the 20th century, banks and thrifts accepted deposits and loaned that money
to home buyers or businesses. Before the Depression, these institutions were vulnerable
to runs, when reports or merely rumors that a bank was in trouble spurred depositors to
demand their cash. If the run was widespread, the bank might not have enough cash on
hand to meet depositors’ demands: runs were common before the Civil War and then
occurred in 1873, 1884, 1890, 1893, 1896, and 1907. To stabilize financial markets,
Congress created the Federal Reserve System in 1913, which acted as the lender of last
resort to banks.
Shadow Banking
But the creation of the Fed was not enough to avert bank runs and sharp contractions in
the financial markets in the 1920s and 1930s. So, in 1933 Congress passed the GlassSteagall Act, which, among other changes, established the Federal Deposit Insurance
Corporation. The FDIC insured bank deposits up to $2,500 – an amount that covered the
vast majority of deposits at the time; that limit would climb to $100,000 by 1980, where it
stayed until it was raised to $250,000 during the crisis in October 2008. Depositors no
longer needed to worry about being first in line at a troubled bank’s door. And if banks
were short of cash, they could now borrow from the Federal Reserve, even when they
could borrow nowhere else. The Fed, acting as lender of last resort, would ensure that
banks would not fail simply from a lack of liquidity.
With these backstops in place, Congress restricted banks’ activities to discourage them
from taking excessive risks, another move intended to help prevent bank failures, with
taxpayer dollars now at risk. Furthermore, Congress let the Federal Reserve cap interest
rates that banks and thrifts – also known as savings and loans, or S&Ls – could pay
depositors. This rule, known as Regulation Q, was also intended to keep institutions safe
by ensuring that competition for deposits did not get out of hand.
The system was stable as long as interest rates remained relatively steady, which they
did during the first two decades after World War II. Beginning in the late-1960s, however,
inflation started to increase, pushing up interest rates. For example, the rates that banks
paid other banks for overnight loans had rarely exceeded 6% in the decades before
1980, when it reached 20%. However, thanks to Regulation Q,1 banks and thrifts were
stuck offering roughly less than 6% on most deposits. Clearly, this was an untenable
bind for the depository institutions, which could not compete on the most basic level of
the interest rate offered on a deposit.
1. Competition
Compete with whom? In the 1970s, Merrill Lynch, Fidelity, Vanguard, and others
persuaded consumers and businesses to abandon banks and thrifts for higher returns.
These firms – eager to find new businesses, particularly after the Securities and
Exchange Commission (SEC) abolished fixed commissions on stock trades in 1975 –
created money market mutual funds that invested these depositors’ money in short-term,
safe securities such as Treasury bonds and highly rated corporate debt, and the funds
paid higher interest rates than banks and thrifts were allowed to pay. The funds
functioned like bank accounts, although with a different mechanism: customers bought
shares redeemable daily at a stable value. In 1977, Merrill Lynch introduced something
even more like a bank account: “cash management accounts,” which allowed customers
to write checks. Other money market mutual funds quickly followed.
Regulation Q is Title 12, part 217 of the United States Code of Federal Regulations. It prohibits banks from
paying interest on demand deposits in accordance with Section 11 of the Glass–Steagall Act (12 U.S.C.
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These funds differed from bank and thrift deposits in one important respect: they were
not protected by FDIC deposit insurance. Nevertheless, consumers liked the higher
interest rates, and the stature of the funds’ sponsors reassured them. The fund sponsors
implicitly promised to maintain the full $1 net asset value of a share. The funds would not
“break the buck,” in Wall Street terms. Even without FDIC insurance, depositors
considered these funds almost as safe as deposits in a bank or thrift. Business boomed,
and so was born a key player in the shadow banking industry, the less-regulated market
for capital that was growing up beside the traditional banking system. Assets in money
market mutual funds jumped from $3 billion in 1977 to more than $740 billion in 1995
and 1.8 trillion by 2000.
2. Maintaining an Edge
To maintain their edge over the insured banks and thrifts, the money market funds
needed safe, high-quality assets to invest in, and they quickly developed an appetite for
two booming markets: the “commercial paper” and “repo” markets. Through these
instruments, Merrill Lynch, Morgan Stanley, and other Wall Street investment banks
could broker and provide (for a fee) short-term financing to large corporations.
Commercial paper was unsecured corporate debt – meaning that it was backed not by a
pledge of collateral but only by the corporation’s promise to pay. These loans were
cheaper because they were short-term – less than nine months, sometimes as short as
two weeks and, eventually, as short as one day; the borrowers usually “rolled them over”
when the loan came due, and then again and again. Because only financially stable
corporations were able to issue commercial paper, it was considered a very safe
investment; companies such as General Electric and IBM, investors believed, would
always be good for the money. Corporations had been issuing commercial paper to raise
money since the beginning of the century, but the practice grew much more popular in
the 1960s.
3. Crisis
This market, though, underwent a crisis that demonstrated that capital markets, too,
were vulnerable to runs. Yet, that crisis actually strengthened the market. In 1970, the
Penn Central Transportation Company, the sixth-largest nonfinancial corporation in the
U.S., filed for bankruptcy with $200 million in commercial paper outstanding. The
railroad’s default caused investors to worry about the broader commercial paper market;
holders of that paper – the lenders – refused to roll over their loans to other corporate
borrowers. The commercial paper market virtually shut down. In response, the Federal
Reserve supported the commercial banks with almost $600 million in emergency loans
and with interest rate cuts. The Fed’s actions enabled the banks, in turn, to lend to
corporations so that they could pay off their commercial paper. After the Penn Central
crisis, the issuers of commercial paper – the borrowers – typically set up standby lines of
credit with major banks to enable them to pay off their debts should there be another
shock. These moves reassured investors that commercial paper was a safe investment.
In the 1960s, the commercial paper market jumped more than sevenfold. Then in the
1970s, it grew almost fourfold. Among the largest buyers of commercial paper were the
money market mutual funds. It seemed a win-win-win deal: the mutual funds could earn
a solid return, stable companies could borrow more cheaply, and Wall Street firms could
earn fees for putting the deals together. By 2000, commercial paper had risen to $1.6
trillion from less than $125 billion in 1980.
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The second major shadow banking market that grew significantly was the market for
repos, or repurchase agreements. Like commercial paper, repos have a long history, but
they proliferated quickly in the 1970s. Wall Street securities dealers often sold Treasury
bonds with their relatively low returns to banks and other conservative investors, while
then investing the cash proceeds of these sales in securities that paid higher interest
rates. The dealers agreed to repurchase the Treasuries – often within a day – at a
slightly higher price than that for which they sold them. This repo transaction – in
essence a loan – made it inexpensive and convenient for Wall Street firms to borrow.
Because these deals were essentially collateralized loans, the securities dealers
borrowed nearly the full value of the collateral, minus a small “haircut.” Like commercial
paper, repos were renewed, or “rolled over,” frequently. For that reason, both forms of
borrowing could be considered “hot money” – because lenders could quickly move in
and out of these investments in search of the highest returns, they could be a risky
source of funding.
The repo market, too, had vulnerabilities, but it, too, had emerged from an early crisis
stronger than ever. In 1982, two major borrowers, the securities firms Drysdale and
Lombard-Wall, defaulted on their repo obligations, creating large losses for lenders. In
the ensuing fallout, the Federal Reserve acted as lender of last resort to support a
shadow banking market. The Fed loosened the terms on which it lent Treasuries to
securities firms, leading to a 10-fold increase in its securities lending. Following this
episode, most repo participants switched to a tri-party arrangement in which a large
clearing bank acted as intermediary between borrower and lender, essentially protecting
the collateral and the funds by putting them in escrow. This mechanism would have
severe consequences in 2007 and 2008. In the 1980s, however, these new procedures
stabilized the repo market.
The new parallel banking system – with commercial paper and repo providing cheaper
financing, and money market funds providing better returns for consumers and
institutional investors – had a crucial catch: its popularity came at the expense of the
banks and thrifts. Some regulators viewed this development with growing alarm.
According to Alan Blinder, the vice chairman of the Federal Reserve from 1994 to 1996,
“We were concerned as bank regulators with the eroding competitive position of banks,
which of course would threaten ultimately their safety and soundness, due to the
competition they were getting from a variety of nonbanks – and these were mainly Wall
Street firms, that were taking deposits from them, and getting into the loan business to
some extent. So, yeah, it was a concern; you could see a downward trend in the share
of banking assets to financial assets.”
During the 1990s the shadow banking system steadily gained ground on the traditional
banking sector – and actually surpassed the banking sector for a brief time after 2000.
Banks argued that their problems stemmed from the Glass-Steagall Act. Glass-Steagall
strictly limited commercial banks’ participation in the securities markets, in part to end
the practices of the 1920s, when banks sold highly speculative securities to depositors.
In 1956, Congress also imposed new regulatory requirements on banks owned by
holding companies, in order to prevent a holding company from endangering any of its
deposit-taking banks.
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Bank supervisors monitored banks’ leverage – their assets relative to equity – because
excessive leverage endangered a bank. Leverage, used by nearly every financial
institution, amplifies returns. For example, if an investor uses $100 of his own money to
purchase a security that increases in value by 10%, he earns $10. However, if he
borrows another $900 and invests 10 times as much ($1,000), the same 10% increase in
value yields a profit of $100, double his out-of-pocket investment. If the investment
sours, though, leverage magnifies the loss just as much. A decline of 10% costs the
unleveraged investor $10, leaving him with $90, but wipes out the leveraged investor’s
$100. An investor buying assets worth 10 times his capital has a leverage ratio of 10:1,
with the numbers representing the total money invested compared to the money the
investor has committed to the deal.
In 1981, bank supervisors established the first formal minimum capital standards, which
mandated that capital – the amount by which assets exceed debt and other liabilities –
should be at least 5% of assets for most banks. Capital, in general, reflects the value of
shareholders’ investment in the bank, which bears the first risk of any potential losses.
By comparison, Wall Street investment banks could employ far greater leverage,
unhindered by oversight of their safety and soundness or by capital requirements
outside of their broker-dealer subsidiaries, which were subject to a net capital rule. The
main shadow banking participants – the money market funds and the investment banks
that sponsored many of them – were not subject to the same supervision as banks and
thrifts. The money in the shadow banking markets came not from federally insured
depositors but principally from investors (in the case of money market funds) or
commercial paper and repo markets (in the case of investment banks). Both money
market funds and securities firms were regulated by the Securities and Exchange
Commission. But the SEC, created in 1934, was supposed to supervise the securities
markets to protect investors. It was charged with ensuring that issuers of securities
disclosed sufficient information for investors, and it required firms that bought, sold, and
brokered transactions in securities to comply with procedural restrictions such as
keeping customers’ funds in separate accounts. Historically, the SEC did not focus on
the safety and soundness of securities firms, although it did impose capital requirements
on broker-dealers designed to protect their clients.
Meanwhile, since deposit insurance did not cover such instruments as money market
mutual funds, the government was not on the hook. There was little concern about a run.
In theory, the investors had knowingly risked their money. If an investment lost value, it
lost value. If a firm failed, it failed. As a result, money market funds had no capital or
leverage standards. “There was no regulation,” former Fed chairman Paul Volcker told
the Financial Crisis Inquiry Commission. “It was kind of a free ride.” The funds had to
follow only regulations restricting the type of securities in which they could invest, the
duration of those securities, and the diversification of their portfolios. These
requirements were supposed to ensure that investors’ shares would not diminish in
value and would be available anytime – important reassurances, but not the same as
FDIC insurance. The only protection against losses was the implicit guarantee of
sponsors like Merrill Lynch with reputations to protect.
Increasingly, the traditional world of banks and thrifts was ill-equipped to keep up with
the parallel world of the Wall Street firms. The new shadow banks had few constraints
on raising and investing money. Commercial banks were at a disadvantage and in
danger of losing their dominant position. Their bind was labeled “disintermediation,” and
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many critics of the financial regulatory system concluded that policy makers, all the way
back to the Depression, had trapped depository institutions in this unprofitable
straitjacket not only by capping the interest rates they could pay depositors and imposing
capital requirements but also by preventing the institutions from competing against the
investment banks (and their money market mutual funds). Moreover, critics argued, the
regulatory constraints on industries across the entire economy discouraged competition
and restricted innovation, and the financial sector was a prime example of such a
hampered industry.
Years later, Fed Chairman Greenspan described the argument for deregulation: “Those
of us who support market capitalism in its more competitive forms might argue that
unfettered markets create a degree of wealth that fosters a more civilized existence. I
have always found that insight compelling.”
III. The Savings and Loan Crisis: “They Put a Lot of Pressure on Their
Traditional financial institutions continued to chafe against the regulations still in place.
The playing field wasn’t level, which “put a lot of pressure on institutions to get higherrate performing assets,” former SEC Chairman Richard Breeden told the FCIC. “And
they put a lot of pressure on their regulators to allow this to happen.”
The banks and the S&Ls went to Congress for help. In 1980, the Depository Institutions
Deregulation and Monetary Control Act repealed the limits on the interest rates that
depository institutions could offer on their deposits. Although this law removed a
significant regulatory constraint on banks and thrifts, it could not restore their competitive
advantage. Depositors wanted a higher rate of return, which banks and thrifts were now
free to pay. But the interest banks and thrifts could earn off of mortgages and other longterm loans was largely fixed and could not match their new costs. While their deposit
base increased, they now faced an interest rate squeeze. In 1979, the difference in
interest earned on the banks’ and thrifts’ safest investments (one-year Treasury notes)
over interest paid on deposits was almost 5.5 percentage points; by 1994, it was only
2.6 percentage points. The institutions lost almost 3 percentage points of the advantage
they had enjoyed when the rates were capped. The 1980 legislation had not done
enough to reduce the competitive pressures facing the banks and thrifts.
That legislation was followed in 1982 by the Garn-St. Germain Act, which significantly
broadened the types of loans and investments that thrifts could make. The act also gave
banks and thrifts broader scope in the mortgage market. Traditionally, they had relied on
30-year, fixed-rate mortgages. But the interest on fixed-rate mortgages on their books
fell short as inflation surged in the mid-1970s and early 1980s and banks and thrifts
found it increasingly difficult to cover the rising costs of their short-term deposits.
In the Garn-St. Germain Act, Congress sought to relieve this interest rate mismatch by
permitting banks and thrifts to issue interest-only, balloon-payment, and adjustable-rate
mortgages (ARMs), even in states where state laws forbade these loans. For
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consumers, interest-only and balloon mortgages made homeownership more affordable,
but only in the short term. Borrowers with ARMs enjoyed lower mortgage rates when
interest rates decreased, but their rates would rise when interest rates rose. For banks
and thrifts, ARMs offered an interest rate that floated in relationship to the rates they
were paying to attract money from depositors. The floating mortgage rate protected
banks and S&Ls from the interest rate squeeze caused by inflation, but it effectively
transferred the risk of rising interest rates to borrowers.
Then, beginning in 1987, the Federal Reserve accommodated a series of requests from
the banks to undertake activities forbidden under Glass-Steagall and its modifications.
The new rules permitted nonbank subsidiaries of bank holding companies to engage in
“bank-ineligible” activities, including selling or holding certain kinds of securities that
were not permissible for national banks to invest in or underwrite. At first, the Fed strictly
limited these bank-ineligible securities activities to no more than 5% of the assets or
revenue of any subsidiary. Over time, however, the Fed relaxed these restrictions. By
1997, bank-ineligible securities could represent up to 25% of assets or revenues of a
securities subsidiary, and the Fed also weakened or eliminated other firewalls between
traditional banking subsidiaries and the new securities subsidiaries of bank holding
Meanwhile, the OCC, the regulator of banks with national charters, was expanding the
permissible activities of national banks to include those that were “functionally equivalent
to, or a logical outgrowth of, a recognized bank power.” Among these new activities were
underwriting as well as trading bets and hedges, known as derivatives, on the prices of
certain assets. Between 1983 and 1994, the OCC broadened the derivatives in which
banks might deal to include those related to debt securities (1983), interest and currency
exchange rates (1988), stock indices (1988), precious metals such as gold and silver
(1991), and equity stocks (1994).
Fed Chairman Greenspan and many other regulators and legislators supported and
encouraged this shift toward deregulated financial markets. They argued that financial
institutions had strong incentives to protect their shareholders and would therefore
regulate themselves through improved risk management. Likewise, financial markets
would exert strong and effective discipline through analysts, credit rating agencies, and
investors. Greenspan argued that the urgent question about government regulation was
whether it strengthened or weakened private regulation. Testifying before Congress in
1997, he framed the issue this way: financial “modernization” was needed to “remove
outdated restrictions that serve no useful purpose, that decrease economic efficiency,
and that . . . limit choices and options for the consumer of financial services.” Removing
the barriers “would permit banking organizations to compete more effectively in their
natural markets. The result would be a more efficient financial system providing better
services to the public.”
During the 1980s and early 1990s, banks and thrifts expanded into higher-risk loans with
higher interest payments. They made loans to oil and gas producers, financed leveraged
buyouts of corporations, and funded developers of residential and commercial real
estate. The largest commercial banks advanced money to companies and governments
in “emerging markets,” such as countries in Asia and Latin America. Those markets
offered potentially higher profits, but were much riskier than the banks’ traditional
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lending. The consequences appeared almost immediately – especially in the real estate
markets, with a bubble and massive overbuilding in residential and commercial sectors
in certain regions. For example, house prices rose 7% per year in Texas from 1980 to
1985. In California, prices rose 13% annually from 1985 to 1990. The bubble burst first in
Texas in 1985 and 1986, but the trouble rapidly spread across the Southeast to the midAtlantic states and New England, then swept back across the country to California and
Arizona. Before the crisis ended, house prices had declined nationally by 2.5% from July
1990 to February 1992 – the first such fall since the Depression – driven by steep drops
in regional markets. In the 1980s, with the mortgages in their portfolios paying
considerably less than current interest rates, spiraling defaults on the thrifts’ residential
and commercial real estate loans, and losses on energy-related, leveraged-buyout, and
overseas loans, the industry was shattered.
Almost 3,000 commercial banks and thrifts failed in what became known as the S&L
crisis of the 1980s and early 1990s. By comparison, only 243 banks had failed between
1934 and 1980. By 1994, one-sixth of federally insured depository institutions had either
closed or required financial assistance, affecting 20% of the banking system’s assets.
More than 1,000 bank and S&L executives were convicted of felonies. By the time the
government cleanup was complete, the ultimate cost of the crisis was $160 billion.
Despite new laws passed by Congress in 1989 and 1991 in response to the S&L crisis
that toughened supervision of thrifts, the impulse toward deregulation continued. The
deregulatory movement focused in part on continuing to dismantle regulations that
limited depository institutions’ activities in the capital markets. In 1991, the Treasury
Department issued an extensive study calling for the elimination of the old regulatory
framework for banks, including removal of all geographic restrictions on banking and
repeal of the Glass-Steagall Act. The study urged Congress to abolish these restrictions
in the belief that large nationwide banks closely tied to the capital markets would be
more profitable and more competitive with the largest banks from the United Kingdom,
Europe, and Japan. The report contended that its proposals would let banks embrace
innovation and produce a “stronger, more diversified financial system that will provide
important benefits to the consumer and important protections to the taxpayer.”
The biggest banks pushed Congress to adopt the Treasury’s recommendations.
Opposed were insurance agents, real estate brokers, and smaller banks, who felt
threatened by the possibility that the largest banks and their huge pools of deposits
would be unleashed to compete without restraint. The House of Representatives
rejected the Treasury’s proposal in 1991, but similar proposals were adopted by
Congress later in the 1990s.
In dealing with the banking and thrift crisis of the 1980s and early 1990s, Congress was
greatly concerned by a spate of high-profile bank bailouts. In 1984, federal regulators
rescued Continental Illinois, the nation’s 7th-largest bank; in 1988, First Republic,
number 14; in 1989, MCorp, number 36; in 1991, Bank of New England, number 33.
These banks had relied heavily on uninsured short-term financing to aggressively
expand into high-risk lending, leaving them vulnerable to abrupt withdrawals once
confidence in their solvency evaporated. Deposits covered by the FDIC were protected
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from loss, but regulators felt obliged to protect the uninsured depositors – those whose
balances exceeded the statutorily protected limits – to prevent potential runs on even
larger banks that reportedly may have lacked sufficient assets to satisfy their obligations,
such as First Chicago, Bank of America, and Manufacturers Hanover.
During a hearing on the rescue of Continental Illinois, Comptroller of the Currency C.
Todd Conover stated that federal regulators would not allow the 11 largest “money
center banks” to fail. This was a new regulatory principle, and within moments it had a
catchy name. Representative Stewart McKinney of Connecticut responded, “We have a
new kind of bank. It is called ‘too big to fail’ – TBTF – and it is a wonderful bank.”
In 1990, during this era of federal rescues of large commercial banks, Drexel Burnham
Lambert – once the country’s fifth-largest investment bank – failed. Crippled by legal
troubles and losses in its junk bond portfolio, the firm was forced into the largest
bankruptcy in the securities industry to date when lenders shunned it in the commercial
paper and repo markets. While creditors, including other investment banks, were rattled
and absorbed heavy losses, the government did not step in, and Drexel’s failure did not
cause a crisis. So far, it seemed that among financial firms, only commercial banks were
deemed too big to fail.
In 1991, Congress tried to limit this “too big to fail” principle, passing the Federal Deposit
Insurance Corporation Improvement Act (FDICIA), which sought to curb the use of
taxpayer funds to rescue failing depository institutions. FDICIA mandated that federal
regulators must intervene early when a bank or thrift got into trouble. In addition, if an
institution did fail, the FDIC had to resolve the failed institution in a manner that
produced the least cost to the FDIC’s deposit insurance fund. However, the legislation
contained two important loopholes. One exempted the FDIC from the least-cost
constraints if it, the Treasury, and the Federal Reserve determined that the failure of an
institution posed a “systemic risk” to markets. The other loophole addressed a concern
raised by some Wall Street investment banks, Goldman Sachs in particular: the
reluctance of commercial banks to help securities firms during previous market
disruptions, such as Drexel’s failure. Wall Street firms successfully lobbied for an
amendment to FDICIA to authorize the Fed to act as lender of last resort to investment
banks by extending loans collateralized by the investment banks’ securities.
In the end, the 1991 legislation sent financial institutions a mixed message: you are not
too big to fail – until and unless you are too big to fail. So the possibility of bailouts for
the biggest, most centrally placed institutions – in the commercial and shadow banking
industries – remained an open question until the next crisis, 16 years later.
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The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. The failure of Bear Sterns was the single most important factor that almost singlehandedly brought down the financial markets in 2007 and 2008.
a) true
b) false
2. When was the Federal Deposit Insurance Corporation, intended to prevent runs on
banks, created:
prior to the Great Depression
during the Great Depression
in 1975
as part of President Obama’s Wall Street Reform Legislation
3. During the 1980s, federal regulation of thrifts was loosened.
a) true
b) false
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1. A: True is incorrect. It was a series of failures and problems during both years that
ultimately resulted in financial collapse on many fronts.
B: False is correct. There was really no single incident that spurred economic
collapse or the collapse of the housing markets, although the demise of certain large
companies previously viewed as too big to fail certainly sent shocks through the
(See page 2-1 of the course material.)
2. A: Incorrect. The runs on the bank occurred, at least in part, because there was no
B: Correct. The FDIC was created in 1933 as part of the Glass-Steagall Act.
C: Incorrect. It was actually created decades before that.
D: Incorrect. The FDIC was created during a prior period.
(See page 2-3 of the course material.)
3. A: True is correct. For example, the feds relaxed restrictions on the types of
investments they could make and eliminated the cap on the interest rates they could
pay depositors.
B: False is incorrect. The era indeed marked a period of reregulation.
(See page 2-7 of the course material.)
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Chapter 3: Securitization and Derivatives
I. Fannie and Freddie
The crisis in the thrift industry created an opening for Fannie Mae and Freddie Mac, the
two massive government-sponsored enterprises (GSEs) created by Congress to support
the mortgage market.
Fannie Mae (officially, the Federal National Mortgage Association) was chartered by the
Reconstruction Finance Corporation during the Great Depression in 1938 to buy
mortgages insured by the Federal Housing Administration (FHA). The new government
agency was authorized to purchase mortgages that adhered to the FHA’s underwriting
standards, thereby virtually guaranteeing the supply of mortgage credit that banks and
thrifts could extend to homebuyers. Fannie Mae either held the mortgages in its portfolio
or, less often, resold them to thrifts, insurance companies, or investors. After World War
II, Fannie Mae got authority to buy home loans guaranteed by the Veterans
Administration (VA) as well.
This system worked well, but it had a weakness: Fannie Mae bought mortgages by
borrowing. By 1968, Fannie’s mortgage portfolio had grown to $7.2 billion and its debt
weighed on the federal government. To get Fannie’s debt off of the government’s sheet,
the Johnson administration and Congress reorganized it as a public corporation and
created a new government entity, Ginnie Mae (officially, the Government National
Mortgage Association) to take over Fannie’s subsidized mortgage programs and loan
portfolio. Ginnie Mae also began guaranteeing pools of FHA and VA mortgages. The
new Fannie Mae still purchased federally insured mortgages, but it was now a hybrid, a
“government-sponsored enterprise.”
Two years later, in 1970, the thrifts persuaded Congress to charter a second GSE,
Freddie Mac (officially, the Federal Home Loan Mortgage Corporation), to help the thrifts
sell their mortgages. The legislation also authorized Fannie and Freddie to buy
“conventional” fixed-rate mortgages, which were not backed by the FHA or the VA.
Conventional mortgages were stiff competition to FHA mortgages because borrowers
could get them more quickly and with lower fees. Still, the conventional mortgages did
have to conform to the GSEs’ loan size limits and underwriting guidelines, such as debtto-income and loan-to-value ratios. The GSEs purchased only these “conforming”
Before 1968, Fannie Mae generally held the mortgages it purchased, profiting from the
difference – or spread – between its cost of funds and the interest paid on these
mortgages. The 1968 and 1970 laws gave Ginnie, Fannie, and Freddie another option:
securitization. Ginnie was the first to securitize mortgages in 1970. A lender would
assemble a pool of mortgages and issue securities backed by the mortgage pool. Those
securities would be sold to investors, with Ginnie guaranteeing timely payment of
Securitization and Derivatives
principal and interest. Ginnie charged a fee to issuers for this guarantee. In 1971,
Freddie got into the business of buying mortgages, pooling them, and then selling
mortgage-backed securities. Freddie collected fees from lenders for guaranteeing timely
payment of principal and interest. In 1981, after a spike in interest rates caused large
losses on Fannie’s portfolio of mortgages, Fannie followed. During the 1980s and 1990s,
the conventional mortgage market expanded, the GSEs grew in importance, and the
market share of the FHA and VA declined.
Fannie and Freddie had dual missions, both public and private: support the mortgage
market and maximize returns for shareholders. They did not originate mortgages; they
purchased them – from banks, thrifts, and mortgage companies – and either held them
in their portfolios or securitized and guaranteed them. Congress granted both
enterprises special privileges, such as exemptions from state and local taxes and a
$2.25 billion line of credit each from the Treasury. The Federal Reserve provided
services such as electronically clearing payments for GSE debt and securities as if they
were Treasury bonds. So Fannie and Freddie could borrow at rates almost as low as the
Treasury paid. Federal laws allowed banks, thrifts, and investment funds to invest in
GSE securities with relatively favorable capital requirements and without limits. By
contrast, laws and regulations strictly limited the amount of loans banks could make to a
single borrower and restricted their investments in the debt obligations of other firms. In
addition, unlike banks and thrifts, the GSEs were required to hold very little capital to
protect against losses: only 0.45% to back their guarantees of mortgage-backed
securities and 2.5% to back the mortgages in their portfolios. This compared to bank and
thrift capital requirements of at least 4% of mortgages assets under capital standards.
Such privileges led investors and creditors to believe that the government implicitly
guaranteed the GSEs’ mortgage-backed securities and debt and that GSE securities
were therefore almost as safe as Treasury bills. As a result, investors accepted very low
returns on GSE-guaranteed mortgage-backed securities and GSE debt obligations.
Mortgages are long-term assets often funded by short-term borrowings. For example,
thrifts generally used customer deposits to fund their mortgages. Fannie bought its
mortgage portfolio by borrowing short- and medium-term. In 1979, when the Fed
increased short-term interest rates to quell inflation, Fannie, like the thrifts, found that its
cost of funding rose while income from mortgages did not. By the 1980s, the Department
of Housing and Urban Development (HUD) estimated Fannie had a negative net worth
of $10 billion. Freddie emerged unscathed because unlike Fannie then, its primary
business was guaranteeing mortgage-backed securities, not holding mortgages in its
portfolio. In guaranteeing mortgage-backed securities, Freddie avoided taking the
interest rate risk that hit Fannie’s portfolio.
In 1982, Congress provided tax relief and HUD relaxed Fannie’s capital requirements to
help the company avert failure. These efforts were consistent with lawmakers’ repeated
proclamations that a vibrant market for home mortgages served the best interests of the
country, but the moves also reinforced the impression that the government would never
abandon Fannie and Freddie. Fannie and Freddie would soon buy and either hold or
securitize mortgages worth hundreds of billions, then trillions, of dollars. Among the
investors were U.S. banks, thrifts, investment funds, and pension funds, as well as
central banks and investment funds around the world. Fannie and Freddie had become
too big to fail.
Securitization and Derivatives
While the government continued to favor Fannie and Freddie, they toughened regulation
of the thrifts following the savings and loan crisis. Thrifts had previously dominated the
mortgage business as large holders of mortgages. In the Financial Institutions Reform,
Recovery, and Enforcement Act of 1989 (FIRREA), Congress imposed tougher, bankstyle capital requirements and regulations on thrifts. By contrast, in the Federal Housing
Enterprises Financial Safety and Soundness Act of 1992, Congress created a supervisor
for the GSEs, the Office of Federal Housing Enterprise Oversight (OFHEO), without
legal powers comparable to those of bank and thrift supervisors in enforcement, capital
requirements, funding, and receivership. Cracking down on thrifts, while not on the
GSEs, was no accident. The GSEs had shown their immense political power during the
drafting of the 1992 law. “OFHEO was structurally weak and almost designed to fail,”
said Armando Falcon Jr., a former director of the agency, to the FCIC.
All this added up to a generous federal subsidy. One 2005 study put the value of that
subsidy at $122 billion or more and estimated that more than half of these benefits
accrued to shareholders, not to homebuyers.
Given these circumstances, regulatory arbitrage worked as it always does: the markets
shifted to the lowest-cost, least-regulated havens. After Congress imposed stricter
capital requirements on thrifts, it became increasingly profitable for them to securitize
with or sell loans to Fannie and Freddie rather than hold on to the loans. The stampede
was on. Fannie’s and Freddie’s debt obligations and outstanding mortgage-backed
securities grew from $759 billion in 1990 to $1.4 trillion in 1995 and $2.4 trillion in 2000.
The legislation that transformed Fannie in 1968 also authorized HUD to prescribe
affordable housing goals for Fannie: to “require that a reasonable portion of the
corporation’s mortgage purchases be related to the national goal of providing adequate
housing for low and moderate income families, but with reasonable economic return to
the corporation.” In 1978, HUD tried to implement the law and, after a barrage of
criticism from the GSEs and the mortgage and real estate industries, issued a weak
regulation encouraging affordable housing. In the 1992 Federal Housing Enterprises
Financial Safety and Soundness Act, Congress extended HUD’s authority to set
affordable housing goals for Fannie and Freddie. Congress also changed the language
to say that in the pursuit of affordable housing, “a reasonable economic return . . . may
be less than the return earned on other activities.” The law required HUD to consider
“the need to maintain the sound financial condition of the enterprises.” The act now
ordered HUD to set goals for Fannie and Freddie to buy loans for low- and moderateincome housing, special affordable housing, and housing in central cities, rural areas,
and other underserved areas. Congress instructed HUD to periodically set a goal for
each category as a percentage of the GSEs’ mortgage purchases.
In 1995, President Bill Clinton announced an initiative to boost homeownership from
65.1% to 67.5% of families by 2000, and one component raised the affordable housing
goals at the GSEs. Between 1993 and 1995, almost 2.8 million households entered the
ranks of homeowners, nearly twice as many as in the previous two years. “But we have
to do a lot better,” Clinton said. “This is the new way home for the American middle
class. We have got to raise incomes in this country. We have got to increase security for
Securitization and Derivatives
people who are doing the right thing, and we have got to make people believe that they
can have some permanence and stability in their lives even as they deal with all the
changing forces that are out there in this global economy.” The push to expand
homeownership continued under President George W. Bush, who, for example,
introduced a “Zero Down Payment Initiative” that under certain circumstances could
remove the 3% down payment rule for first-time home buyers with FHA-insured
In describing the GSEs’ affordable housing loans, Andrew Cuomo, secretary of Housing
and Urban Development from 1997 to 2001 and now governor of New York, told the
FCIC, “Affordability means many things. There were moderate income loans. These
were teachers, these were firefighters, these were municipal employees, these were
people with jobs who paid mortgages. These were not subprime, predatory loans at all.”
Fannie and Freddie were now crucial to the housing market, but their dual missions –
promoting mortgage lending while maximizing returns to shareholders – were
problematic. Former Fannie CEO Daniel Mudd told the FCIC that “the GSE structure
required the companies to maintain a fine balance between financial goals and what we
call the mission goals . . . the root cause of the GSEs’ troubles lies with their business
model.” Former Freddie CEO Richard Syron concurred: “I don’t think it’s a good
business model.”
Fannie and Freddie accumulated political clout because they depended on federal
subsidies and an implicit government guarantee, and because they had to deal with
regulators, affordable housing goals, and capital standards imposed by Congress and
HUD. From 1999 to 2008, the two reported spending more than $164 million on
lobbying, and their employees and political action committees contributed $15 million to
federal election campaigns. The “Fannie and Freddie political machine resisted any
meaningful regulation using highly improper tactics,” Falcon, who regulated them from
1999 to 2005, testified. “OFHEO was constantly subjected to malicious political attacks
and efforts of intimidation.” James Lockhart, the director of OFHEO and its successor,
the Federal Housing Finance Agency, from 2006 through 2009, testified that he argued
for reform from the moment he became director and that the companies were “allowed to
be . . . so politically strong that for many years they resisted the very legislation that
might have saved them.” Former HUD secretary Mel Martinez described to the FCIC
“the whole army of lobbyists that continually paraded in a bipartisan fashion through my
offices. . . . It’s pretty amazing the number of people that were in their employ.”
In 1995, that army helped secure new regulations allowing the GSEs to count toward
their affordable housing goals not just their whole loans but mortgage-related securities
issued by other companies, which the GSEs wanted to purchase as investments. Still,
Congressional Budget Office Director June O’Neill declared in 1998 that “the goals are
not difficult to achieve, and it is not clear how much they have affected the enterprises’
actions. In fact . . . depository institutions as well as the Federal Housing Administration
devote a larger proportion of their mortgage lending to targeted borrowers and areas
than do the enterprises.”
Securitization and Derivatives
Something else was clear: Fannie and Freddie, with their low borrowing costs and lax
capital requirements, were immensely profitable throughout the 1990s. In 2000, Fannie
had a return on equity of 26%; Freddie, 39%. That year, Fannie and Freddie held or
guaranteed more than $2 trillion of mortgages, backed by only $35.7 billion of
shareholder equity.
II. Structured Finance: “It Wasn’t Reducing the Risk”
While Fannie and Freddie enjoyed a near-monopoly on securitizing fixed-rate mortgages
that were within their permitted loan limits, in the 1980s the markets began to securitize
many other types of loans, including adjustable-rate mortgages (ARMs) and other
mortgages the GSEs were not eligible or willing to buy. The mechanism worked the
same: an investment bank, such as Lehman Brothers or Morgan Stanley (or a securities
affiliate of a bank), bundled loans from a bank or other lender into securities and sold
them to investors, who received investment returns funded by the principal and interest
payments from the loans. Investors held or traded these securities, which were often
more complicated than the GSEs’ basic mortgage-backed securities; the assets were
not just mortgages but equipment leases, credit card debt, auto loans, and manufactured
housing loans. Over time, banks and securities firms used securitization to mimic
banking activities outside the regulatory framework for banks. For example, where banks
traditionally took money from deposits to make loans and held them until maturity, banks
now used money from the capital markets – often from money market mutual funds – to
make loans, packaging them into securities to sell to investors.
1. Commercial Bank Benefit
For commercial banks, the benefits were large. By moving loans off their books, the
banks reduced the amount of capital they were required to hold as protection against
losses, thereby improving their earnings. Securitization also let banks rely less on
deposits for funding, because selling securities generated cash that could be used to
make loans. Banks could also keep parts of the securities on their books as collateral for
borrowing, and fees from securitization became an important source of revenues.
2. Benefits to Investors
Private securitizations, or structured finance securities, had two key benefits to investors:
pooling and tranching. If many loans were pooled into one security, a few defaults would
have minimal impact. Structured finance securities could also be sliced up and sold in
portions – known as tranches – which let buyers customize their payments. Risk-averse
investors would buy tranches that paid off first in the event of default, but had lower
yields. Return-oriented investors bought riskier tranches with higher yields. Bankers
often compared it to a waterfall; the holders of the senior tranches – at the top of the
waterfall – were paid before the more junior tranches. And if payments came in below
expectations, those at the bottom would be the first to be left high and dry.
Securitization and Derivatives
Securitization was designed to benefit lenders, investment bankers, and investors.
Lenders earned fees for originating and selling loans. Investment banks earned fees for
issuing mortgage-backed securities. These securities fetched a higher price than if the
underlying loans were sold individually, because the securities were customized to
investors’ needs, were more diversified, and could be easily traded. Purchasers of the
safer tranches got a higher rate of return than ultra-safe Treasury notes without much
extra risk – at least in theory. However, the financial engineering behind these
investments made them harder to understand and to price than individual loans. To
determine likely returns, investors had to calculate the statistical probabilities that certain
kinds of mortgages might default, and to estimate the revenues that would be lost
because of those defaults. Then investors had to determine the effect of the losses on
the payments to different tranches.
3. Rating New Products
This complexity transformed the three leading credit rating agencies – Moody’s,
Standard & Poor’s (S&P), and Fitch – into key players in the process, positioned
between the issuers and the investors of securities. Before securitization became
common, the credit rating agencies had mainly helped investors evaluate the safety of
municipal and corporate bonds and commercial paper. Although evaluating probabilities
was their stock-in-trade, they found that rating these securities required a new type of
Participants in the securitization industry realized that they needed to secure favorable
credit ratings in order to sell structured products to investors. Investment banks therefore
paid handsome fees to the rating agencies to obtain the desired ratings.
4. Market Explodes
With these pieces in place – banks that wanted to shed assets and transfer risk,
investors ready to put their money to work, securities firms poised to earn fees, rating
agencies ready to expand, and information technology capable of handling the job – the
securitization market exploded. By 1999, when the market was 16 years old, about $900
billion worth of securitizations, beyond those done by Fannie, Freddie, and Ginnie, were
outstanding. That included $114 billion of automobile loans and over $250 billion of
credit card debt; nearly $150 billion worth of securities were mortgages ineligible for
securitization by Fannie and Freddie. Many were subprime.
Securitization was not just a boon for commercial banks; it was also a lucrative new line
of business for the Wall Street investment banks, with which the commercial banks
worked to create the new securities. Wall Street firms such as Salomon Brothers and
Morgan Stanley became major players in these complex markets and relied increasingly
on quantitative analysts, called “quants.” As early as the 1970s, Wall Street executives
had hired quants – analysts adept in advanced mathematical theory and computers – to
develop models to predict how markets or securities might change. Securitization
increased the importance of this expertise. Scott Patterson, author of The Quants, told
the FCIC that using models dramatically changed finance. “Wall Street is essentially
floating on a sea of mathematics and computer power,” Patterson said.
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5. Products Become More Complicated
The increasing dependence on mathematics let the quants create more complex
products and let their managers say, and maybe even believe, that they could better
manage those products’ risk. JP Morgan developed the first “Value at Risk” model
(VaR), and the industry soon adopted different versions. These models purported to
predict with at least 95% certainty how much a firm could lose if market prices changed.
But models relied on assumptions based on limited historical data; for mortgage-backed
securities, the models would turn out to be woefully inadequate. And modeling human
behavior was different from the problems the quants had addressed in graduate school.
“It’s not like trying to shoot a rocket to the moon where you know the law of gravity,”
Emanuel Derman, a Columbia University finance professor who worked at Goldman
Sachs for 17 years, told the Commission. “The way people feel about gravity on a given
day isn’t going to affect the way the rocket behaves.”
Paul Volcker, Fed chairman from 1979 to 1987, told the Commission that regulators
were concerned as early as the late 1980s that once banks began selling instead of
holding the loans they were making, they would care less about loan quality. Yet as
these instruments became increasingly complex, regulators increasingly relied on the
banks to police their own risks.
III. The Growth of Derivatives: “By Far the Most Significant Event in
Finance During the Past Decade”
During the financial crisis, leverage and complexity became closely identified with one
element of the story: derivatives. Derivatives are financial contracts whose prices are
determined by, or “derived” from, the value of some underlying asset, rate, index, or
event. They are not used for capital formation or investment, as are securities; rather,
they are instruments for hedging business risk or for speculating on changes in prices,
interest rates, and the like. Derivatives come in many forms; the most common are overthe-counter-swaps and exchange-traded futures and options. They may be based on
commodities (including agricultural products, metals, and energy products), interest
rates, currency rates, stocks and indexes, and credit risk. They can even be tied to
events such as hurricanes or announcements of government figures.
Many financial and commercial firms use such derivatives. A firm may hedge its price
risk by entering into a derivatives contract that offsets the effect of price movements.
Losses suffered because of price movements can be recouped through gains on the
derivatives contract. Institutional investors that are risk-averse sometimes use interest
rate swaps to reduce the risk to their investment portfolios of inflation and rising interest
rates by trading fixed interest payments for floating payments with risk-taking entities,
such as hedge funds. Hedge funds may use these swaps for the purpose of speculating,
in hopes of profiting on the rise or fall of a price or interest rate.
The derivatives markets are organized as exchanges or as over-the-counter (OTC)
markets, although some recent electronic trading facilities blur the distinctions. The
oldest U.S. exchange is the Chicago Board of Trade, where futures and options are
traded. Such exchanges are regulated by federal law and play a useful role in price
discovery – that is, in revealing the market’s view on prices of commodities or rates
Securitization and Derivatives
underlying futures and options. OTC derivatives are traded by large financial institutions
– traditionally, bank holding companies and investment banks – which act as derivatives
dealers, buying and selling contracts with customers. Unlike the futures and options
exchanges, the OTC market is neither centralized nor regulated. Nor is it transparent,
and thus price discovery is limited. No matter the measurement – trading volume, dollar
volume, risk exposure – derivatives represent a very significant sector of the U.S.
financial system.
The principal legislation governing these markets is the Commodity Exchange Act of
1936, which originally applied only to derivatives on domestic agricultural products. In
1974, Congress amended the act to require that futures and options contracts on
virtually all commodities, including financial instruments, be traded on a regulated
exchange, and created a new federal independent agency, the Commodity Futures
Trading Commission (CFTC), to regulate and supervise the market.
Outside of this regulated market, an over-the-counter market began to develop and grow
rapidly in the 1980s. The large financial institutions acting as OTC derivatives dealers
worried that the Commodity Exchange Act’s requirement that trading occur on a
regulated exchange might be applied to the products they were buying and selling. In
1993, the CFTC sought to address these concerns by exempting certain
nonstandardized OTC derivatives from that requirement and from certain other
provisions of the Commodity Exchange Act, except for prohibitions against fraud and
As the OTC market grew following the CFTC’s exemption, a wave of significant losses
and scandals hit the market. Among many examples, in 1994 Procter & Gamble, a
leading consumer products company, reported a pretax loss of $157 million, the largest
derivatives loss by a nonfinancial firm, stemming from OTC interest and foreign
exchange rate derivatives sold to it by Bankers Trust. Procter & Gamble sued Bankers
Trust for fraud – a suit settled when Bankers Trust forgave most of the money that
Procter & Gamble owed it. That year, the CFTC and the Securities and Exchange
Commission (SEC) fined Bankers Trust $10 million for misleading Gibson Greeting
Cards on interest rate swaps resulting in a mark-to-market loss of $23 million, larger
than Gibson’s prior-year profits. In late 1994, Orange County, California, announced it
had lost $1.5 billion speculating in OTC derivatives. The county filed for bankruptcy – the
largest by a municipality in U.S. history. Its derivatives dealer, Merrill Lynch, paid $400
million to settle claims. In response, the U.S. General Accounting Office issued a report
on financial derivatives that found dangers in the concentration of OTC derivatives
activity among 15 major dealers, concluding that “the sudden failure or abrupt withdrawal
from trading of any one of these large dealers could cause liquidity problems in the
markets and could also pose risks to the others, including federally insured banks and
the financial system as a whole.”While Congress then held hearings on the OTC
derivatives market, the adoption of regulatory legislation failed amid intense lobbying by
the OTC derivatives dealers and opposition by Fed Chairman Greenspan.
In 1996, Japan’s Sumitomo Corporation lost $2.6 billion on copper derivatives traded on
a London exchange. The CFTC charged the company with using derivatives to
manipulate copper prices, including using OTC derivatives contracts to disguise the
speculation and to finance the scheme. Sumitomo settled for $150 million in penalties
and restitution. The CFTC also charged Merrill Lynch with knowingly and intentionally
aiding, abetting, and assisting the manipulation of copper prices; it settled for a fine of
$15 million.
Securitization and Derivatives
Debate intensified in 1998. In May, the CFTC under Chairperson Brooksley Born said
the agency would reexamine the way it regulated the OTC derivatives market, given the
market’s rapid evolution and the string of major losses since 1993. The CFTC requested
comments. It got them.
Some came from other regulators, who took the unusual step of publicly criticizing the
CFTC. On the day that the CFTC issued a concept release, Treasury Secretary Robert
Rubin, Greenspan, and SEC Chairman Arthur Levitt issued a joint statement denouncing
the CFTC’s move: “We have grave concerns about this action and its possible
consequences. . . . We are very concerned about reports that the CFTC’s action may
increase the legal uncertainty concerning certain types of OTC derivatives.” They
proposed a moratorium on the CFTC’s ability to regulate OTC derivatives.
For months, Rubin, Greenspan, Levitt, and Deputy Treasury Secretary Lawrence
Summers opposed the CFTC’s efforts in testimony to Congress and in other public
pronouncements. As Alan Greenspan said: “Aside from safety and soundness regulation
of derivatives dealers under the banking and securities laws, regulation of derivatives
transactions that are privately negotiated by professionals is unnecessary.”
In September, the Federal Reserve Bank of New York orchestrated a $3.6 billion
recapitalization of Long-Term Capital Management (LTCM) by 14 major OTC derivatives
dealers. An enormous hedge fund, LTCM had amassed more than $1 trillion in notional
amount of OTC derivatives and $125 billion of securities on $4.8 billion of capital without
the knowledge of its major derivatives counterparties or federal regulators. Greenspan
testified to Congress that in the New York Fed’s judgment, LTCM’s failure would
potentially have had systemic effects: a default by LTCM “would not only have a
significant distorting impact on market prices but also in the process could produce large
losses, or worse, for a number of creditors and counterparties, and for other market
participants who were not directly involved with LTCM.”
Nonetheless, just weeks later, in October 1998, Congress passed the requested
Greenspan continued to champion derivatives and advocate deregulation of the OTC
market and the exchange-traded market. “By far the most significant event in finance
during the past decade has been the extraordinary development and expansion of
financial derivatives,” Greenspan said at a Futures Industry Association conference in
March 1999. “The fact that the OTC markets function quite effectively without the
benefits of [CFTC regulation] provides a strong argument for development of a less
burdensome regime for exchange-traded financial derivatives.”
The following year – after Born’s resignation – the President’s Working Group on
Financial Markets, a committee of the heads of the Treasury, Federal Reserve, SEC,
and Commodity Futures Trading Commission charged with tracking the financial system
and chaired by then Treasury Secretary Larry Summers, essentially adopted
Greenspan’s view. The group issued a report urging Congress to deregulate OTC
derivatives broadly and to reduce CFTC regulation of exchange-traded derivatives as
Securitization and Derivatives
In December 2000, in response, Congress passed and President Clinton signed the
Commodity Futures Modernization Act of 2000 (CFMA), which in essence deregulated
the OTC derivatives market and eliminated oversight by both the CFTC and the SEC.
The law also preempted application of state laws on gaming and on bucket shops (illegal
brokerage operations) that otherwise could have made OTC derivatives transactions
illegal. The SEC did retain antifraud authority over securities-based OTC derivatives
such as stock options. In addition, the regulatory powers of the CFTC relating to
exchange-traded derivatives were weakened but not eliminated.
The CFMA effectively shielded OTC derivatives from virtually all regulation or oversight.
Subsequently, other laws enabled the expansion of the market. For example, under a
2005 amendment to the bankruptcy laws, derivatives counterparties were given the
advantage over other creditors of being able to immediately terminate their contracts and
seize collateral at the time of bankruptcy.
The OTC derivatives market boomed. At year-end 2000, when the CFMA was passed,
the notional amount of OTC derivatives outstanding globally was $95.2 trillion, and the
gross market value was $3.2 trillion. In the seven and a half years from then until June
2008, when the market peaked, outstanding OTC derivatives increased more than
sevenfold to a notional amount of $672.6 trillion; their gross market value was $20.3
Greenspan testified to the FCIC that credit default swaps – a small part of the market
when Congress discussed regulating derivatives in the 1990s – “did create problems”
during the financial crisis. Rubin testified that when the CFMA passed he was “not
opposed to the regulation of derivatives” and had personally agreed with Born’s views,
but that “very strongly held views in the financial services industry in opposition to
regulation” were insurmountable. Summers told the FCIC that while risks could not
necessarily have been foreseen years ago, “by 2008 our regulatory framework with
respect to derivatives was manifestly inadequate,” and that “the derivatives that proved
to be by far the most serious, those associated with credit default swaps, increased 100
fold between 2000 and 2008.”
One reason for the rapid growth of the derivatives market was the capital requirements
advantage that many financial institutions could obtain through hedging with derivatives.
As discussed above, financial firms may use derivatives to hedge their risks. Such use of
derivatives can lower a firm’s Value at Risk as determined by computer models. In
addition to gaining this advantage in risk management, such hedges can lower the
amount of capital that banks are required to hold, thanks to a 1996 amendment to the
regulatory regime known as the Basel International Capital Accord, or “Basel I.”
Meeting in Basel, Switzerland, in 1988, the world’s central banks and bank supervisors
adopted principles for banks’ capital standards, and U.S. banking regulators made
adjustments to implement them. Among the most important was the requirement that
banks hold more capital against riskier assets. Fatefully, the Basel rules made capital
requirements for mortgages and mortgage-backed securities looser than for all other
assets related to corporate and consumer loans. Indeed, capital requirements for banks’
holdings of Fannie’s and Freddie’s securities were less than for all other assets except
those explicitly backed by the U.S. government.
Securitization and Derivatives
These international capital standards accommodated the shift to increased leverage. In
1996, large banks sought more favorable capital treatment for their trading, and the
Basel Committee on Banking Supervision adopted the Market Risk Amendment to Basel
I. This provided that if banks hedged their credit or market risks using derivatives, they
could hold less capital against their exposures from trading and other activities.
OTC derivatives let derivatives traders – including the large banks and investment banks
– increase their leverage. For example, entering into an equity swap that mimicked the
returns of someone who owned the actual stock may have had some upfront costs, but
the amount of collateral posted was much smaller than the upfront cost of purchasing
the stock directly. Often no collateral was required at all. Traders could use derivatives to
receive the same gains – or losses – as if they had bought the actual security, and with
only a fraction of a buyer’s initial financial outlay. Warren Buffett, the chairman and chief
executive officer of Berkshire Hathaway Inc., testified to the FCIC about the unique
characteristics of the derivatives market, saying, “they accentuated enormously, in my
view, the leverage in the system.” He went on to call derivatives “very dangerous stuff,”
difficult for market participants, regulators, auditors, and investors to understand –
indeed, he concluded, “I don’t think I could manage” a complex derivatives book.
A key OTC derivative in the financial crisis was the credit default swap (CDS), which
offered the seller a little potential upside at the relatively small risk of a potentially large
downside. The purchaser of a CDS transferred to the seller the default risk of an
underlying debt. The debt security could be any bond or loan obligation. The CDS buyer
made periodic payments to the seller during the life of the swap. In return, the seller
offered protection against default or specified “credit events” such as a partial default. If
a credit event such as a default occurred, the CDS seller would typically pay the buyer
the face value of the debt.
Credit default swaps were often compared to insurance: the seller was described as
insuring against a default in the underlying asset. However, while similar to insurance,
CDS escaped regulation by state insurance supervisors because they were treated as
deregulated OTC derivatives. This made CDS very different from insurance in at least
two important respects. First, only a person with an insurable interest can obtain an
insurance policy. A car owner can insure only the car she owns – not her neighbor’s. But
a CDS purchaser can use it to speculate on the default of a loan the purchaser does not
own. These are often called “naked credit default swaps” and can inflate potential losses
and corresponding gains on the default of a loan or institution.
Before the CFMA was passed, there was uncertainty about whether or not state
insurance regulators had authority over credit default swaps. In June 2000, in response
to a letter from the law firm of Skadden, Arps, Slate, Meagher & Flom, LLP, the New
York State Insurance Department determined that “naked” credit default swaps did not
count as insurance and were therefore not subject to regulation.
In addition, when an insurance company sells a policy, insurance regulators require that
it put aside reserves in case of a loss. In the housing boom, CDS were sold by firms that
failed to put up any reserves or initial collateral or to hedge their exposure. In the run-up
to the crisis, AIG, the largest U.S. insurance company, would accumulate a one-half
trillion dollar position in credit risk through the OTC market without being required to post
one dollar’s worth of initial collateral or making any other provision for loss. AIG was not
alone. The value of the underlying assets for CDS outstanding worldwide grew from $6.4
Securitization and Derivatives
trillion at the end of 2004 to a peak of $58.2 trillion at the end of 2007. A significant
portion was apparently speculative or naked credit default swaps.
Much of the risk of CDS and other derivatives was concentrated in a few of the very
largest banks, investment banks, and others – such as AIG Financial Products, a unit of
AIG – that dominated dealing in OTC derivatives. Among U.S. bank holding companies,
97% of the notional amount of OTC derivatives, millions of contracts, were traded by just
five large institutions (in 2008, JPMorgan Chase, Citigroup, Bank of America, Wachovia,
and HSBC) – many of the same firms that would find themselves in trouble during the
financial crisis. The country’s five largest investment banks were also among the world’s
largest OTC derivatives dealers.
While financial institutions surveyed by the FCIC said they do not track revenues and
profits generated by their derivatives operations, some firms did provide estimates. For
example, Goldman Sachs estimated that between 25% and 35% of its revenues from
2006 through 2009 were generated by derivatives, including 70% to 75% of the firm’s
commodities business, and half or more of its interest rate and currencies business.
From May 2007 through November 2008, $133 billion, or 86%, of the $155 billion of
trades made by Goldman’s mortgage department were derivative transactions.
When the nation’s biggest financial institutions were teetering on the edge of failure in
2008, everyone watched the derivatives markets. What were the institutions’ holdings?
Who were the counterparties? How would they fare? Market participants and regulators
would find themselves straining to understand an unknown battlefield shaped by unseen
exposures and interconnections as they fought to keep the financial system from
Securitization and Derivatives
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. Historically, Fannie Mae made its money by selling off mortgages it issued to third
a) true
b) false
2. What effect did the Commodity Futures Modernization Act of 2000 – signed into law
by President Clinton – have on the sale of derivatives:
none whatsoever
it illegalized the sale
it created a new regulatory scheme for their registration and sale
it deregulated their sale
Securitization and Derivatives
1. A: True is incorrect. To the contrary, historically Fannie Mae held the mortgage and
made its profit on the difference between the loan payment and the cost of the loan,
the so-called “spread.”
B: False is correct. Selling off the loans did not readily occur until the recent
housing boom.
(See page 3-2 of the course material.)
2. A: Incorrect. The Act deregulated much of the derivatives market.
B: Incorrect. While the Act limited the amount of regulation on such securities, it did
not outlaw them.
C: Incorrect. To the contrary, the Act deregulated such securities.
D: Correct. The end result of the legislation was to nearly eliminate all regulation of
the marketplace for the sale of derivatives.
(See page 3-10 of the course material.)
Securitization and Derivatives
Chapter 4: Deregulation Redux
I. Expansion of Banking Activities
By the mid-1990s, the parallel banking system was booming, some of the largest
commercial banks appeared increasingly like the large investment banks, and all of them
were becoming larger, more complex, and more active in securitization. Some
academics and industry analysts argued that advances in data processing,
telecommunications, and information services created economies of scale and scope in
finance and thereby justified ever-larger financial institutions. Bigger would be safer, the
argument went, and more diversified, innovative, efficient, and better able to serve the
needs of an expanding economy.
Others contended that the largest banks were not necessarily more efficient but grew
because of their commanding market positions and creditors’ perception they were too
big to fail. As they grew, the large banks pressed regulators, state legislatures, and
Congress to remove almost all remaining barriers to growth and competition. They had
much success. In 1994, Congress authorized nationwide banking with the Riegle-Neal
Interstate Banking and Branching Efficiency Act. This let bank holding companies
acquire banks in every state, and removed most restrictions on opening branches in
more than one state. It preempted any state law that restricted the ability of out-of-state
banks to compete within the state’s borders.
Removing barriers helped consolidate the banking industry. Between 1990 and 2005, 74
“megamergers” occurred involving banks with assets of more than $10 billion each.
Meanwhile, the 10 largest jumped from owning 25% of the industry’s assets to 55%.
From 1998 to 2007, the combined assets of the five largest U.S. banks – Bank of
America, Citigroup, JP Morgan, Wachovia, and Wells Fargo – more than tripled, from
$2.2 trillion to $6.8 trillion. And investment banks were growing bigger, too. Smith Barney
acquired Shearson in 1993 and Salomon Brothers in 1997, while Paine Webber
purchased Kidder, Peabody in 1995. Two years later, Morgan Stanley merged with Dean
Witter, and Bankers Trust purchased Alex Brown & Sons. The assets of the five largest
investment banks – Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers,
and Bear Stearns – quadrupled, from $1 trillion in 1998 to $4 trillion in 2007.
In 1996, the Economic Growth and Regulatory Paperwork Reduction Act required
federal regulators to review their rules every decade and solicit comments on “outdated,
unnecessary, or unduly burdensome” rules. Some agencies responded with gusto. In
2003, the Federal Deposit Insurance Corporation’s annual report included a photograph
of the vice chairman, John Reich; the director of the Office of Thrift Supervision (OTS),
James Gilleran; and three banking industry representatives using a chainsaw and
pruning shears to cut the “red tape” binding a large stack of documents representing
Deregulation Redux
Less enthusiastic agencies felt heat. Former Securities and Exchange Commission
chairman Arthur Levitt told the FCIC that once word of a proposed regulation got out,
industry lobbyists would rush to complain to members of the congressional committee
with jurisdiction over the financial activity at issue. According to Levitt, these members
would then “harass” the SEC with frequent letters demanding answers to complex
questions and appearances of officials before Congress. These requests consumed
much of the agency’s time and discouraged it from making regulations.
However, others said interference – at least from the executive branch – was modest.
John Hawke, a former comptroller of the currency, told the FCIC he found the Treasury
Department “exceedingly sensitive” to his agency’s independence. His successor, John
Dugan, said “statutory firewalls” prevented interference from the executive branch.
Deregulation went beyond dismantling regulations; its supporters were also disinclined
to adopt new regulations or challenge industry on the risks of innovations. Federal
Reserve officials argued that financial institutions, with strong incentives to protect
shareholders, would regulate themselves by carefully managing their own risks.
Likewise, Fed and other officials believed that markets would self-regulate through the
activities of analysts and investors. “It is critically important to recognize that no market is
ever truly unregulated,” said Fed Chairman Alan Greenspan in 1997. “The self-interest of
market participants generates private market regulation. Thus, the real question is not
whether a market should be regulated. Rather, the real question is whether government
intervention strengthens or weakens private regulation.”
To create checks and balances and keep any agency from becoming arbitrary or
inflexible, senior policy makers pushed to keep multiple regulators. In 1994, Greenspan
testified against proposals to consolidate bank regulation: “The current structure
provides banks with a method of shifting their regulator, an effective test that provides a
limit on the arbitrary position or excessively rigid posture of any one regulator. The
pressure of a potential loss of institutions has inhibited excessive regulation and acted
as a countervailing force to the bias of a regulatory agency to over regulate.” Further,
some regulators, including the OTS and Office of the Comptroller of the Currency
(OCC), were funded largely by assessments from the institutions they regulated. As a
result, the larger the number of institutions that chose these regulators, the greater their
Emboldened by success and the tenor of the times, the largest banks and their
regulators continued to oppose limits on banks’ activities or growth. The barriers
separating commercial banks and investment banks had been crumbling, little by little,
and now seemed the time to remove the last remnants of the restrictions that separated
banks, securities firms, and insurance companies.
In the spring of 1996, after years of opposing repeal of Glass-Steagall, the Securities
Industry Association – the trade organization of Wall Street firms such as Goldman
Sachs and Merrill Lynch – changed course. Because restrictions on banks had been
slowly removed during the previous decade, banks already had beachheads in securities
and insurance. Despite numerous lawsuits against the Fed and the OCC, securities
firms and insurance companies could not stop this piecemeal process of deregulation
through agency rulings.
Deregulation Redux
In 1998, Citicorp forced the issue by seeking a merger with the insurance giant Travelers
to form Citigroup. The Fed approved it, citing a technical exemption to the Bank Holding
Company Act, but Citigroup would have to divest itself of many Travelers assets within
five years unless the laws were changed. Congress had to make a decision: Was it
prepared to break up the nation’s largest financial firm? Was it time to repeal the GlassSteagall Act, once and for all?
As Congress began fashioning legislation, the banks were close at hand. In 1999, the
financial sector spent $187 million lobbying at the federal level, and individuals and
political action committees (PACs) in the sector donated $202 million to federal election
campaigns in the 2000 election cycle. From 1999 through 2008, federal lobbying by the
financial sector reached $2.7 billion; campaign donations from individuals and PACs
topped $1 billion.
In November 1999, Congress passed and President Clinton signed the Gramm-LeachBliley Act (GLBA), which lifted most of the remaining Glass-Steagall-era restrictions. The
new law embodied many of the measures Treasury had previously advocated. The New
York Times reported that Citigroup CEO Sandy Weill hung in his office “a hunk of wood
– at least 4 feet wide – etched with his portrait and the words ‘The Shatterer of GlassSteagall.’”
1. Effects on Bank Holding Companies
Now, as long as bank holding companies satisfied certain safety and soundness
conditions, they could underwrite and sell banking, securities, and insurance products
and services. Their securities affiliates were no longer bound by the Fed’s 25% limit –
their primary regulator, the SEC, set their only boundaries. Supporters of the legislation
argued that the new holding companies would be more profitable (due to economies of
scale and scope), safer (through a broader diversification of risks), more useful to
consumers (thanks to the convenience of one-stop shopping for financial services), and
more competitive with large foreign banks, which already offered loans, securities, and
insurance products. The legislation’s opponents warned that allowing banks to combine
with securities firms would promote excessive speculation and could trigger a crisis like
the crash of 1929.
2. Exceptions
To win the securities industry’s support, the new law left in place two exceptions that let
securities firms own thrifts and industrial loan companies, a type of depository institution
with stricter limits on its activities. Through them, securities firms could access FDICinsured deposits without supervision by the Fed. Some securities firms immediately
expanded their industrial loan company and thrift subsidiaries. Merrill’s industrial loan
company grew from less than $1 billion in assets in 1998 to $4 billion in 1999, and to $78
billion in 2007. Lehman’s thrift grew from $88 million in 1998 to $3 billion in 1999, and its
assets rose as high as $24 billion in 2005.
Deregulation Redux
3. “Fed-Lite”
For institutions regulated by the Fed, the new law also established a hybrid regulatory
structure known colloquially as “Fed-Lite.” The Fed supervised financial holding
companies as a whole, looking only for risks that cut across the various subsidiaries
owned by the holding company. To avoid duplicating other regulators’ work, the Fed was
required to rely “to the fullest extent possible” on examinations and reports of those
agencies regarding subsidiaries of the holding company, including banks, securities
firms, and insurance companies. The expressed intent of Fed-Lite was to eliminate
excessive or duplicative regulation. However, Fed Chairman Ben Bernanke told the
FCIC that Fed-Lite “made it difficult for any single regulator to reliably see the whole
picture of activities and risks of large, complex banking institutions.” Indeed, the
regulators, including the Fed, would fail to identify excessive risks and unsound practices
building up in nonbank subsidiaries of financial holding companies such as Citigroup and
4. Stability Undermined
The convergence of banks and securities firms also undermined the supportive
relationship between banking and securities markets that Fed Chairman Greenspan had
considered a source of stability. He compared it to a “spare tire”: if large commercial
banks ran into trouble, their large customers could borrow from investment banks and
others in the capital markets; if those markets froze, banks could lend using their
deposits. After 1990, securitized mortgage lending provided another source of credit to
home buyers and other borrowers that softened a steep decline in lending by thrifts and
banks. The system’s resilience following the crisis in Asian financial markets in the late
1990s further proved his point, Greenspan said.
5. Regime Encouraged Growth
The new regime encouraged growth and consolidation within and across banking,
securities, and insurance. The bank-centered financial holding companies such as
Citigroup, JP Morgan, and Bank of America could compete directly with the “big five”
investment banks – Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers,
and Bear Stearns – in securitization, stock and bond underwriting, loan syndication, and
trading in over-the-counter (OTC) derivatives. The biggest bank holding companies
became major players in investment banking. The strategies of the largest commercial
banks and their holding companies came to more closely resemble the strategies of
investment banks. Each had advantages: commercial banks enjoyed greater access to
insured deposits, and the investment banks enjoyed less regulation. Both prospered
from the late 1990s until the outbreak of the financial crisis in 2007. However,
Greenspan’s “spare tire” that had helped make the system less vulnerable would be
gone when the financial crisis emerged – all the wheels of the system would be spinning
on the same axle.
Deregulation Redux
II. Dot-Com Crash: “Lay on More Risk”
The late 1990s was a good time for investment banking. Annual public underwritings and
private placements of corporate securities in U.S. markets almost quadrupled, from $600
billion in 1994 to $2.2 trillion in 2001. Annual initial public offerings of stocks (IPOs)
soared from $28 billion in 1994 to $76 billion in 2000 as banks and securities firms
sponsored IPOs for new Internet and telecommunications companies – the dot-coms
and telecoms. A stock market boom ensued comparable to the great bull market of the
1920s. The value of publicly traded stocks rose from $5.8 trillion in December 1994 to
$17.8 trillion in March 2000. The boom was particularly striking in recent dot-com and
telecom issues on the NASDAQ exchange. Over this period, the NASDAQ skyrocketed
from 752 to 5,048.
In the spring of 2000, the tech bubble burst. The “new economy” dot-coms and telecoms
had failed to match the lofty expectations of investors, who had relied on bullish – and,
as it turned out, sometimes deceptive – research reports issued by the same banks and
securities firms that had underwritten the tech companies’ initial public offerings.
Between March 2000 and March 2001, the NASDAQ fell by almost two-thirds. This
slump accelerated after the terrorist attacks on September 11 as the nation slipped into
recession. Investors were further shaken by revelations of accounting frauds and other
scandals at prominent firms such as Enron and Worldcom.
Some leading commercial and investment banks settled with regulators over improper
practices in the allocation of IPO shares during the bubble – for spinning (doling out
shares in “hot” IPOs in return for reciprocal business) and laddering (doling out shares to
investors who agreed to buy more later at higher prices). The regulators also found that
public research reports prepared by investment banks’ analysts were tainted by conflicts
of interest. The SEC, New York’s attorney general, the National Association of Securities
Dealers (now FINRA), and state regulators settled enforcement actions against 10 firms
for $875 million, forbade certain practices, and instituted reforms.
The sudden collapses of Enron and WorldCom were shocking; with assets of $63 billion
and $104 billion, respectively, they were the largest corporate bankruptcies before the
default of Lehman Brothers in 2008.
Following legal proceedings and investigations, Citigroup, JP Morgan, Merrill Lynch, and
other Wall Street banks paid billions of dollars – although admitted no wrongdoing – for
helping Enron hide its debt until just before its collapse. Enron and its bankers had
created entities to do complex transactions generating fictitious earnings, disguised debt
as sales and derivative transactions, and understated the firm’s leverage. Executives at
the banks had pressured their analysts to write glowing evaluations of Enron. The
scandal cost Citigroup, JP Morgan, CIBC, Merrill Lynch, and other financial institutions
more than $400 million in settlements with the SEC; Citigroup, JP Morgan, CIBC,
Lehman Brothers, and Bank of America paid another $6.9 billion to investors to settle
class action lawsuits. In response, the Sarbanes-Oxley Act of 2002 required the
Deregulation Redux
personal certification of financial reports by CEOs and CFOs; independent audit
committees; longer jail sentences and larger fines for executives who misstate financial
results; and protections for whistleblowers.
Some firms that lent to companies that failed during the stock market bust were
successfully hedged, having earlier purchased credit default swaps on these firms.
Regulators seemed to draw comfort from the fact that major banks had succeeded in
transferring losses from those relationships to investors through these and other hedging
transactions. In November 2002, Fed Chairman Greenspan said credit derivatives
“appear to have effectively spread losses” from defaults by Enron and other large
corporations. Although he conceded the market was “still too new to have been tested”
thoroughly, he observed that “to date, it appears to have functioned well.”
This resilience led many executives and regulators to presume the financial system had
achieved unprecedented stability and strong risk management. The Wall Street banks’
pivotal role in the Enron debacle did not seem to trouble senior Fed officials.
The Fed cut interest rates aggressively in order to contain damage from the dotcom and
telecom bust, the terrorist attacks, and the financial market scandals. In January 2001,
the federal funds rate, the overnight bank-to-bank lending rate, was 6.5%. By mid-2003,
the Fed had cut that rate to just 1%, the lowest in half a century, where it stayed for
another year. In addition, to offset the market disruptions following the 9/11 attacks, the
Fed flooded the financial markets with money by purchasing more than $150 billion in
government securities and lending $45 billion to banks. It also suspended restrictions on
bank holding companies so the banks could make large loans to their securities
affiliates. With these actions, the Fed prevented a protracted liquidity crunch in the
financial markets during the fall of 2001.
Why wouldn’t the markets assume the central bank would act again – and again save
the day? Two weeks before the Fed cut short-term rates in January 2001, the Economist
anticipated it: “the ‘Greenspan put’ is once again the talk of Wall Street. . . . The idea is
that the Federal Reserve can be relied upon in times of crisis to come to the rescue,
cutting interest rates and pumping in liquidity, thus providing a floor for equity prices.”
The “Greenspan put” was analysts’ shorthand for investors’ faith that the Fed would
keep the capital markets functioning no matter what. The Fed’s policy was clear: to
restrain growth of an asset bubble, it would take only small steps, such as warning
investors some asset prices might fall; but after a bubble burst, it would use all the tools
available to stabilize the markets. Greenspan argued that intentionally bursting a bubble
would heavily damage the economy.
This asymmetric policy – allowing unrestrained growth, then working hard to cushion the
impact of a bust – raised the question of “moral hazard”: did the policy encourage
investors and financial institutions to gamble because their upside was unlimited while
the full power and influence of the Fed protected their downside (at least against
catastrophic losses)? Greenspan himself warned about this in a 2005 speech, noting
that higher asset prices were “in part the indirect result of investors accepting lower
compensation for risk” and cautioning that “newly abundant liquidity can readily
disappear.” Yet the only real action would be an upward march of the federal funds rate
that had begun in the summer of 2004, although, as he pointed out in the same 2005
speech, this had little effect.
Deregulation Redux
And the markets were undeterred. “We had convinced ourselves that we were in a less
risky world,” former Federal Reserve governor and National Economic Council director
under President George W. Bush Lawrence Lindsey told the Commission. “And how
should any rational investor respond to a less risky world? They should lay on more
III. The Wages of Finance: “Well, This One’s Doing It, So How Can I Not Do
For almost half a century after the Great Depression, pay inside the financial industry
and out was roughly equal. Beginning in 1980, they diverged. By 2007, financial sector
compensation was more than 80% greater than in other businesses – a considerably
larger gap than before the Great Depression.
Until 1970, the New York Stock Exchange, a private self-regulatory organization,
required members to operate as partnerships. Peter J. Solomon, a former Lehman
Brothers partner, testified before the FCIC that this profoundly affected the investment
bank’s culture. Before the change, he and the other partners had sat in a single room at
headquarters, not to socialize but to “overhear, interact, and monitor” each other. They
were all on the hook together. “Since they were personally liable as partners, they took
risk very seriously,” Solomon said. Brian Leach, formerly an executive at Morgan
Stanley, described to FCIC staff Morgan Stanley’s compensation practices before it
issued stock and became a public corporation: “When I first started at Morgan Stanley, it
was a private company. When you’re a private company, you don’t get paid until you
retire. I mean, you get a good, you know, year-to-year compensation.” But the big payout
was “when you retire.”
When the investment banks went public in the 1980s and 1990s, the close relationship
between bankers’ decisions and their compensation broke down. They were now trading
with shareholders’ money. Talented traders and managers once tethered to their firms
were now free agents who could play companies against each other for more money. To
keep them from leaving, firms began providing aggressive incentives, often tied to the
price of their shares and often with accelerated payouts. To keep up, commercial banks
did the same. Some included “clawback” provisions that would require the return of
compensation under narrow circumstances, but those proved too limited to restrain the
behavior of traders and managers.
Studies have found that the real value of executive pay, adjusted for inflation, grew only
0.8% a year during the 30 years after World War II, lagging companies’ increasing size.
But the rate picked up during the 1970s and rose faster each decade, reaching 10% a
year from 1995 to 1999. Much of the change reflected higher earnings in the financial
sector, where by 2005 executives’ pay averaged $3.4 million annually, the highest of any
industry. Though base salaries differed relatively little across sectors, banking and
finance paid much higher bonuses and awarded more stock. And brokers and dealers
did by far the best, averaging more than $7 million in compensation.
Deregulation Redux
Both before and after going public, investment banks typically paid out half their
revenues in compensation. For example, Goldman Sachs spent between 44% and 49%
a year between 2005 and 2008, when Morgan Stanley allotted between 46% and 59%.
Merrill paid out similar percentages in 2005 and 2006, but gave 141% in 2007 – a year it
suffered dramatic losses.
As the scale, revenue, and profitability of the firms grew, compensation packages soared
for senior executives and other key employees. John Gutfreund, reported to be the
highest-paid executive on Wall Street in the late 1980s, received $3.2 million in 1986 as
CEO of Salomon Brothers. Stanley O’Neal’s package was worth more than $91 million in
2006, the last full year he was CEO of Merrill Lynch. In 2007, Lloyd Blankfein, CEO at
Goldman Sachs, received $68.5 million; Richard Fuld, CEO of Lehman Brothers, and
Jamie Dimon, CEO of JPMorgan Chase, received about $34 million and $28 million,
respectively. That year, Wall Street paid workers in New York roughly $33 billion in yearend bonuses alone. Total compensation for the major U.S. banks and securities firms
was estimated at $137 billion.
Stock options became a popular form of compensation, allowing employees to buy the
company’s stock in the future at some predetermined price, and thus to reap rewards
when the stock price was higher than that predetermined price. In fact, the option would
have no value if the stock price was below that price. Encouraging the awarding of stock
options was 1993 legislation making compensation in excess of $1 million taxable to the
corporation unless performance-based. Stock options had potentially unlimited upside,
while the downside was simply to receive nothing if the stock didn’t rise to the
predetermined price. The same applied to plans that tied pay to return on equity: they
meant that executives could win more than they could lose. These pay structures had
the unintended consequence of creating incentives to increase both risk and leverage,
which could lead to larger jumps in a company’s stock price.
As these options motivated financial firms to take more risk and use more leverage, the
evolution of the system provided the means. Shadow banking institutions faced few
regulatory constraints on leverage; changes in regulations loosened the constraints on
commercial banks. OTC derivatives allowing for enormous leverage proliferated. And
risk management, thought to be keeping ahead of these developments, would fail to rein
in the increasing risks.
The dangers of the new pay structures were clear, but senior executives believed they
were powerless to change it. Former Citigroup CEO Sandy Weill told the Commission, “I
think if you look at the results of what happened on Wall Street, it became, ‘Well, this
one’s doing it, so how can I not do it, if I don’t do it, then the people are going to leave
my place and go someplace else.’” Managing risk “became less of an important function
in a broad base of companies, I would guess.”
And regulatory entities, one source of checks on excessive risk taking, had challenges
recruiting financial experts who could otherwise work in the private sector. Lord Adair
Turner, chairman of the U.K. Financial Services Authority, told the Commission, “It’s not
easy. This is like a continual process of, you know, high-skilled people versus highskilled people, and the poachers are better paid than the gamekeepers.” Bernanke said
the same at an FCIC hearing: “It’s just simply never going to be the case that the
government can pay what Wall Street can pay.”
Deregulation Redux
Tying compensation to earnings also, in some cases, created the temptation to
manipulate the numbers. Former Fannie Mae regulator Armando Falcon Jr. told the
FCIC, “Fannie began the last decade with an ambitious goal – double earnings in 5
years to $6.46 [per share]. A large part of the executives’ compensation was tied to
meeting that goal.” Achieving it brought CEO Franklin Raines $52 million of his $90
million pay from 1998 to 2003. However, Falcon said, the goal “turned out to be
unachievable without breaking rules and hiding risks. Fannie and Freddie executives
worked hard to persuade investors that mortgage-related assets were a riskless
investment, while at the same time covering up the volatility and risks of their own
mortgage portfolios and balance sheets.” Fannie’s estimate of how many mortgage
holders would pay off was off by $400 million at year-end 1998, which meant no
bonuses. So Fannie counted only half the $400 million on its books, enabling Raines
and other executives to meet the earnings target and receive 100% of their bonuses.
Compensation structures were skewed all along the mortgage securitization chain, from
people who originated mortgages to people on Wall Street who packaged them into
securities. Regarding mortgage brokers, often the first link in the process, FDIC
Chairman Sheila Bair told the FCIC that their “standard compensation practice . . . was
based on the volume of loans originated rather than the performance and quality of the
loans made.” SEC Chairman Mary Schapiro told the FCIC, “Many major financial
institutions created asymmetric compensation packages that paid employees enormous
sums for short-term success, even if these same decisions result in significant long-term
losses or failure for investors and taxpayers.”
IV. Financial Sector Growth: “I Think We Overdid Finance Versus the Real
For about two decades, beginning in the early 1980s, the financial sector grew faster
than the rest of the economy – rising from about 5% of gross domestic product (GDP) to
about 8% in the early 21st century. In 1980, financial sector profits were about 15% of
corporate profits. In 2003, they hit a high of 33% but fell back to 27% in 2006, on the eve
of the financial crisis. The largest firms became considerably larger. JP Morgan’s assets
increased from $667 billion in 1999 to $2.2 trillion in 2008, a compound annual growth
rate of 16%. Bank of America and Citigroup grew by 14% and 12% a year, respectively,
with Citigroup reaching $1.9 trillion in assets in 2008 (down from $2.2 trillion in 2007)
and Bank of America $1.8 trillion. The investment banks also grew significantly from
2000 to 2007, often much faster than commercial banks. Goldman’s assets grew from
$250 billion in 1999 to $1.1 trillion by 2007, an annual growth rate of 21%. At Lehman,
assets rose from $192 billion to $691 billion, or 17%.
Fannie and Freddie grew quickly, too. Fannie’s assets and guaranteed mortgages
increased from $1.4 trillion in 2000 to $3.2 trillion in 2008, or 11% annually. At Freddie,
they increased from $1 trillion to $2.2 trillion, or 10% a year. As they grew, many
financial firms added lots of leverage. That meant potentially higher returns for
shareholders, and more money for compensation. Increasing leverage also meant less
capital to absorb losses.
Fannie and Freddie were the most leveraged. The law set the government sponsored
enterprises’ minimum capital requirement at 2.5% of assets plus 0.45% of the mortgagebacked securities they guaranteed. So they could borrow more than $200 for each dollar
of capital used to guarantee mortgage-backed securities. If they wanted to own the
Deregulation Redux
securities, they could borrow $40 for each dollar of capital. Combined, Fannie and
Freddie owned or guaranteed $5.3 trillion of mortgage-related assets at the end of 2007
against just $70.7 billion of capital, a ratio of 75:1.
From 2000 to 2007, large banks and thrifts generally had $16 to $22 in assets for each
dollar of capital, for leverage ratios between 16:1 and 22:1. For some banks, leverage
remained roughly constant. JP Morgan’s reported leverage was between 20:1 and 22:1.
Wells Fargo’s generally ranged between 16:1 and 17:1. Other banks upped their
leverage. Bank of America’s rose from 18:1 in 2000 to 27:1 in 2007. Citigroup’s
increased from 18:1 to 22:1, then shot up to 32:1 by the end of 2007, when Citigroup
brought off-balance sheet assets onto the balance sheet. More than other banks,
Citigroup held assets off of its balance sheet, in part to hold down capital requirements.
In 2007, even after bringing $80 billion worth of assets on balance sheet, substantial
assets remained off. If those had been included, leverage in 2007 would have been
48:1, or about 53% higher. In comparison, at Wells Fargo and Bank of America,
including off-balance-sheet assets would have raised the 2007 leverage ratios 17% and
28%, respectively.
Because investment banks were not subject to the same capital requirements as
commercial and retail banks, they were given greater latitude to rely on their internal risk
models in determining capital requirements, and they reported higher leverage. At
Goldman Sachs, leverage increased from 17:1 in 2000 to 32:1 in 2007. Morgan Stanley
and Lehman increased about 67% and 22%, respectively, and both reached 40:1 by the
end of 2007. Several investment banks artificially lowered leverage ratios by selling
assets right before the reporting period and subsequently buying them back.
As the investment banks grew, their business models changed. Traditionally, investment
banks advised and underwrote equity and debt for corporations, financial institutions,
investment funds, governments, and individuals. An increasing amount of the investment
banks’ revenues and earnings was generated by trading and investments, including
securitization and derivatives activities. At Goldman, revenues from trading and principal
investments increased from 39% of the total in 1997 to 68% in 2007. At Merrill Lynch,
they generated 55% of revenue in 2006, up from 42% in 1997. At Lehman, similar
activities generated up to 80% of pretax earnings in 2006, up from 32% in 1997. At Bear
Stearns, they accounted for more than 100% of pretax earnings in some years after
2002 because of pretax losses in other businesses.
Between 1978 and 2007, debt held by financial companies grew from $3 trillion to $36
trillion, more than doubling from 130% to 270% of GDP. Former Treasury Secretary
John Snow told the FCIC that while the financial sector must play a “critical” role in
allocating capital to the most productive uses, it was reasonable to ask whether over the
last 20 or 30 years it had become too large. Financial firms had grown mainly by simply
lending to each other, he said, not by creating opportunities for investment. In 1978,
financial companies borrowed $13 in the credit markets for every $100 borrowed by
nonfinancial companies. By 2007, financial companies were borrowing $51 for every
$100. “We have a lot more debt than we used to have, which means we have a much
bigger financial sector,” said Snow. “I think we overdid finance versus the real economy
and got it a little lopsided as a result.”
Deregulation Redux
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. The era between 1990 and the mid-2000s saw many financial institutions merge.
a) true
b) false
2. The Gramm-Leach-Bliley Act significantly increased regulation of the financial sector.
a) true
b) false
3. Historically, how did salaries for financial industry employees compare to persons
working in other sectors of the economy:
a) it was roughly equal
b) employees in the financial sector generally were paid far less than other private
c) financial sector employees were historically paid more, but not significantly more,
than employees in other sectors
d) financial sector employees have always been paid significantly more than
employees in other sectors
4. What caused salaries in the financial sector to escalate in recent years:
congressional mandates for higher levels of compensation
shareholders demanded that executives receive higher salaries
many banks became public companies
Deregulation Redux
1. A: True is correct. This was indeed an era of consolidation in the financial sector.
Particularly the largest banks saw their assets grow at an incredible rate of speed.
B: False is incorrect. The level of consolidation in this period was indeed massive,
with the size of the largest banks becoming nothing short of massive.
(See page 4-1 of the course material.)
2. A: True is incorrect. To the contrary, this law signed by President Clinton, removed
restrictions on financial institutions.
B: False is correct. The Act gave financial institutions much more flexibility in the
types of businesses they could engage in.
(See page 4-3 of the course material.)
3. A: Correct. Until the mid 2000s, pay for financial sector employees was roughly
equivalent to those of other private business sectors.
B: Incorrect. They were generally paid a similar salary.
C: Incorrect. They were not paid more until recently.
D: Incorrect. It was only in the 2000s that pay disparity emerged.
(See page 4-7 of the course material.)
A: Incorrect. To the contrary, Congress has recently attempted to put caps on
executive compensation.
B: Incorrect. Shareholders would logically prefer lower salaries.
C: Correct. When many financial institutions went public, compensation escalated
as shareholder money was being used to pay those salaries.
D: Incorrect. Employees certainly wanted to make more money, but the precipitating
event was an escalation in the number of public companies.
(See page 4-7 of the course material.)
Deregulation Redux
Chapter 5: Subprime Lending
In the early 1980s, subprime lenders such as Household Finance Corp. and thrifts such
as Long Beach Savings and Loan made home equity loans, often second mortgages, to
borrowers who had yet to establish credit histories or had troubled financial histories,
sometimes reflecting setbacks such as unemployment, divorce, medical emergencies,
and the like. Banks might have been unwilling to lend to these borrowers, but a subprime
lender would if the borrower paid a higher interest rate to offset the extra risk. “No one
can debate the need for legitimate non-prime (subprime) lending products,” Gail Burks,
president of the Nevada Fair Housing Center, Inc., testified to the FCIC.
Interest rates on subprime mortgages, with substantial collateral – the house – weren’t
as high as those for car loans, and were much less than credit cards. The advantages of
a mortgage over other forms of debt were solidified in 1986 with the Tax Reform Act,
which barred deducting interest payments on consumer loans, but kept the deduction for
mortgage interest payments.
In the 1980s and into the early 1990s, before computerized “credit scoring” – a statistical
technique used to measure a borrower’s creditworthiness – automated the assessment
of risk, mortgage lenders (including subprime lenders) relied on other factors when
underwriting mortgages. As Tom Putnam, a Sacramento-based mortgage banker, told
the Commission, they traditionally lent based on the four C’s: credit (quantity, quality,
and duration of the borrower’s credit obligations), capacity (amount and stability of
income), capital (sufficient liquid funds to cover down payments, closing costs, and
reserves), and collateral (value and condition of the property). Their decisions depended
on judgments about how strength in one area, such as collateral, might offset
weaknesses in others, such as credit. They underwrote borrowers one at a time, out of
local offices.
In a few cases, such as CitiFinancial, subprime lending firms were part of a bank holding
company, but most – including Household, Beneficial Finance, The Money Store, and
Champion Mortgage – were independent consumer finance companies. Without access
to deposits, they generally funded themselves with short-term lines of credit, or
“warehouse lines,” from commercial or investment banks. In many cases, the finance
companies did not keep the mortgages. Some sold the loans to the same banks
extending the warehouse lines. The banks would securitize and sell the loans to
investors or keep them on their balance sheets. In other cases, the finance company
itself packaged and sold the loans – often partnering with the banks extending the
warehouse lines. Meanwhile, the S&Ls that originated subprime loans generally financed
their own mortgage operations and kept the loans on their balance sheets.
I. Mortgage Securitization: “This Stuff Is So Complicated How Is Anybody
Going to Know?”
Debt outstanding in U.S. credit markets tripled during the 1980s, reaching $13.8 trillion in
1990; 11% was securitized mortgages and GSE debt. Later, mortgage securities made
up 18% of the debt markets, overtaking government Treasuries as the single largest
component – a position they maintained through the financial crisis.
Subprime Lending
In the 1990s mortgage companies, banks, and Wall Street securities firms began
securitizing mortgages. And more of them were subprime. Salomon Brothers, Merrill
Lynch, and other Wall Street firms started packaging and selling “non-agency”
mortgages – that is, loans that did not conform to Fannie’s and Freddie’s standards.
Selling these required investors to adjust expectations. With securitizations handled by
Fannie and Freddie, the question was not “will you get the money back” but “when,”
former Salomon Brothers trader and CEO of PentAlpha Jim Callahan told the FCIC. With
these new non-agency securities, investors had to worry about getting paid back, and
that created an opportunity for S&P and Moody’s. As Lewis Ranieri, a pioneer in the
market, told the Commission, when he presented the concept of non-agency
securitization to policy makers, they asked, “‘This stuff is so complicated how is anybody
going to know? How are the buyers going to buy?’” Ranieri said, “One of the solutions
was, it had to have a rating. And that put the rating services in the business.”
Non-agency securitizations were only a few years old when they received a powerful
stimulus from an unlikely source: the federal government. The savings and loan crisis
had left Uncle Sam with $402 billion in loans and real estate from failed thrifts and
banks. Congress established the Resolution Trust Corporation (RTC) in 1989 to offload
mortgages and real estate, and sometimes the failed thrifts themselves, now owned by
the government. While the RTC was able to sell $6.1 billion of these mortgages to
Fannie and Freddie, most did not meet the GSEs’ standards. Some were what might be
called subprime today, but others had outright documentation errors or servicing
problems, not unlike the low-documentation loans that later became popular.
RTC officials soon concluded that they had neither the time nor the resources to sell off
the assets in their portfolio one by one and thrift by thrift. They turned to the private
sector, contracting with real estate and financial professionals to securitize some of the
assets. By the time the RTC concluded its work, it had securitized $25 billion in
residential mortgages. The RTC in effect helped expand the securitization of mortgages
ineligible for GSE guarantees. In the early 1990s, as investors became more familiar
with the securitization of these assets, mortgage specialists and Wall Street bankers got
in on the action. Securitization and subprime originations grew hand in hand. Subprime
originations increased from $70 billion in 1996 to $100 billion in 2000. The proportion
securitized in the late 1990s peaked at 56%, and subprime mortgage originations’ share
of all originations hovered around 10%.
Securitizations by the RTC and by Wall Street were similar to the Fannie and Freddie
securitizations. The first step was to get principal and interest payments from a group of
mortgages to flow into a single pool. But in “private-label” securities (that is,
securitizations not done by Fannie or Freddie), the payments were then “tranched” in a
way to protect some investors from losses. Investors in the tranches received different
streams of principal and interest in different orders.
Most of the earliest private-label deals, in the late 1980s and early 1990s, used a
rudimentary form of tranching. There were typically two tranches in each deal. The less
risky tranche received principal and interest payments first and was usually guaranteed
by an insurance company. The more risky tranche received payments second, was not
guaranteed, and was usually kept by the company that originated the mortgages.
Subprime Lending
Within a decade, securitizations had become much more complex: they had more
tranches, each with different payment streams and different risks, which were tailored to
meet investors’ demands. The entire private-label mortgage securitization market –
those who created, sold, and bought the investments – would become highly dependent
on this slice-and-dice process, and regulators and market participants alike took for
granted that it efficiently allocated risk to those best able and willing to bear that risk.
To demonstrate how this process worked, we’ll describe a typical deal, named CMLTI
2006-NC2, involving $947 million in mortgage-backed bonds. In 2006, New Century
Financial, a California-based lender, originated and sold 4,499 subprime mortgages to
Citigroup, which sold them to a separate legal entity that Citigroup sponsored that would
own the mortgages and issue the tranches. The entity purchased the loans with cash it
had raised by selling the securities these loans would back. The entity had been created
as a separate legal structure so that the assets would sit off Citigroup’s balance sheet,
an arrangement with tax and regulatory benefits.
The 4,499 mortgages carried the rights to the borrowers’ monthly payments, which the
Citigroup entity divided into 19 tranches of mortgage-backed securities; each tranche
gave investors a different priority claim on the flow of payments from the borrowers, and
a different interest rate and repayment schedule. The credit rating agencies assigned
ratings to most of these tranches for investors, who – as securitization became
increasingly complicated – came to rely more heavily on these ratings. Tranches were
assigned letter ratings by the rating agencies based on their riskiness. In this report,
ratings are generally presented in S&P’s classification system, which assigns ratings
such as “AAA” (the highest rating for the safest investments, referred to here as triple-A),
“AA” (less safe than AAA), “A,” “BBB,” and “BB,” and further distinguishes ratings with
“+” and “–.” Anything rated below “BBB-” is considered “junk.” Moody’s uses a similar
system in which “Aaa” is highest, followed by “Aa,” “A,” “Baa,” “Ba,” and so forth. For
example, an S&P rating of BBB would correspond to a Moody’s rating of Baa. In this
Citigroup deal, the four senior tranches – the safest – were rated triple-A by the
Below the senior tranches and next in line for payments were eleven “mezzanine”
tranches – so named because they sat between the riskiest and the safest tranches.
These were riskier than the senior tranches and, because they paid off more slowly,
carried a higher risk that an increase in interest rates would make the locked-in interest
payments less valuable. As a result, they paid a correspondingly higher interest rate.
Three of these tranches in the Citigroup deal were rated AA, three were A, three were
BBB (the lowest investment-grade rating), and two were BB, or junk.
The last to be paid was the most junior tranche, called the “equity,” “residual,” or “firstloss” tranche, set up to receive whatever cash flow was left over after all the other
investors had been paid. This tranche would suffer the first losses from any defaults of
the mortgages in the pool. Commensurate with this high risk, it provided the highest
yields. In the Citigroup deal, as was common, this piece of the deal was not rated at all.
Citigroup and a hedge fund each held half the equity tranche.
Subprime Lending
While investors in the lower-rated tranches received higher interest rates because they
knew there was a risk of loss, investors in the triple-A tranches did not expect payments
from the mortgages to stop. This expectation of safety was important, so the firms
structuring securities focused on achieving high ratings. In the structure of this Citigroup
deal, which was typical, $737 million, or 78%, was rated triple-A.
II. Greater Access to Lending: “A Business Where We Can Make Some
As private-label securitization began to take hold, new computer and modeling
technologies were reshaping the mortgage market. In the mid-1990s, standardized data
with loan-level information on mortgage performance became more widely available.
Lenders underwrote mortgages using credit scores, such as the FICO score, developed
by Fair Isaac Corporation. In 1994, Freddie Mac rolled out Loan Prospector, an
automated system for mortgage underwriting for use by lenders, and Fannie Mae
released its own system, Desktop Underwriter, two months later. The days of laborious,
slow, and manual underwriting of individual mortgage applicants were over, lowering
cost and broadening access to mortgages.
This new process was based on quantitative expectations: Given the borrower, the
home, and the mortgage characteristics, what was the probability payments would be on
time? What was the probability that borrowers would prepay their loans, either because
they sold their homes or refinanced at lower interest rates?
In the 1990s, technology also affected implementation of the Community Reinvestment
Act (CRA). Congress enacted the CRA in 1977 to ensure that banks and thrifts served
their communities, in response to concerns that banks and thrifts were refusing to lend in
certain neighborhoods without regard to the creditworthiness of individuals and
businesses in those neighborhoods (a practice known as redlining).
The CRA called on banks and thrifts to invest, lend, and service areas where they took
in deposits, so long as these activities didn’t impair their own financial safety and
soundness. It directed regulators to consider CRA performance whenever a bank or thrift
applied for regulatory approval for mergers, to open new branches, or to engage in new
The CRA encouraged banks to lend to borrowers to whom they may have previously
denied credit. While these borrowers often had lower-than-average income, a 1997
study indicated that loans made under the CRA performed consistently with the rest of
the banks’ portfolios, suggesting CRA lending was not riskier than the banks’ other
lending. “There is little or no evidence that banks’ safety and soundness have been
compromised by such lending, and bankers often report sound business opportunities,”
Federal Reserve Chairman Alan Greenspan said of CRA lending in 1998.
In 1993, President Bill Clinton asked regulators to improve banks’ CRA performance
while responding to industry complaints that the regulatory review process for
compliance was too burdensome and too subjective. In 1995, the Fed, Office of Thrift
Supervision (OTS), Office of the Comptroller of the Currency (OCC), and Federal
Deposit Insurance Corporation (FDIC) issued regulations that shifted the regulatory
focus from the efforts that banks made to comply with the CRA to their actual results.
Regulators and community advocates could now point to objective, observable numbers
that measured banks’ compliance with the law.
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Former comptroller John Dugan told FCIC staff that the impact of the CRA had been
lasting, because it encouraged banks to lend to people who in the past might not have
had access to credit. He said, “There is a tremendous amount of investment that goes
on in inner cities and other places to build things that are quite impressive. . . . And the
bankers conversely say, ‘This is proven to be a business where we can make some
money; not a lot, but when you factor that in plus the good will that we get from it, it kind
of works.’”
Lawrence Lindsey, a former Fed governor who was responsible for the Fed’s Division of
Consumer and Community Affairs, which oversees CRA enforcement, told the FCIC that
improved enforcement had given the banks an incentive to invest in technology that
would make lending to lower-income borrowers profitable by such means as creating
credit scoring models customized to the market. Shadow banks not covered by the CRA
would use these same credit scoring models, which could draw on now more substantial
historical lending data for their estimates, to underwrite loans. “We basically got a cycle
going which particularly the shadow banking industry could, using recent historic data,
show the default rates on this type of lending were very, very low,” he said. Indeed,
default rates were low during the prosperous 1990s, and regulators, bankers, and
lenders in the shadow banking system took note of this success.
III. Subprime Lenders in Turmoil: “Adverse Market Conditions”
Among nonbank mortgage originators, the late 1990s were a turning point. During the
market disruption caused by the Russian debt crisis and the Long-Term Capital
Management collapse, the markets saw a “flight to quality” – that is, a steep fall in
demand among investors for risky assets, including subprime securitizations. The rate of
subprime mortgage securitization dropped from 55.1% in 1998 to 37.4% in 1999.
Meanwhile, subprime originators saw the interest rate at which they could borrow in
credit markets skyrocket. They were caught in a squeeze: borrowing costs increased at
the very moment that their revenue stream dried up. And some were caught holding
tranches of subprime securities that turned out to be worth far less than the value they
had been assigned.
Mortgage lenders that depended on liquidity and short-term funding had immediate
problems. For example, Southern Pacific Funding (SFC), an Oregon-based subprime
lender that securitized its loans, reported relatively positive second-quarter results in
August 1998. Then, in September, SFC notified investors about “recent adverse market
conditions” in the securities markets and expressed concern about “the continued
viability of securitization in the foreseeable future.” A week later, SFC filed for bankruptcy
protection. Several other nonbank subprime lenders that were also dependent on shortterm financing from the capital markets also filed for bankruptcy in 1998 and 1999. In the
two years following the Russian default crisis, 8 of the top 10 subprime lenders declared
bankruptcy, ceased operations, or sold out to stronger firms.
When these firms were sold, their buyers would frequently absorb large losses. First
Union, a large regional bank headquartered in North Carolina, incurred charges of
almost $1.7 billion after it bought The Money Store. First Union eventually shut down or
sold off most of The Money Store’s operations.
Subprime Lending
Conseco, a leading insurance company, purchased Green Tree Financial, another
subprime lender. Disruptions in the securitization markets, as well as unexpected
mortgage defaults, eventually drove Conseco into bankruptcy in December 2002. At the
time, this was the third-largest bankruptcy in U.S. history (after WorldCom and Enron).
Accounting misrepresentations would also bring down subprime lenders. Keystone, a
small national bank in West Virginia that made and securitized subprime mortgage
loans, failed in 1999. In the securitization process – as was common practice in the
1990s – Keystone retained the riskiest “first-loss” residual tranches for its own account.
These holdings far exceeded the bank’s capital. But Keystone assigned them grossly
inflated values. The OCC closed the bank in September 1999, after discovering “fraud
committed by the bank management,” as executives had overstated the value of the
residual tranches and other bank assets. Perhaps the most significant failure occurred at
Superior Bank, one of the most aggressive subprime mortgage lenders. Like Keystone, it
too failed after having kept and overvalued the first-loss tranches on its balance sheet.
Many of the lenders that survived or were bought in the 1990s reemerged in other forms.
Long Beach was the ancestor of Ameriquest and Long Beach Mortgage (which was in
turn purchased by Washington Mutual), two of the more aggressive lenders during the
first decade of the new century. Associates First was sold to Citigroup, and Household
bought Beneficial Mortgage before it was itself acquired by HSBC in 2003.
With the subprime market disrupted, subprime originations totaled $100 billion in 2000,
down from $135 billion two years earlier. Over the next few years, however, subprime
lending and securitization would more than rebound.
IV. The Regulators: “Oh, I See”
During the 1990s, various federal agencies had taken increasing notice of abusive
subprime lending practices. But the regulatory system was not well equipped to respond
consistently – and on a national basis – to protect borrowers. State regulators, as well as
either the Fed or the FDIC, supervised the mortgage practices of state banks. The OCC
supervised the national banks. The OTS or state regulators were responsible for the
thrifts. Some state regulators also licensed mortgage brokers, a growing portion of the
market, but did not supervise them.
Despite this diffusion of authority, one entity was unquestionably authorized by Congress
to write strong and consistent rules regulating mortgages for all types of lenders: the
Federal Reserve, through the Truth in Lending Act of 1968. In 1969, the Fed adopted
Regulation Z for the purpose of implementing the act. But while Regulation Z applied to
all lenders, its enforcement was divided among America’s many financial regulators.
One sticking point was the supervision of nonbank subsidiaries such as subprime
lenders. The Fed had the legal mandate to supervise bank holding companies, including
the authority to supervise their nonbank subsidiaries. The Federal Trade Commission
was given explicit authority by Congress to enforce the consumer protections embodied
in the Truth in Lending Act with respect to these nonbank lenders. Although the FTC
brought some enforcement actions against mortgage companies, Henry Cisneros, a
former secretary of the Department of Housing and Urban Development (HUD), worried
that its budget and staff were not commensurate with its mandate to supervise these
lenders. “We could have had the FTC oversee mortgage contracts,” Cisneros told the
Commission. “But the FTC is up to their neck in work today with what they’ve got. They
don’t have the staff to go out and search out mortgage problems.”
Subprime Lending
Glenn Loney, deputy director of the Fed’s Consumer and Community Affairs Division
from 1998 to 2010, told the FCIC that ever since he joined the agency in 1975, Fed
officials had been debating whether they – in addition to the FTC – should enforce rules
for nonbank lenders. But they worried about whether the Fed would be stepping on
congressional prerogatives by assuming enforcement responsibilities that legislation had
delegated to the FTC. “A number of governors came in and said, ‘You mean to say we
don’t look at these?’” Loney said. “And then we tried to explain it to them, and they’d say,
‘Oh, I see.’” The Federal Reserve would not exert its authority in this area, nor others
that came under its purview in 1994, with any real force until after the housing bubble
The 1994 legislation that gave the Fed new responsibilities was the Home Ownership
and Equity Protection Act (HOEPA), passed by Congress and signed by President
Clinton to address growing concerns about abusive and predatory mortgage lending
practices that especially affected low-income borrowers. HOEPA specifically noted that
certain communities were “being victimized . . . by second mortgage lenders, home
improvement contractors, and finance companies who peddle high rate, high-fee home
equity loans to cash-poor homeowners.” For example, a Senate report highlighted the
case of a 72-year-old homeowner, who testified at a hearing that she paid more than
$23,000 in upfront finance charges on a $150,000 second mortgage. In addition, the
monthly payments on the mortgage exceeded her income.
HOEPA prohibited abusive practices relating to certain high-cost refinance mortgage
loans, including prepayment penalties, negative amortization, and balloon payments with
a term of less than five years. The legislation also prohibited lenders from making highcost refinance loans based on the collateral value of the property alone and “without
regard to the consumers’ repayment ability, including the consumers’ current and
expected income, current obligations, and employment.” However, only a small
percentage of mortgages were initially subject to the HOEPA restrictions, because the
interest rate and fee levels for triggering HOEPA’s coverage were set too high to catch
most subprime loans. Even so, HOEPA specifically directed the Fed to act more broadly
to “prohibit acts or practices in connection with [mortgage loans] that [the Board] finds to
be unfair, deceptive or designed to evade the provisions of this [act].”
In June 1997, two years after HOEPA took effect, the Fed held the first set of public
hearings required under the act. The venues were Los Angeles, Atlanta, and
Washington, D.C. Consumer advocates reported abuses by home equity lenders. A
report summarizing the hearings, jointly issued with the Department of Housing and
Urban Development and released in July 1998, said that mortgage lenders
acknowledged that some abuses existed, blamed some of these on mortgage brokers,
and suggested that the increasing securitization of subprime mortgages was likely to
limit the opportunity for widespread abuses. The report stated, “Creditors that package
and securitize their home equity loans must comply with a series of representations and
warranties. These include creditors’ representations that they have complied with strict
underwriting guidelines concerning the borrower’s ability to repay the loan.” But in the
years to come, these representations and warranties would prove to be inaccurate.
Still, the Fed continued not to press its prerogatives. In January 1998, it formalized its
long-standing policy of “not routinely conducting consumer compliance examinations of
nonbank subsidiaries of bank holding companies,” a decision that would be criticized by
a November 1999 General Accounting Office report for creating a “lack of regulatory
oversight.” The July 1998 report also made recommendations on mortgage reform.
Subprime Lending
While preparing draft recommendations for the report, Fed staff wrote to the Fed’s
Committee on Consumer and Community Affairs that “given the Board’s traditional
reluctance to support substantive limitations on market behavior, the draft report
discusses various options but does not advocate any particular approach to addressing
these problems.”
In the end, although the two agencies did not agree on the full set of recommendations
addressing predatory lending, both the Fed and HUD supported legislative bans on
balloon payments and advance collection of lump-sum insurance premiums, stronger
enforcement of current laws, and nonregulatory strategies such as community outreach
efforts and consumer education and counseling. But Congress did not act on these
The Fed-Lite provisions under the Gramm-Leach-Bliley Act affirmed the Fed’s hands-off
approach to the regulation of mortgage lending. Even so, the shakeup in the subprime
industry in the late 1990s had drawn regulators’ attention to at least some of the risks
associated with this lending. For that reason, the Federal Reserve, FDIC, OCC, and
OTS jointly issued subprime lending guidance on March 1, 1999. This guidance applied
only to regulated banks and thrifts, and even for them it would not be binding, but merely
laid out the criteria underlying regulators’ bank examinations. It explained that “recent
turmoil in the equity and asset-backed securities market has caused some non-bank
subprime specialists to exit the market, thus creating increased opportunities for financial
institutions to enter, or expand their participation in, the subprime lending business.”
The agencies then identified key features of subprime lending programs and the need
for increased capital, risk management, and board and senior management oversight.
They further noted concerns about various accounting issues, notably the valuation of
any residual tranches held by the securitizing firm. The guidance went on to warn,
“Institutions that originate or purchase subprime loans must take special care to avoid
violating fair lending and consumer protection laws and regulations. Higher fees and
interest rates combined with compensation incentives can foster predatory pricing. . . .
An adequate compliance management program must identify, monitor and control the
consumer protection hazards associated with subprime lending.”
In spring 2000, in response to growing complaints about lending practices, and at the
urging of members of Congress, HUD Secretary Andrew Cuomo and Treasury Secretary
Lawrence Summers convened the joint National Predatory Lending Task Force. It
included members of consumer advocacy groups; industry trade associations
representing mortgage lenders, brokers, and appraisers; local and state officials; and
academics. As the Fed had done three years earlier, this new entity took to the field,
conducting hearings in Atlanta, Los Angeles, New York, Baltimore, and Chicago. The
task force found “patterns” of abusive practices, reporting “substantial evidence of toofrequent abuses in the subprime lending market.” Questionable practices included loan
flipping (repeated refinancing of borrowers’ loans in a short time), high fees and
prepayment penalties that resulted in borrowers’ losing the equity in their homes, and
outright fraud and abuse involving deceptive or high-pressure sales tactics. The report
cited testimony regarding incidents of forged signatures, falsification of incomes and
appraisals, illegitimate fees, and bait-and-switch tactics. The investigation confirmed that
subprime lenders often preyed on the elderly, minorities, and borrowers with lower
incomes and less education, frequently targeting individuals who had “limited access to
the mainstream financial sector” – meaning the banks, thrifts, and credit unions, which it
viewed as subject to more extensive government oversight.
Subprime Lending
Consumer protection groups took the same message to public officials. In interviews
with and testimony to the FCIC, representatives of the National Consumer Law Center
(NCLC), Nevada Fair Housing Center, Inc., and California Reinvestment Coalition each
said they had contacted Congress and the four bank regulatory agencies multiple times
about their concerns over unfair and deceptive lending practices. “It was apparent on the
ground as early as ‘96 or ‘98 . . . that the market for low-income consumers was being
flooded with inappropriate products,” Diane Thompson of the NCLC told the
The HUD-Treasury task force recommended a set of reforms aimed at protecting
borrowers from the most egregious practices in the mortgage market, including better
disclosure, improved financial literacy, strengthened enforcement, and new legislative
protections. However, the report also recognized the downside of restricting the lending
practices that offered many borrowers with less-than-prime credit a chance at
homeownership. It was a dilemma. Gary Gensler, who worked on the report as a senior
Treasury official and is currently the chairman of the Commodity Futures Trading
Commission, told the FCIC that the report’s recommendations “lasted on Capitol Hill a
very short time. . . . There wasn’t much appetite or mood to take these
But problems persisted, and others would take up the cause. Through the early years of
the new decade, “the really poorly underwritten loans, the payment shock loans”
continued to proliferate outside the traditional banking sector, said FDIC Chairman
Sheila Bair, who served at Treasury as the assistant secretary for financial institutions
from 2001 to 2002. In testimony to the Commission, she observed that these poorquality loans pulled market share from traditional banks and “created negative
competitive pressure for the banks and thrifts to start following suit.” She added,
[Subprime lending] was started and the lion’s share of it occurred in the
nonbank sector, but it clearly created competitive pressures on banks. . . .
I think nipping this in the bud in 2000 and 2001 with some strong
consumer rules applying across the board that just simply said you’ve got
to document a customer’s income to make sure they can repay the loan,
you’ve got to make sure the income is sufficient to pay the loans when the
interest rate resets, just simple rules like that . . . could have done a lot to
stop this.
After Bair was nominated to her position at Treasury, and when she was making the
rounds on Capitol Hill, Senator Paul Sarbanes, chairman of the Committee on Banking,
Housing, and Urban Affairs, told her about lending problems in Baltimore, where
foreclosures were on the rise. He asked Bair to read the HUD-Treasury report on
predatory lending, and she became interested in the issue. Sarbanes introduced
legislation to remedy the problem, but it faced significant resistance from the mortgage
industry and within Congress, Bair told the Commission. Bair decided to try to get the
industry to adopt a set of “best practices” that would include a voluntary ban on
mortgages that strip borrowers of their equity, and would offer borrowers the opportunity
to avoid prepayment penalties by agreeing instead to pay a higher interest rate. She
reached out to Edward Gramlich, a governor at the Fed who shared her concerns, to
enlist his help in getting companies to abide by these rules. Bair said that Gramlich didn’t
Subprime Lending
talk out of school but made it clear to her that the Fed avenue wasn’t going to happen.
Similarly, Sandra Braunstein, the director of the Division of Consumer and Community
Affairs at the Fed, said that Gramlich told the staff that Greenspan was not interested in
increased regulation.
When Bair and Gramlich approached a number of lenders about the voluntary program,
Bair said some originators appeared willing to participate. But the Wall Street firms that
securitized the loans resisted, saying that they were concerned about possible liability if
they did not adhere to the proposed best practices, she recalled. The effort died.
Of course, even as these initiatives went nowhere, the market did not stand still.
Subprime mortgages were proliferating rapidly, becoming mainstream products.
Originations were increasing, and products were changing. By 1999, three of every four
subprime mortgages was a first mortgage, and of those 82% were used for refinancing
rather than a home purchase. Fifty-nine percent of those refinancings were cash-outs,
helping to fuel consumer spending while whittling away homeowners’ equity.
Subprime Lending
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. Before the technological advances of “credit scoring,” what was not used to
determine whether or not a person would be a creditable borrower:
their credit history
they had the capacity to make the loan payments
they had capital to finance the deal
they were courteous and considerate
2. In the U.S throughout the 1980s, the credit markets tripled in regard to the
outstanding debt.
a) true
b) false
3. What was the name of the Act that made financial institutions lend to those in their
communities who met the necessary loan qualifications:
the Community Fairness Act
the Tax Reform Act
the Community Reinvestment Act
none of the above
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1. A: Incorrect. Credit history was one of the four C’s used to determine a borrower’s
B: Incorrect. Their capacity to make the loan payments was another one of the four
C: Incorrect. One of the four C’s was also having the proper capital to finance the
D: Correct. This had no effect on determining if a borrower was worthy or not. The
four C’s which included credit, capacity, capital, and collateral were used before
“credit scoring.”
(See page 5-1 of the course material.)
2. A: True is correct. The 1980s saw huge increases in the outstanding debt of U.S.
credit markets.
B: False is incorrect. In 1990, the U.S. credit markets’ outstanding debt reached
$13.8 trillion.
(See page 5-1 of the course material.)
3. A: Incorrect. There is no such Act.
B: Incorrect. The Tax Reform Act allowed for the interest on mortgage payments only
to be deducted, and not on other types of loans.
C: Correct. This Act made certain that banks were lending to borrowers from their
neighborhoods who qualified for loans.
D: Incorrect. One of the responses is correct.
(See page 5-4 of the course material.)
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Chapter 6: Credit Expansion
By the end of 2000, the economy had grown 39 straight quarters. Federal Reserve
Chairman Alan Greenspan argued the financial system had achieved unprecedented
resilience. Large financial companies were – or at least to many observers at the time,
appeared to be – profitable, diversified, and, executives and regulators agreed,
protected from catastrophe by sophisticated new techniques of managing risk.
The housing market was also strong. Between 1995 and 2000, prices rose at an annual
rate of 5.2%; over the next five years, the rate would hit 11.5%. Lower interest rates for
mortgage borrowers were partly the reason, as was greater access to mortgage credit
for households who had traditionally been left out – including subprime borrowers. Lower
interest rates and broader access to credit were available for other types of borrowing,
too, such as credit cards and auto loans.
Increased access to credit meant a more stable, secure life for those who managed their
finances prudently. It meant families could borrow during temporary income drops, pay
for unexpected expenses, or buy major appliances and cars. It allowed other families to
borrow and spend beyond their means. Most of all, it meant a shot at homeownership,
with all its benefits; and for some, an opportunity to speculate in the real estate market.
As home prices rose, homeowners with greater equity felt more financially secure and,
partly as a result, saved less and less. Many others went one step further, borrowing
against the equity. The effect was unprecedented debt: between 2001 and 2007,
mortgage debt nationally nearly doubled. Household debt rose from 80% of disposable
personal income in 1993 to almost 130% by mid-2006. More than three-quarters of this
increase was mortgage debt. Part of the increase was from new home purchases, part
from new debt on older homes.
Mortgage credit became more available when subprime lending started to grow again
after many of the major subprime lenders failed or were purchased in 1998 and 1999.
Afterward, the biggest banks moved in. In 2000, Citigroup, with $800 billion in assets,
paid $31 billion for Associates First Capital, the second-biggest subprime lender. Still,
subprime lending remained only a niche, just 9.5% of new mortgages in 2000.
Subprime lending risks and questionable practices remained a concern. Yet the Federal
Reserve did not aggressively employ the unique authority granted it by the Home
Ownership and Equity Protection Act (HOEPA). Although in 2004 the Fed fined Citigroup
$70 million for lending violations, it only minimally revised the rules for a narrow set of
high-cost mortgages. Following losses by several banks in subprime securitization, the
Fed and other regulators revised capital standards.
I. Housing: “A Powerful Stabilizing Force”
By the beginning of 2001, the economy was slowing, even though unemployment
remained at a 30-year low of 4%. To stimulate borrowing and spending, the Federal
Reserve’s Federal Open Market Committee lowered short-term interest rates
aggressively. On January 3, 2001, in a rare conference call between scheduled
meetings, it cut the benchmark federal funds rate – at which banks lend to each other
overnight – by a half percentage point, rather than the more typical quarter point. Later
that month, the committee cut the rate another half point, and it continued cutting
throughout the year – 11 times in all – to 1.75%, the lowest in 40 years.
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In the end, the recession of 2001 was relatively mild, lasting only eight months, from
March to November, and gross domestic product, or GDP – the most common gauge of
the economy – dropped by only 0.3%. Some policy makers concluded that perhaps, with
effective monetary policy, the economy had reached the so-called end of the business
cycle, which some economists had been predicting since before the tech crash.
“Recessions have become less frequent and less severe,” said Ben Bernanke, then a
Fed governor, in a speech early in 2004. “Whether the dominant cause of the Great
Moderation is structural change, improved monetary policy, or simply good luck is an
important question about which no consensus has yet formed.”
With the recession over and mortgage rates at 40-year lows, housing kicked into high
gear – no again. The nation would lose more than 340,000 nonfarm jobs in 2002 but
make small gains in construction. In states where bubbles soon appeared, construction
picked up quickly. California ended 2002 with a total of only 2,300 more jobs, but with
21,100 new construction jobs. In Florida, 14% of net job growth was in construction. In
2003, builders started more than 1.8 million single-family dwellings, a rate unseen since
the late 1970s. From 2002 to 2005, residential construction contributed three times more
to the economy than it had contributed on average since 1990.
But elsewhere the economy remained sluggish, and employment gains were frustratingly
small. Experts began talking about a “jobless recovery” – more production without a
corresponding increase in employment. For those with jobs, wages stagnated. Between
2002 and 2005, weekly private nonfarm, nonsupervisory wages actually fell by 1% after
adjusting for inflation. Faced with these challenges, the Fed shifted perspective, now
considering the possibility that consumer prices could fall, an event that had worsened
the Great Depression seven decades earlier. While concerned, the Fed believed
deflation would be avoided. In a widely quoted 2002 speech, Bernanke said the chances
of deflation were “extremely small” for two reasons. First, the economy’s natural
resilience: “Despite the adverse shocks of the past year, our banking system remains
healthy and well-regulated, and firm and household balance sheets are for the most part
in good shape.” Second, the Fed would not allow it. “I am confident that the Fed would
take whatever means necessary to prevent significant deflation in the United States. . . .
[T]he U.S. government has a technology, called a printing press (or, today, its electronic
equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no
The Fed’s monetary policy kept short-term interest rates low. During 2003, the strongest
U.S. companies could borrow for 90 days in the commercial paper market at an average
1.1%, compared with 6.3% just three years earlier; rates on three-month Treasury bills
dropped below 1% in mid-2003 from 6% in 2000.
Low rates cut the cost of homeownership: interest rates for the typical 30-year fixed-rate
mortgage traditionally moved with the overnight fed funds rate, and from 2000 to 2003,
this relationship held. By 2003, creditworthy home buyers could get fixed-rate mortgages
for 5.2%, 3 percentage points lower than three years earlier. The savings were
immediate and large. For a home bought at the median price of $180,000, with a 20%
down payment, the monthly mortgage payment would be $286 less than in 2000. Or to
turn the perspective around – as many people did – for the same monthly payment of
$1,077, a homeowner could move up from a $180,000 home to a $245,000 one.
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An adjustable-rate mortgage (ARM) gave buyers even lower initial payments or made a
larger house affordable – unless interest rates rose. In 2001, just 4% of prime borrowers
with new mortgages chose ARMs; in 2003, 10% did. In 2004, the proportion rose to
21%. Among subprime borrowers, already heavy users of ARMs, it rose from around
60% to 76%.
As people jumped into the housing market, prices rose, and in hot markets they really
took off. In Florida, average home prices gained 4.1% annually from 1995 to 2000 and
then 11.1% annually from 2000 to 2003. In California, those numbers were even higher:
6.1% and 13.6%. In California, a house bought for $200,000 in 1995 was worth
$454,428 nine years later. However, soaring prices were not necessarily the norm. In
Washington State, prices continued to appreciate, but more slowly: 5.9% annually from
1995 to 2000, 5.5% annually from 2000 to 2003. In Ohio, the numbers were 4.3% and
3.6%. Nationwide, home prices rose 9.8% annually from 2000 to 2003 – historically high,
but well under the fastest-growing markets.
Homeownership increased steadily, peaking at 69.2% of households in 2004. Because
so many families were benefiting from higher home values, household wealth rose to
nearly six times income, up from five times a few years earlier. The top 10% of
households by net worth, of whom 96% owned their homes, saw the value of their
primary residences rise between 2001 and 2004 from $372,800 to $450,000 (adjusted
for inflation), an increase of more than $77,000. Median net worth for all households in
the top 10%, after accounting for other housing value and assets, as well as all liabilities,
was $1.4 million in 2004. Homeownership rates for the bottom 25% of households ticked
up from 14% to 15% between 2001 and 2004; the median value of their primary
residences rose from $52,700 to $65,000, an increase of more than $12,000. Median net
worth for households in the bottom 25% was $1,700 in 2004.
Historically, every $1,000 increase in housing wealth boosted consumer spending by an
estimated $50 a year. But economists debated whether the wealth increases would
affect spending more than in past years, because so many homeowners at so many
levels of wealth saw increases and because it was easier and cheaper to tap home
Higher home prices and low mortgage rates brought a wave of refinancing to the prime
mortgage market. In 2003 alone, lenders refinanced over 15 million mortgages, more
than one in four – an unprecedented level. Many homeowners took out cash while
cutting their interest rates. From 2001 through 2003, cash-out refinancings netted these
households an estimated $427 billion; homeowners accessed another $430 billion via
home equity loans. Some were typical second liens; others were a newer invention, the
home equity line of credit. These operated much like a credit card, letting the borrower
borrow and repay as needed, often with the convenience of an actual plastic card.
According to the Fed’s 2004 Survey of Consumer Finances, 45.0% of homeowners who
tapped their equity used that money for expenses such as medical bills, taxes,
electronics, and vacations, or to consolidate debt; another 31.0% used it for home
improvements; and the rest purchased more real estate, cars, investments, clothing, or
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A Congressional Budget Office paper from 2007 reported on the recent history: “As
housing prices surged in the late 1990s and early 2000s, consumers boosted their
spending faster than their income rose. That was reflected in a sharp drop in the
personal savings rate.” Between 1998 and 2005, increased consumer spending
accounted for between 67% and 168% of GDP growth in any year – rising above 100%
in years when spending growth offset declines elsewhere in the economy. Meanwhile,
the personal savings rate dropped from 5.2% to 1.4%. Some components of spending
grew remarkably fast: home furnishings and other household durables, recreational
goods and vehicles, spending at restaurants, and health care. Overall consumer
spending grew faster than the economy, and in some years it grew faster than real
disposable income.
Nonetheless, the economy looked stable. By 2003, it had weathered the brief recession
of 2001 and the dot-com bust, which had caused the largest loss of wealth in decades.
With new financial products like the home equity line of credit, households could borrow
against their homes to compensate for investment losses or unemployment. Deflation,
against which the Fed had struck preemptively, did not materialize.
At a congressional hearing in November 2002, Greenspan acknowledged – at least
implicitly – that after the dot-com bubble burst, the Fed cut interest rates in part to
promote housing. Greenspan argued that the Fed’s low-interest-rate policy had
stimulated the economy by encouraging home sales and housing starts with “mortgage
interest rates that are at lows not seen in decades.” As Greenspan explained, “Mortgage
markets have also been a powerful stabilizing force over the past two years of economic
distress by facilitating the extraction of some of the equity that homeowners had built
up.” In February 2004, he reiterated his point, referring to “a large extraction of cash from
home equity.”
II. Subprime Loans
The subprime market roared back from its shakeout in the late 1990s. The value of
subprime loans originated almost doubled from 2001 through 2003, to $310 billion. In
2000, 52% of these were securitized; in 2003, 63%. Low interest rates spurred this
boom, which would have long-term repercussions, but so did increasingly widespread
computerized credit scores, the growing statistical history on subprime borrowers, and
the scale of the firms entering the market.
Subprime was dominated by a narrowing field of ever-larger firms; the marginal players
from the past decade had merged or vanished. By 2003, the top 25 subprime lenders
made 93% of all subprime loans, up from 47% in 1996.
There were now three main kinds of companies in the subprime origination and
securitization business: commercial banks and thrifts, Wall Street investment banks, and
independent mortgage lenders. Some of the biggest banks and thrifts – Citigroup,
National City Bank, HSBC, and Washington Mutual – spent billions on boosting
subprime lending by creating new units, acquiring firms, or offering financing to other
mortgage originators. Almost always, these operations were sequestered in nonbank
subsidiaries, leaving them in a regulatory no-man’s-land.
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When it came to subprime lending, now it was Wall Street investment banks that worried
about competition posed by the largest commercial banks and thrifts. Former Lehman
president Bart McDade told the FCIC that the banks had gained their own securitization
skills and didn’t need the investment banks to structure and distribute. So the investment
banks moved into mortgage origination to guarantee a supply of loans they could
securitize and sell to the growing legions of investors. For example, Lehman Brothers,
the fourth-largest investment bank, purchased six different domestic lenders between
1998 and 2004, including BNC and Aurora. Bear Stearns, the fifth-largest, ramped up its
subprime lending arm and eventually acquired three subprime originators in the United
States, including Encore. In 2006, Merrill Lynch acquired First Franklin, and Morgan
Stanley bought Saxon Capital; in 2007, Goldman Sachs upped its stake in Senderra
Funding, a small subprime lender.
Meanwhile, several independent mortgage companies took steps to boost growth. New
Century and Ameriquest were especially aggressive. New Century’s “Focus 2000” plan
concentrated on “originating loans with characteristics for which whole loan buyers will
pay a high premium.” Those “whole loan buyers” were the firms on Wall Street that
purchased loans and, most often, bundled them into mortgage-backed securities. They
were eager customers. In 2003, New Century sold $20.8 billion in whole loans, up from
$3.1 billion three years before, launching the firm from tenth to second place among
subprime originators. Three-quarters went to two securitizing firms – Morgan Stanley
and Credit Suisse – but New Century reassured its investors that there were “many
more prospective buyers.”
Ameriquest, in particular, pursued volume. According to the company’s public
statements, it paid its account executives less per mortgage than the competition, but it
encouraged them to make up the difference by underwriting more loans. “Our people
make more volume per employee than the rest of the industry,” Aseem Mital, CEO of
Ameriquest, said in 2005. The company cut costs elsewhere in the origination process,
too. The back office for the firm’s retail division operated in assembly line fashion, Mital
told a reporter for American Banker; the work was divided into specialized tasks,
including data entry, underwriting, customer service, account management, and funding.
Ameriquest used its savings to undercut by as much as 0.55% what competing
originators charged securitizing firms, according to an industry analyst’s estimate.
Between 2000 and 2003, Ameriquest loan origination rose from an estimated $4 billion
to $39 billion annually. That vaulted the firm from eleventh to first place among subprime
originators. “They are clearly the aggressor,” Countrywide CEO Angelo Mozilo told his
investors in 2005. By 2005, Countrywide was third on the list.
The subprime players followed diverse strategies. Lehman and Countrywide pursued a
“vertically integrated” model, involving them in every link of the mortgage chain:
originating and funding the loans, packaging them into securities, and finally selling the
securities to investors. Others concentrated on niches: New Century, for example,
mainly originated mortgages for immediate sale to other firms in the chain.
When originators made loans to hold through maturity – an approach known as
originate-to-hold – they had a clear incentive to underwrite carefully and consider the
risks. However, when they originated mortgages to sell, for securitization or otherwise –
no known as originate-to-distribute – they no longer risked losses if the loan defaulted.
As long as they made accurate representations and warranties, the only risk was to their
reputations if a lot of their loans went bad – but during the boom, loans were not going
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bad. In total, this originate-to-distribute pipeline carried more than half of all mortgages
before the crisis, and a much larger piece of subprime mortgages.
For decades, a version of the originate-to-distribute model produced safe mortgages.
Fannie and Freddie had been buying prime, conforming mortgages since the 1970s,
protected by strict underwriting standards. But some saw that the model now had
problems. “If you look at how many people are playing, from the real estate agent all the
way through to the guy who is issuing the security and the underwriter and the
underwriting group and blah, blah, blah, then nobody in this entire chain is responsible to
anybody,” Lewis Ranieri, an early leader in securitization, told the FCIC, not the outcome
he and other investment bankers had expected. “None of us wrote and said, ‘Oh, by the
way, you have to be responsible for your actions,’” Ranieri said. “It was pretty selfevident.”
The starting point for many mortgages was a mortgage broker. These independent
brokers, with access to a variety of lenders, worked with borrowers to complete the
application process. Using brokers allowed more rapid expansion, with no need to build
branches; lowered costs, with no need for full-time salespeople; and extended
geographic reach.
For brokers, compensation generally came as up-front fees – from the borrower, from
the lender, or both – so the loan’s performance mattered little. These fees were often
paid without the borrower’s knowledge. Indeed, many borrowers mistakenly believed the
mortgage brokers acted in borrowers’ best interest. One common fee paid by the lender
to the broker was the “yield spread premium”: on higher-interest loans, the lending bank
would pay the broker a higher premium, giving the incentive to sign the borrower to the
highest possible rate. “If the broker decides he’s going to try and make more money on
the loan, then he’s going to raise the rate,” said Jay Jeffries, a former sales manager for
Fremont Investment & Loan, to the Commission. “We’ve got a higher rate loan, we’re
paying the broker for that yield spread premium.”
In theory, borrowers are the first defense against abusive lending. By shopping around,
they should realize, for example, if a broker is trying to sell them a higher priced loan or
to place them in a subprime loan when they would qualify for a less expensive prime
loan. But many borrowers do not understand the most basic aspects of their mortgage. A
study by two Federal Reserve economists estimated at least 38% of borrowers with
adjustable-rate mortgages did not understand how much their interest rates could reset
at one time, and more than half underestimated how high their rates could reach over
the years. The same lack of awareness extended to other terms of the loan – for
example, the level of documentation provided to the lender. “Most borrowers didn’t even
realize that they were getting a no-doc loan,” said Michael Calhoun, president of the
Center for Responsible Lending. “They’d come in with their W-2 and end up with a nodoc loan simply because the broker was getting paid more and the lender was getting
paid more and there was extra yield left over for Wall Street because the loan carried a
higher interest rate.”
And borrowers with less access to credit are particularly ill equipped to challenge the
more experienced person across the desk. “While many [consumers] believe they are
pretty good at dealing with day-to-day financial matters, in actuality they engage in
financial behaviors that generate expenses and fees: overdrawing checking accounts,
making late credit card payments, or exceeding limits on credit card charges,”
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Annamaria Lusardi, a professor of economics at Dartmouth College, told the FCIC.
“Comparing terms of financial contracts and shopping around before making financial
decisions are not at all common among the population.”
Critics argued that with this much money at stake, mortgage brokers had every incentive
to seek “the highest combination of fees and mortgage interest rates the market will
bear.” Herb Sandler, the founder and CEO of the thrift Golden West Financial
Corporation, told the FCIC that brokers were the “whores of the world.” As the housing
and mortgage market boomed, so did the brokers. Wholesale Access, which tracks the
mortgage industry, reported that from 2000 to 2003, the number of brokerage firms rose
from about 30,000 to 50,000. In 2000, brokers originated 55% of loans; in 2003, they
peaked at 68%. JP Morgan CEO Jamie Dimon testified to the FCIC that his firm
eventually ended its broker-originated business in 2009 after discovering the loans had
more than twice the losses of the loans that JP Morgan itself originated.
As the housing market expanded, another problem emerged, in subprime and prime
mortgages alike: inflated appraisals. For the lender, inflated appraisals meant greater
losses if a borrower defaulted. But for the borrower or for the broker or loan officer who
hired the appraiser, an inflated value could make the difference between closing and
losing the deal. Imagine a home selling for $200,000 that an appraiser says is actually
worth only $175,000. In this case, a bank won’t lend a borrower, say, $180,000 to buy
the home. The deal dies. Sure enough, appraisers began feeling pressure. One 2003
survey found that 55% of the appraisers had felt pressed to inflate the value of homes;
by 2006, this had climbed to 90%. The pressure came most frequently from the
mortgage brokers, but appraisers reported it from real estate agents, lenders, and in
many cases borrowers themselves. Most often, refusal to raise the appraisal meant
losing the client. Dennis J. Black, president of the Florida appraisal and brokerage
services firm D. J. Black & Co. and an appraiser with 24 years’ experience, held
continuing education sessions all over the country for the National Association of
Independent Fee Appraisers. He heard complaints from the appraisers that they had
been pressured to ignore missing kitchens, damaged walls, and inoperable mechanical
systems. Black told the FCIC, “The story I have heard most often is the client saying he
could not use the appraisal because the value was [not] what they needed.” The client
would hire somebody else.
Changes in regulations reinforced the trend toward laxer appraisal standards, as Karen
Mann, a Sacramento appraiser with 30 years’ experience, explained in testimony to the
FCIC. In 1994, the Federal Reserve, Office of the Comptroller of the Currency, Office of
Thrift Supervision, and Federal Deposit Insurance Corporation loosened the appraisal
requirements for the lenders they regulated by raising from $100,000 to $250,000 the
minimum home value at which an appraisal from a licensed professional was required.
In addition, Mann cited the lack of oversight of appraisers, noting, “We had a vast
increase of licensed appraisers in [California] in spite of the lack of qualified/experienced
trainers.” The Bakersfield appraiser Gary Crabtree told the FCIC that California’s Office
of Real Estate Appraisers had eight investigators to supervise 21,000 appraisers.
In 2005, the four bank regulators issued new guidance to strengthen appraisals. They
recommended that an originator’s loan production staff not select appraisers. That led
Washington Mutual to use an “appraisal management company,” First American
Corporation, to choose appraisers. Nevertheless, in 2007 the New York State attorney
general sued First American: relying on internal company documents, the complaint
alleged the corporation improperly let Washington Mutual’s loan production staff “hand-
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pick appraisers who bring in appraisal values high enough to permit WaMu’s loans to
close, and improperly permit[ted] WaMu to pressure . . . appraisers to change appraisal
values that are too low to permit loans to close.”
III. Citigroup
As subprime originations grew, Citigroup decided to expand, with troubling
consequences. Barely a year after the Gramm-Leach-Bliley Act validated its 1998
merger with Travelers, Citigroup made its next big move. In September 2000, it paid $31
billion for Associates First, then the second-largest subprime lender in the country (after
Household Finance.). Such a merger would usually have required approval from the
Federal Reserve and the other bank regulators because Associates First owned three
small banks (in Utah, Delaware, and South Dakota). But because these banks were
specialized, a provision tucked away in Gramm-Leach-Bliley kept the Fed out of the mix.
The OCC, FDIC, and New York State banking regulators reviewed the deal. Consumer
groups fought it, citing a long record of alleged lending abuses by Associates First,
including high prepayment penalties, excessive fees, and other opaque charges in loan
documents – all targeting unsophisticated borrowers who typically could not evaluate the
forms. “It’s simply unacceptable to have the largest bank in America take over the icon of
predatory lending,” said Martin Eakes, founder of a nonprofit community lender in North
Advocates for the merger argued that a large bank under a rigorous regulator could
reform the company, and Citigroup promised to take strong actions. Regulators
approved the merger in November 2000, and by the next summer Citigroup had started
suspending mortgage purchases from close to two-thirds of the brokers and half the
banks that had sold loans to Associates First. “We were aware that brokers were at the
heart of that public discussion and were at the heart of a lot of the [controversial] cases,”
said Pam Flaherty, a Citigroup senior vice president for community relations and
The merger exposed Citigroup to enhanced regulatory scrutiny. In 2001, the Federal
Trade Commission, which regulates independent mortgage companies’ compliance with
consumer protection laws, launched an investigation into Associates First’s premerger
business and found that the company had pressured borrowers to refinance into
expensive mortgages and to buy expensive mortgage insurance. In 2002, Citigroup
reached a record $215 million civil settlement with the FTC over Associates’ “systematic
and widespread deceptive and abusive lending practices.”
In 2001, the New York Fed used the occasion of Citigroup’s next proposed acquisition –
European American Bank on Long Island, New York – to launch its own investigation of
CitiFinancial, which now contained Associates First. “The manner in which [Citigroup]
approached that transaction invited regulatory scrutiny,” former Fed Governor Mark
Olson told the FCIC. “They bought a passel of problems for themselves and it was at
least a two-year [issue].” The Fed eventually accused CitiFinancial of converting
unsecured personal loans (usually for borrowers in financial trouble) into home equity
loans without properly assessing the borrower’s ability to repay. Reviewing lending
practices from 2000 and 2001, the Fed also accused the unit of selling credit insurance
to borrowers without checking if they would qualify for a mortgage without it. For these
violations and for impeding its investigation, the Fed in 2004 assessed $70 million in
penalties. The company said it expected to pay another $30 million in restitution to
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IV. Federal Rules Revisited
As Citigroup was buying Associates First in 2000, the Federal Reserve revisited the
rules protecting borrowers from predatory conduct. It conducted its second round of
hearings on the Home Ownership and Equity Protection Act (HOEPA), and subsequently
the staff offered two reform proposals. The first would have effectively barred lenders
from granting any mortgage – not just the limited set of high-cost loans defined by
HOEPA – solely on the value of the collateral and without regard to the borrower’s ability
to repay. For high-cost loans, the lender would have to verify and document the
borrower’s income and debt; for other loans, the documentation standard was weaker,
as the lender could rely on the borrower’s payment history and the like. The staff memo
explained this would mainly “affect lenders who make no-documentation loans.” The
second proposal addressed practices such as deceptive advertisements,
misrepresenting loan terms, and having consumers sign blank documents – acts that
involve fraud, deception, or misrepresentations.
Despite evidence of predatory tactics from their own hearings and from the recently
released HUD-Treasury report, Fed officials remained divided on how aggressively to
strengthen borrower protections. They grappled with the same trade-off that the HUDTreasury report had recently noted. “We want to encourage the growth in the subprime
lending market,” Fed Governor Edward Gramlich remarked at the Financial Services
Roundtable in early 2004. “But we also don’t want to encourage the abuses; indeed, we
want to do what we can to stop these abuses.” Fed General Counsel Scott Alvarez told
the FCIC, “There was concern that if you put out a broad rule, you would stop things that
were not unfair and deceptive because you were trying to get at the bad practices and
you just couldn’t think of all of the details you would need. And if you did think of all of
the details, you’d end up writing a rule that people could get around very easily.”
Greenspan, too, later said that to prohibit certain products might be harmful. “These and
other kinds of loan products, when made to borrowers meeting appropriate underwriting
standards, should not necessarily be regarded as improper,” he said, “and on the
contrary facilitated the national policy of making homeownership more broadly
available.” Instead, at least for certain violations of consumer protection laws, he
suggested another approach: “If there is egregious fraud, if there is egregious practice,
one doesn’t need supervision and regulation, what one needs is law enforcement.” But
the Federal Reserve would not use the legal system to rein in predatory lenders. From
2000 to the end of Greenspan’s tenure in 2006, the Fed referred to the Justice
Department only three institutions for fair lending violations related to mortgages: First
American Bank, in Carpentersville, Illinois; Desert Community Bank, in Victorville,
California; and the New York branch of Societe Generale, a large French bank.
Fed officials rejected the staff proposals. After some wrangling, in December 2001 the
Fed did modify HOEPA, but only at the margins. Explaining its actions, the board
highlighted compromise: “The final rule is intended to curb unfair or abusive lending
practices without unduly interfering with the flow of credit, creating unnecessary creditor
burden, or narrowing consumers’ options in legitimate transactions.” The status quo
would change little. Fed economists had estimated the percentage of subprime loans
covered by HOEPA would increase from 9% to as much as 38% under the new
regulations. But lenders changed the terms of mortgages to avoid the new rules’ revised
interest rate and fee triggers. By late 2005, it was clear that the new regulations would
end up covering only about 1% of subprime loans. Nevertheless, reflecting on the
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Federal Reserve’s efforts, Greenspan contended in an FCIC interview that the Fed had
developed a set of rules that have held up to this day.
This was a missed opportunity, says FDIC Chairman Sheila Bair, who described the
“one bullet” that might have prevented the financial crisis: “I absolutely would have been
over at the Fed writing rules, prescribing mortgage lending standards across the board
for everybody, bank and nonbank, that you cannot make a mortgage unless you have
documented income that the borrower can repay the loan.”
The Fed held back on enforcement and supervision, too. While discussing HOEPA rule
changes in 2000, the staff of the Fed’s Division of Consumer and Community Affairs also
proposed a pilot program to examine lending practices at bank holding companies’
nonbank subsidiaries, such as CitiFinancial and HSBC Finance, whose influence in the
subprime market was growing. The nonbank subsidiaries were subject to enforcement
actions by the Federal Trade Commission, while the banks and thrifts were overseen by
their primary regulators. As the holding company regulator, the Fed had the authority to
examine nonbank subsidiaries for “compliance with the [Bank Holding Company Act] or
any other Federal law that the Board has specific jurisdiction to enforce”; however, the
consumer protection laws did not explicitly give the Fed enforcement authority in this
The Fed resisted routine examinations of these companies, and despite the support of
Fed Governor Gramlich, the initiative stalled. Sandra Braunstein, then a staff member in
the Fed’s Consumer and Community Affairs Division and now its director, told the FCIC
that Greenspan and other officials were concerned that routinely examining the nonbank
subsidiaries could create an uneven playing field because the subsidiaries had to
compete with the independent mortgage companies, over which the Fed had no
supervisory authority (although the Fed’s HOEPA rules applied to all lenders). In an
interview with the FCIC, Greenspan went further, arguing that with or without a mandate,
the Fed lacked sufficient resources to examine the nonbank subsidiaries. Worse, the
former chairman said, inadequate regulation sends a misleading message to the firms
and the market; if you examine an organization incompletely, it tends to put a sign in
their window that it was examined by the Fed, and partial supervision is dangerous
because it creates a Good Housekeeping stamp. But if resources were the issue, the
Fed chairman could have argued for more. The Fed draws income from interest on the
Treasury bonds it owns, so it did not have to ask Congress for appropriations. It was
always mindful, however, that it could be subject to a government audit of its finances.
In the same FCIC interview, Greenspan recalled that he sat in countless meetings on
consumer protection, but that he couldn’t pretend to have the kind of expertise on this
subject that the staff had.
Gramlich, who chaired the Fed’s consumer subcommittee, favored tighter supervision of
all subprime lenders – including units of banks, thrifts, bank holding companies, and
state-chartered mortgage companies. He acknowledged that because such oversight
would extend Fed authority to firms (such as independent mortgage companies) whose
lending practices were not subject to routine supervision, the change would require
congressional legislation “and might antagonize the states.” But without such oversight,
the mortgage business was “like a city with a murder law, but no cops on the beat.” In an
interview in 2007, Gramlich told the Wall Street Journal that he privately urged
Greenspan to clamp down on predatory lending. Greenspan demurred and, lacking
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support on the board, Gramlich backed away. Gramlich told the Journal, “He was
opposed to it, so I did not really pursue it.” (Gramlich died in 2008 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 as
anecdotal. Patricia McCoy, a law professor at the University of Connecticut who served
on the Fed’s Consumer Advisory Council between 2002 and 2004, was familiar with the
Fed’s reaction to stories of individual consumers. “That is classic Fed mindset,” said
McCoy. “If you cannot prove that it is a broad-based problem that threatens systemic
consequences, then you will be dismissed.” It frustrated Margot Saunders of the National
Consumer Law Center: “I stood up at a Fed meeting in 2005 and said, ‘How many
anecdotes makes it real? . . . How many tens [of] thousands of anecdotes will it take to
convince you that this is a trend?’”
The Fed’s reluctance to take action trumped the 2000 HUD-Treasury report and reports
issued by the General Accounting Office in 1999 and 2004. The Fed did not begin
routinely examining subprime subsidiaries until a pilot program in July 2007, under new
chairman Ben Bernanke. The Fed did not issue new rules under HOEPA until July 2008,
a year after the subprime market had shut down. These rules banned deceptive
practices in a much broader category of “higher-priced mortgage loans”; moreover, they
prohibited making those loans without regard to the borrower’s ability to pay, and
required companies to verify income and assets. The rules would not take effect until
October 1, 2009, which was too little, too late.
Looking back, Fed General Counsel Alvarez said his institution succumbed to the
climate of the times. He told the FCIC, “The mind-set was that there should be no
regulation; the market should take care of policing, unless there already is an identified
problem. . . . We were in the reactive mode because that’s what the mind-set was of the
‘90s and the early 2000s.” The strong housing market also reassured people. Alvarez
noted the long history of low mortgage default rates and the desire to help people who
traditionally had few dealings with banks become homeowners.
V. States’ Position
As the Fed balked, many states proceeded on their own, enacting “mini-HOEPA” laws
and undertaking vigorous enforcement. They would face opposition from two federal
regulators, the OCC and the OTS.
In 1999, North Carolina led the way, establishing a fee trigger of 5%: that is, for the most
part any mortgage with points and fees at origination of more than 5% of the loan
qualified as “high-cost mortgage” subject to state regulations. This was considerably
lower than the 8% set by the Fed’s 2001 HOEPA regulations. Other provisions
addressed an even broader class of loans, banning prepayment penalties for mortgage
loans under $150,000 and prohibiting repeated refinancing, known as loan “flipping.”
These rules did not apply to federally chartered thrifts. In 1996, the Office of Thrift
Supervision reasserted its “long-standing position” that its regulations “occupy the entire
field of lending regulation for federal savings associations, leaving no room for state
regulation.” Exempting states from “a hodgepodge of conflicting and overlapping state
lending requirements,” the OTS said, would let thrifts deliver “low-cost credit to the public
free from undue regulatory duplication and burden.” Meanwhile, “the elaborate network
of federal borrower-protection statutes” would protect consumers.
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Nevertheless, other states copied North Carolina’s tactic. State attorneys general
launched thousands of enforcement actions, including more than 3,000 in 2006 alone.
By 2007, 29 states and the District of Columbia would pass some form of anti-predatory
lending legislation. In some cases, two or more states teamed up to produce large
settlements: in 2002, for example, a suit by Illinois, Massachusetts, and Minnesota
recovered more than $50 million from First Alliance Mortgage Company, even though
the firm had filed for bankruptcy. Also that year, Household Finance – later acquired by
HSBC – was ordered to pay $484 million in penalties and restitution to consumers. In
2006, a coalition of 49 states and the District of Columbia settled with Ameriquest for
$325 million and required the company to follow restrictions on its lending practices.
As we will see, however, these efforts would be severely hindered with respect to
national banks when the OCC in 2004 officially joined the OTS in constraining states
from taking such actions. “The federal regulators’ refusal to reform [predatory] practices
and products served as an implicit endorsement of their legality,” Illinois Attorney
General Lisa Madigan testified to the Commission.
VI. Community-Lending Pledges
While consumer groups unsuccessfully lobbied the Fed for more protection against
predatory lenders, they also lobbied the banks to invest in and loan to low- and
moderate-income communities. The resulting promises were sometimes called “CRA
commitments” or “community development” commitments. These pledges were not
required under law, including the Community Reinvestment Act of 1977; in fact, they
were often outside the scope of the CRA. For example, they frequently involved lending
to individuals whose incomes exceeded those covered by the CRA, lending in
geographic areas not covered by the CRA, or lending to minorities, on which the CRA is
silent. The banks would either sign agreements with community groups or else
unilaterally pledge to lend to and invest in specific communities or populations.
Banks often made these commitments when courting public opinion during the merger
mania at the turn of the 21st century. One of the most notable promises was made by
Citigroup soon after its merger with Travelers in 1998: a $115 billion lending and
investment commitment, some of which would include mortgages. Later, Citigroup made
a $120 billion commitment when it acquired California Federal Bank in 2002. When
merging with FleetBoston Financial Corporation in 2004, Bank of America announced its
largest commitment to date: $750 billion over 10 years. Chase announced commitments
of $18.1 billion and $800 billion, respectively, in its mergers with Chemical Bank and
Bank One. The National Community Reinvestment Coalition, an advocacy group,
eventually tallied more than $4.5 trillion in commitments from 1977 to 2007; mortgage
lending made up a significant portion of them.
Although banks touted these commitments in press releases, the NCRC says it and
other community groups could not verify this lending happened. The FCIC sent a series
of requests to Bank of America, JP Morgan, Citigroup, and Wells Fargo, the nation’s four
largest banks, regarding their “CRA and community lending commitments.” In response,
the banks indicated they had fulfilled most promises. According to the documents
provided, the value of commitments to community groups was much smaller than the
larger unilateral pledges by the banks. Further, the pledges generally covered broader
categories than did the CRA, including mortgages to minority borrowers and to
borrowers with up-to-median income. For example, only 22% of the mortgages made
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under JP Morgan’s $800 billion “community development initiative” would have fallen
under the CRA. Bank of America, which would count all low- and moderate-income and
minority lending as satisfying its pledges, stated that just over half were likely to meet
CRA requirements.
Many of these loans were not very risky. This is not surprising, because such broad
definitions necessarily included loans to borrowers with strong credit histories—low
income and weak or subprime credit are not the same. In fact, Citigroup’s 2002 pledge
of $80 billion in mortgage lending “consisted of entirely prime loans” to low- and
moderate-income households, low- and moderate-income neighborhoods, and minority
borrowers. These loans performed well. JP Morgan’s largest commitment to a
community group was to the Chicago CRA Coalition: $12 billion in loans over 11 years.
Of loans issued between 2004 and 2006, fewer than 5% have been 90-or-more days
delinquent, even as of late 2010. Wachovia made $12 billion in mortgage loans between
2004 and 2006 under its $100 billion in unilateral pledges: only about 7.3% were ever
more than 90 days delinquent over the life of the loan, compared with an estimated
national average of 14%. The better performance was partly the result of Wachovia’s
lending concentration in the relatively stable Southeast, and partly a reflection of the
credit profile of many of these borrowers.
During the early years of the CRA, the Federal Reserve Board, when considering
whether to approve mergers, gave some weight to commitments made to regulators.
This changed in February 1989, when the board denied Continental Bank’s application
to merge with Grand Canyon State Bank, saying the bank’s commitment to improve
community service could not offset its poor lending record. In April 1989, the FDIC,
OCC, and Federal Home Loan Bank Board (the precursor of the OTS) joined the Fed in
announcing that commitments to regulators about lending would be considered only
when addressing “specific problems in an otherwise satisfactory record.” Internal
documents, and its public statements, show the Fed never considered pledges to
community groups in evaluating mergers and acquisitions, nor did it enforce them. As
Glenn Loney, a former Fed official, told Commission staff, “At the very beginning, [we]
said we’re not going to be in a posture where the Fed’s going to be sort of coercing
banks into making deals with . . . community groups so that they can get their
applications through.”
In fact, the rules implementing the 1995 changes to the CRA made it clear that the
Federal Reserve would not consider promises to third parties or enforce prior
agreements with those parties. The rules state “an institution’s record of fulfilling these
types of agreements [with third parties] is not an appropriate CRA performance
criterion.” Still, the banks highlighted past acts and assurances for the future. In 1998, for
example, when NationsBank said it was merging with BankAmerica, it also announced a
10-year, $350 billion initiative that included pledges of $115 billion for affordable
housing, $30 billion for consumer lending, $180 billion for small businesses, and $25 and
$10 billion for economic and community development, respectively.
This merger was perhaps the most controversial of its time because of the size of the
two banks. The Fed held four public hearings and received more than 1,600 comments.
Supporters touted the community investment commitment, while opponents decried its
lack of specificity. The Fed’s internal staff memorandum recommending approval
repeated the Fed’s insistence on not considering these promises: “The Board considers
CRA agreements to be agreements between private parties and has not facilitated,
monitored, judged, required, or enforced agreements or specific portions of agreements.
Credit Expansion
. . . NationsBank remains obligated to meet the credit needs of its entire community,
including [low- and moderate-income] areas, with or without private agreements.”
In its public order approving the merger, the Federal Reserve mentioned the
commitment but then went on to state that “an applicant must demonstrate a satisfactory
record of performance under the CRA without reliance on plans or commitments for
future action. . . . The Board believes that the CRA plan – whether made as a plan or as
an enforceable commitment – has no relevance in this case without the demonstrated
record of performance of the companies involved.”
So were these commitments a meaningful step, or only a gesture? Lloyd Brown, a
managing director at Citigroup, told the FCIC that most of the commitments would have
been fulfilled in the normal course of business. Speaking of the 2007 merger with
Countrywide, Andrew Plepler, head of Global Corporate Social Responsibility at Bank of
America, told the FCIC: “At a time of mergers, there is a lot of concern, sometimes, that
one plus one will not equal two in the eyes of communities where the acquired bank has
been investing. . . . So, what we do is reaffirm our intention to continue to lend and invest
so that the communities where we live and work will continue to economically thrive.” He
explained further that the pledge amount was arrived at by working “closely with our
business partners” who project current levels of business activity that qualifies toward
community lending goals into the future to assure the community that past lending and
investing practices will continue. In essence, banks promised to keep doing what they
had been doing, and community groups had the assurance that they would.
VII. Bank Capital Standards
Although the Federal Reserve had decided against stronger protections for consumers,
it internalized the lessons of 1998 and 1999, when the first generation of subprime
lenders put themselves at serious risk; some, such as Keystone Bank and Superior
Bank, collapsed when the values of the subprime securitized assets they held proved to
be inflated. In response, the Federal Reserve and other regulators reworked the capital
requirements on securitization by banks and thrifts.
In October 2001, they introduced the “Recourse Rule” governing how much capital a
bank needed to hold against securitized assets. If a bank retained an interest in a
residual tranche of a mortgage security, as Keystone, Superior, and others had done, it
would have to keep a dollar in capital for every dollar of residual interest. That seemed to
make sense, since the bank, in this instance, would be the first to take losses on the
loans in the pool. Under the old rules, banks held only 8% in capital to protect against
losses on residual interests and any other exposures they retained in securitizations;
Keystone and others had been allowed to seriously understate their risks and to not hold
sufficient capital. Ironically, because the new rule made the capital charge on residual
interests 100%, it increased banks’ incentive to sell the residual interests in
securitizations – so that they were no longer the first to lose when the loans went bad.
The Recourse Rule also imposed a new framework for asset-backed securities. The
capital requirement would be directly linked to the rating agencies’ assessment of the
tranches. Holding securities rated AAA or AA required far less capital than holding lowerrated investments. For example, $100 invested in AAA or AA mortgage-backed
securities required holding only $1.60 in capital (the same as for securities backed by
government-sponsored enterprises). But the same amount invested in anything with a
BB rating required $16 in capital, or 10 times more.
Credit Expansion
Banks could reduce the capital they were required to hold for a pool of mortgages simply
by securitizing them, rather than holding them on their books as whole loans. If a bank
kept $100 in mortgages on its books, it might have to set aside about $5, including $4 in
capital against unexpected losses and $1 in reserves against expected losses. But if the
bank created a $100 mortgage-backed security, sold that security in tranches, and then
bought all the tranches, the capital requirement would be about $4.10. “Regulatory
capital arbitrage does play a role in bank decision making,” said David Jones, a Fed
economist who wrote an article about the subject in 2000, in an FCIC interview. But “it is
not the only thing that matters.”
And a final comparison: under bank regulatory capital standards, a $100 triple-A
corporate bond required $8 in capital – five times as much as the triple-A mortgagebacked security. Unlike the corporate bond, it was ultimately backed by real estate.
The new requirements put the rating agencies in the driver’s seat. How much capital a
bank held depended in part on the ratings of the securities it held. Tying capital
standards to the views of rating agencies would come in for criticism after the crisis
began. It was “a dangerous crutch,” former Treasury Secretary Henry Paulson testified
to the Commission. However, the Fed’s Jones noted it was better than the alternative –
“to let the banks rate their own exposures.” That alternative “would be terrible,” he said,
noting that banks had been coming to the Fed and arguing for lower capital
requirements on the grounds that the rating agencies were too conservative.
Meanwhile, banks and regulators were not prepared for significant losses on triple-A
mortgage-backed securities, which were, after all, supposed to be among the safest
investments. Nor were they prepared for ratings downgrades due to expected losses,
which would require banks to post more capital. And were downgrades to occur at the
moment the banks wanted to sell their securities to raise capital, there would be no
buyers. All these things would occur within a few years.
Credit Expansion
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. The housing boom of the 2000s was due solely to the low mortgage costs that
existed during that period.
a) true
b) false
2. Increasing home prices and low mortgage rates during the housing boom led to
fewer people refinancing because it was easier to buy a new house than to fix one
a) true
b) false
3. Which of the following groups were not among the largest group of subprime lenders
during the housing boom:
small community banks
large banks and thrifts
investment banks
both a and c above
4. States made no efforts to regulate financial institutions during the housing boom.
a) true
b) false
5. Which of the following rules govern how much money a bank was required to
maintain as capital against securitized assets:
The Tranche Rule
The Recourse Rule
The Subprime Rule
The Bank Stabilization Rule
Credit Expansion
1. A: True is incorrect. The low cost of borrowing money was certainly one of the
factors that led to the meteoric rise in home prices. However, it was by no means the
only reason.
B: False is correct. Other factors led to the housing boom. These included more
flexible lending standards.
(See page 6-1 of the course material.)
2. A: True is incorrect. The opposite was true. Higher prices meant most people had
equity they could borrow against. In addition, the cost of borrowing was low.
B: False is correct. People borrowed against their homes because it was cheap and
easy. Money did not usually go towards home improvement. New cars and other
expenses were financed from second mortgages.
(See page 6-1 of the course material.)
3. A: Correct. It was larger institutions that issued the vast majority of subprime
mortgages during the boom years.
B: Incorrect. Large banks and thrifts were among those writing the most subprime
C: Incorrect. Investment banks joined large banks and thrifts in issuing subprime
D: Incorrect. Only one of the groups was not involved in the surge in subprime loans.
(See page 6-4 of the course material.)
4. A: True is incorrect. A number of states did attempt regulation in the face of what
appeared to be little action from the federal government.
B: False is correct. Attempts by the state to act were largely blocked by various
federal regulators.
(See page 6-11 of the course material.)
Credit Expansion
5. A: Incorrect. A tranche is simply a portion of a pool of securities issued by a
B: Correct. The rule, issued by the Fed in 2001, determined how much capital a
bank was required to maintain to protect against losses associated with securities
C: Incorrect. This rule was not directly related to subprime loans.
D: Incorrect. There is no such rule.
(See page 6-14 of the course material.)
Credit Expansion
Chapter 7: The Mortgage Machine
In 2004, commercial banks, thrifts, and investment banks caught up with Fannie Mae
and Freddie Mac in securitizing home loans. By 2005, they had taken the lead. The two
government sponsored enterprises maintained their monopoly on securitizing prime
mortgages below their loan limits, but the wave of home refinancing by prime borrowers
spurred by very low, steady interest rates petered out. Meanwhile, Wall Street focused
on the higher-yield loans that the GSEs could not purchase and securitize – loans too
large, called jumbo loans, and nonprime loans that didn’t meet the GSEs’ standards. The
nonprime loans soon became the biggest part of the market – “subprime” loans for
borrowers with weak credit and “Alt-A” loans, with characteristics riskier than prime
loans, to borrowers with strong credit.
By 2005 and 2006, Wall Street was securitizing one-third more loans than Fannie and
Freddie. In just two years, private-label mortgage-backed securities had grown more
than 30%, reaching $1.15 trillion in 2006; 71% were subprime or Alt-A.
Many investors preferred securities highly rated by the rating agencies – or were
encouraged or restricted by regulations to buy them. And with yields low on other highly
rated assets, investors hungered for Wall Street mortgage securities backed by higheryield mortgages – those loans made to subprime borrowers, those with nontraditional
features, those with limited or no documentation (“no-doc loans”), or those that failed in
some other way to meet strong underwriting standards.
“Securitization could be seen as a factory line,” former Citigroup CEO Charles Prince
told the FCIC. “As more and more and more of these subprime mortgages were created
as raw material for the securitization process, not surprisingly in hindsight, more and
more of it was of lower and lower quality. And at the end of that process, the raw
material going into it was actually bad quality, it was toxic quality, and that is what ended
up coming out the other end of the pipeline. Wall Street obviously participated in that
flow of activity.”
The origination and securitization of these mortgages also relied on short-term financing
from the shadow banking system. Unlike banks and thrifts with access to deposits,
investment banks relied more on money market funds and other investors for cash;
commercial paper and repo loans were the main sources. With house prices already up
91% from 1995 to 2003, this flood of money and the securitization apparatus helped
boost home prices another 36% from the beginning of 2004 until the peak in April 2006 –
even as homeownership was falling. The biggest gains over this period were in the
“sand states”: places like the Los Angeles suburbs (54%), Las Vegas (36%), and
Orlando (72%).
I. Foreign Investors: “An Irresistible Profit Opportunity”
From June 2003 through June 2004, the Federal Reserve kept the federal funds rate low
at 1% to stimulate the economy following the 2001 recession. Over the next two years,
as deflation fears waned, the Fed gradually raised rates to 5.25% in 17 quarter point
The Mortgage Machine
In the view of some, the Fed simply kept rates too low too long. John Taylor, a Stanford
economist and former under secretary of treasury for international affairs, blamed the
crisis primarily on this action. If the Fed had followed its usual pattern, he told the FCIC,
short-term interest rates would have been much higher, discouraging excessive
investment in mortgages. “The boom in housing construction starts would have been
much more mild, might not even call it a boom, and the bust as well would have been
mild,” Taylor said. Others were more blunt: “Greenspan bailed out the world’s largest
equity bubble with the world’s largest real estate bubble,” wrote William A. Fleckenstein,
the president of a Seattle-based money management firm.
Ben Bernanke and Alan Greenspan disagree. Both the current and former Fed chairman
argue that deciding to purchase a home depends on long-term interest rates on
mortgages, not the short-term rates controlled by the Fed, and that short-term and longterm rates had become de-linked. “Between 1971 and 2002, the fed funds rate and the
mortgage rate moved in lock-step,” Greenspan said. When the Fed started to raise rates
in 2004, officials expected mortgage rates to rise, too, slowing growth. Instead, mortgage
rates continued to fall for another year. The construction industry continued to build
houses, peaking at an annualized rate of 2.27 million starts in January 2006 – more than
a 30-year high.
As Greenspan told Congress in 2005, this was a “conundrum.” One theory pointed to
foreign money. Developing countries were booming and – vulnerable to financial
problems in the past – encouraged strong saving. Investors in these countries placed
their savings in apparently safe and high-yield securities in the United States. Fed
Chairman Bernanke called it a “global savings glut.”
As the United States ran a large current account deficit, flows into the country were
unprecedented. Over six years from 2000 to 2006, U.S. Treasury debt held by foreign
official public entities rose from $0.6 trillion to $1.43 trillion; as a percentage of U.S. debt
held by the public, these holdings increased from 18.2% to 28.8%. Foreigners also
bought securities backed by Fannie and Freddie, which, with their implicit government
guarantee, seemed nearly as safe as Treasuries. As the Asian financial crisis ended in
1998, foreign holdings of GSE securities held steady at the level of almost 10 years
earlier, about $186 billion. By 2000 – just two years later – foreigners owned $348 billion
in GSE securities; by 2004, $875 billion. “You had a huge inflow of liquidity. A very
unique kind of situation where poor countries like China were shipping money to
advanced countries because their financial systems were so weak that they [were] better
off shipping [money] to countries like the United States rather than keeping it in their own
countries,” former Fed governor Frederic Mishkin told the FCIC. “The system was awash
with liquidity, which helped lower long-term interest rates.”
Foreign investors sought other high-grade debt almost as safe as Treasuries and GSE
securities but with a slightly higher return. They found the triple-A assets pouring from
the Wall Street mortgage securitization machine. As overseas demand drove up prices
for securitized debt, it “created an irresistible profit opportunity for the U.S. financial
system: to engineer ‘quasi’ safe debt instruments by bundling riskier assets and selling
the senior tranches,” Pierre-Olivier Gourinchas, an economist at the University of
California, Berkeley, told the FCIC.
The Mortgage Machine
Paul Krugman, an economist at Princeton University, told the FCIC, “It’s hard to
envisage us having had this crisis without considering international monetary capital
movements. The U.S. housing bubble was financed by large capital inflows. So were
Spanish and Irish and Baltic bubbles. It’s a combination of, in the narrow sense, of a less
regulated financial system and a world that was increasingly wide open for big
international capital movements.”
It was an ocean of money.
II. Mortgages: “A Good Loan”
The refinancing boom was over, but originators still needed mortgages to sell to the
Street. They needed new products that, as prices kept rising, could make expensive
homes more affordable to still-eager borrowers. The solution was riskier, more
aggressive, mortgage products that brought higher yields for investors but
correspondingly greater risks for borrowers. “Holding a subprime loan has become
something of a high-stakes wager,” the Center for Responsible Lending warned in 2006.
Subprime mortgages rose from 8% of mortgage originations in 2003 to 20% in 2005.
About 70% of subprime borrowers used hybrid adjustable-rate mortgages (ARMs) such
as 2/28s and 3/27s – mortgages whose low “teaser” rate lasts for the first two or three
years, and then adjusts periodically thereafter. Prime borrowers also used more
alternative mortgages. The dollar volume of Alt-A securitization rose almost 350% from
2003 to 2005. In general, these loans made borrowers’ monthly mortgage payments on
ever more expensive homes affordable – at least initially. Popular Alt-A products
included interest-only mortgages and payment-option ARMs. Option ARMs let borrowers
pick their payment each month, including payments that actually increased the principal
– any shortfall on the interest payment was added to the principal, something called
negative amortization. If the balance got large enough, the loan would convert to a fixedrate mortgage, increasing the monthly payment – perhaps dramatically. Option ARMs
rose from 2% of mortgages in 2003 to 9% in 2006.
Simultaneously, underwriting standards for nonprime and prime mortgages weakened.
Combined loan-to-value ratios – reflecting first, second, and even third mortgages –
rose. Debt-to-income ratios climbed, as did loans made for non-owner-occupied
properties. Fannie Mae and Freddie Mac’s market share shrank from 57% of all
mortgages purchased in 2003 to 42% in 2004, and down to 37% by 2006. Taking their
place were private-label securitizations – meaning those not issued and guaranteed by
the GSEs.
In this new market, originators competed fiercely; Countrywide Financial Corporation
took the crown. It was the biggest mortgage originator from 2004 until the market
collapsed in 2007. Even after Countrywide nearly failed, buckling under a mortgage
portfolio with loans that its co-founder and CEO Angelo Mozilo once called “toxic,”
Mozilo would describe his 40-year-old company to the Commission as having helped 25
million people buy homes and prevented social unrest by extending loans to minorities,
historically the victims of discrimination: “Countrywide was one of the greatest
companies in the history of this country and probably made more difference to society, to
the integrity of our society, than any company in the history of America.” Lending to
home buyers was only part of the business. Countrywide’s President and COO David
Sambol told the Commission, as long as a loan did not harm the company from a
financial or reputation standpoint, Countrywide was “a seller of securities to Wall Street.”
The Mortgage Machine
Countrywide’s essential business strategy was “originating what was salable in the
secondary market.” The company sold or securitized 87% of the $1.5 trillion in
mortgages it originated between 2002 and 2005.
In 2004, Mozilo announced a very aggressive goal of gaining “market dominance” by
capturing 30% of the origination market. His share at the time was 12%. But
Countrywide was not unique: Ameriquest, New Century, Washington Mutual, and others
all pursued loans as aggressively. They competed by originating types of mortgages
created years before as niche products, but now transformed into riskier, mass-market
versions. “The definition of a good loan changed from ‘one that pays’ to ‘one that could
be sold,’” Patricia Lindsay, formerly a fraud specialist at New Century, told the FCIC.
III. 2/28s and 3/27s: “Adjust for the Affordability”
Historically, 2/28s or 3/27s, also known as hybrid ARMs, let credit-impaired borrowers
repair their credit. During the first two or three years, a lower interest rate meant a
manageable payment schedule and enabled borrowers to demonstrate they could make
timely payments. Eventually the interest rates would rise sharply, and payments could
double or even triple, leaving borrowers with few alternatives: if they had established
their creditworthiness, they could refinance into a similar mortgage or one with a better
interest rate, often with the same lender; if unable to refinance, the borrower was unlikely
to be able to afford the new higher payments and would have to sell the home and repay
the mortgage. If they could not sell or make the higher payments, they would have to
But as house prices rose after 2000, the 2/28s and 3/27s acquired a new role: helping to
get people into homes or to move up to bigger homes. “As homes got less and less
affordable, you would adjust for the affordability in the mortgage because you couldn’t
really adjust people’s income,” Andrew Davidson, the president of Andrew Davidson &
Co. and a veteran of the mortgage markets, told the FCIC. Lenders qualified borrowers
at low teaser rates, with little thought to what might happen when rates reset. Hybrid
ARMs became the workhorses of the subprime securitization market.
Consumer protection groups such as the Leadership Conference on Civil Rights railed
against 2/28s and 3/27s, which, they said, neither rehabilitated credit nor turned renters
into owners. David Berenbaum from the National Community Reinvestment Coalition
testified to Congress in the summer of 2007: “The industry has flooded the market with
exotic mortgage lending such as 2/28 and 3/27 ARMs. These exotic subprime
mortgages overwhelm borrowers when interest rates shoot up after an introductory time
period.” To their critics, they were simply a way for lenders to strip equity from lowincome borrowers. The loans came with big fees that got rolled into the mortgage,
increasing the chances that the mortgage could be larger than the home’s value at the
reset date. If the borrower could not refinance, the lender would foreclose – and then
own the home in a rising real estate market.
IV. Option ARMs: “Our Most Profitable Mortgage Loan”
When they were originally introduced in the 1980s, option ARMs were niche products,
too, but by 2004 they too became loans of choice because their payments were lower
than more traditional mortgages. During the housing boom, many borrowers repeatedly
made only the minimum payments required, adding to the principal balance of their loan
every month.
The Mortgage Machine
An early seller of option ARMs was Golden West Savings, an Oakland, California-based
thrift founded in 1929 and acquired in 1963 by Marion and Herbert Sandler. In 1975, the
Sandlers merged Golden West with World Savings; Golden West Financial Corp., the
parent company, operated branches under the name World Savings Bank. The thrift
issued about $274 billion in option ARMs between 1981 and 2005. Unlike other
mortgage companies, Golden West held onto them.
Sandler told the FCIC that Golden West’s option ARMs – marketed as “Pick-a-Pay”
loans – had the lowest losses in the industry for that product. Even in 2005 – the last
year prior to its acquisition by Wachovia – when its portfolio was almost entirely in option
ARMs, Golden West’s losses were low by industry standards. Sandler attributed Golden
West’s performance to its diligence in running simulations about what would happen to
its loans under various scenarios for example, if interest rates went up or down or if
house prices dropped 5%, even 10%. “For a quarter of a century, it worked exactly as
the simulations showed that it would,” Sandler said. “And we have never been able to
identify a single loan that was delinquent because of the structure of the loan, much less
a loss or foreclosure.” But after Wachovia acquired Golden West in 2006 and the
housing market soured, charge-offs on the Pick-a-Pay portfolio would suddenly jump
from 0.04% to 2.69% by September 2008. And foreclosures would climb.
Early in the decade, banks and thrifts such as Countrywide and Washington Mutual
increased their origination of option ARM loans, changing the product in ways that made
payment shocks more likely. At Golden West, after 10 years, or if the principal balance
grew to 125% of its original size, the Pick-a-Pay mortgage would recast into a new fixedrate mortgage. At Countrywide and Washington Mutual, the new loans would recast in
as little as five years, or when the balance hit just 110% of the original size. They also
offered lower teaser rates – as low as 1% – and loan-to-value ratios as high as 100%. All
of these features raised the chances that the borrower’s required payment could rise
more sharply, more quickly, and with less cushion.
In 2002, Washington Mutual was the second-largest mortgage originator, just ahead of
Countrywide. It had offered the option ARM since 1986, and in 2003, as cited by the
Senate Permanent Subcommittee on Investigations, the originator conducted a study “to
explore what Washington Mutual could do to increase sales of Option ARMs, our most
profitable mortgage loan.” A focus group made clear that few customers were requesting
option ARMs and that “this is not a product that sells itself.” The study found “the best
selling point for the Option Arm” was to show consumers “how much lower their monthly
payment would be by choosing the Option Arm versus a fixed-rate loan.” The study also
revealed that many WaMu brokers “felt these loans were ‘bad’ for customers.” One
member of the focus group remarked, “A lot of (Loan) Consultants don’t believe in it . . .
and don’t think [it’s] good for the customer. You’re going to have to change the mindset.”
Despite these challenges, option ARM originations soared at Washington Mutual from
$30 billion in 2003 to $68 billion in 2004, when they were more than half of WaMu’s
originations and had become the thrift’s signature adjustable-rate home loan product.
The average FICO score was around 700, well into the range considered “prime,” and
about two-thirds were jumbo loans – mortgage loans exceeding the maximum Fannie
Mae and Freddie Mac were allowed to purchase or guarantee. More than half were in
The Mortgage Machine
Countrywide’s option ARM business peaked at $14.5 billion in originations in the second
quarter of 2005, about 25% of all its loans originated that quarter. But it had to relax
underwriting standards to get there. In July 2004, Countrywide decided it would lend up
to 90% of a home’s appraised value, up from 80%, and reduced the minimum credit
score to as low as 620. In early 2005, Countrywide eased standards again, increasing
the allowable combined loan-to-value ratio (including second liens) to 95%.
The risk in these loans was growing. From 2003 to 2005, the average loan-to-value ratio
rose about 4%, the combined loan-to-value ratio rose about 6%, and debt-to-income
ratios had risen from 34% to 38%: borrowers were pledging more of their income to their
mortgage payments. Moreover, 68% of these two originators’ option ARMs had low
documentation in 2005. The percentage of these loans made to investors and
speculators – that is, borrowers with no plans to use the home as their primary residence
– also rose.
These changes worried the lenders even as they continued to make the loans. In
September 2004 and August 2005, Mozilo emailed to senior management that these
loans could bring “financial and reputational catastrophe.” Countrywide should not
market them to investors, he insisted. “Pay option loans being used by investors is a
pure commercial spec[ulation] loan and not the traditional home loan that we have
successfully managed throughout our history,” Mozilo wrote to Carlos Garcia, CEO of
Countrywide Bank. Speculative investors “should go to Chase or Wells not us. It is also
important for you and your team to understand from my point of view that there is
nothing intrinsically wrong with pay options loans themselves, the problem is the quality
of borrowers who are being offered the product and the abuse by third party originators. .
. . [I]f you are unable to find sufficient product then slow down the growth of the Bank for
the time being.”
However, Countrywide’s growth did not slow. Nor did the volume of option ARMs
retained on its balance sheet, increasing from $5 billion in 2004 to $26 billion in 2005
and peaking in 2006 at $33 billion. Finding these loans very profitable, through 2006,
WaMu also retained option ARMs – more than $60 billion with the bulk from California,
followed by Florida. But in the end, these loans would cause significant losses during the
Mentioning Countrywide and WaMu as tough, “in our face” competitors, John Stumpf,
the CEO, chairman, and president of Wells Fargo, recalled Wells’s decision not to write
option ARMs, even as it originated many other high-risk mortgages. These were “hard
decisions to make at the time,” he said, noting “we did lose revenue, and we did lose
Across the market, the volume of option ARMs had risen nearly fourfold from 2003 to
2006, from approximately $65 billion to $255 billion. By then, WaMu and Countrywide
had plenty of evidence that more borrowers were making only the minimum payments
and that their mortgages were negatively amortizing – which meant their equity was
being eaten away. The percentage of Countrywide’s option ARMs that were negatively
amortizing grew from just 1% in 2004 to 53% in 2005 and then to more than 90% by
2007. At WaMu, it was 2% in 2003, 28% in 2004, and 82% in 2007. Declines in house
prices added to borrowers’ problems: any equity remaining after the negative
amortization would simply be eroded. Increasingly, borrowers would owe more on their
mortgages than their homes were worth on the market, giving them an incentive to walk
away from both home and mortgage.
The Mortgage Machine
Kevin Stein, from the California Reinvestment Coalition, testified to the FCIC that option
ARMs were sold inappropriately: “Nowhere was this dynamic more clearly on display
than in the summer of 2006 when the Federal Reserve convened HOEPA (Home
Ownership and Equity Protection Act) hearings in San Francisco. At the hearing,
consumers testified to being sold option ARM loans in their primary non-English
language, only to be pressured to sign English-only documents with significantly worse
terms. Some consumers testified to being unable to make even their initial payments
because they had been lied to so completely by their brokers.” Mona Tawatao, a
regional counsel with Legal Services of Northern California, described the borrowers she
was assisting as “people who got steered or defrauded into entering option ARMs with
teaser rates or pick-a-pay loans forcing them to pay into – pay loans that they could
never pay off. Prevalent among these clients are seniors, people of color, people with
disabilities, and limited English speakers and seniors who are African American and
V. Underwriting Standards: “We’re Going to Have to Hold Our Nose”
Another shift would have serious consequences. For decades, the down payment for a
prime mortgage had been 20% (in other words, the loan-to-value ratio (LTV) had been
80%). As prices continued to rise, finding the cash to put 20% down became harder, and
from 2000 on, lenders began accepting smaller down payments.
There had always been a place for borrowers with down payments below 20%.
Typically, lenders required such borrower to purchase private mortgage insurance for a
monthly fee. If a mortgage ended in foreclosure, the mortgage insurance company would
make the lender whole. Worried about defaults, the GSEs would not buy or guarantee
mortgages with down payments below 20% unless the borrower bought the insurance.
Unluckily for many homeowners, for the housing industry, and for the financial system,
lenders devised a way to get rid of these monthly fees that had added to the cost of
homeownership: lower down payments that did not require insurance.
Lenders had latitude in setting down payments. In 1991, Congress ordered federal
regulators to prescribe standards for real estate lending that would apply to banks and
thrifts. The goal was to “curtail abusive real estate lending practices in order to reduce
risk to the deposit insurance funds and enhance the safety and soundness of insured
depository institutions.” Congress had debated including explicit LTV standards, but
chose not to, leaving that to the regulators. In the end, regulators declined to introduce
standards for LTV ratios or for documentation for home mortgages. The agencies
explained: “A significant number of commenters expressed concern that rigid application
of a regulation implementing LTV ratios would constrict credit, impose additional lending
costs, reduce lending flexibility, impede economic growth, and cause other undesirable
In 1999, regulators revisited the issue, as high LTV lending was increasing. They
tightened reporting requirements and limited a bank’s total holdings of loans with LTVs
above 90% that lacked mortgage insurance or some other protection; they also
reminded the banks and thrifts that they should establish internal guidelines to manage
the risk of these loans.
The Mortgage Machine
High LTV lending soon became even more common, thanks to the so-called piggyback
mortgage. The lender offered a first mortgage for perhaps 80% of the home’s value and
a second mortgage for another 10% or even 20%. Borrowers liked these because their
monthly payments were often cheaper than a traditional mortgage plus the required
mortgage insurance, and the interest payments were tax deductible. Lenders liked them
because the smaller first mortgage – even without mortgage insurance – could
potentially be sold to the GSEs.
At the same time, the piggybacks added risks. A borrower with a higher combined LTV
had less equity in the home. In a rising market, should payments become
unmanageable, the borrower could always sell the home and come out ahead. However,
should the payments become unmanageable in a falling market, the borrower might owe
more than the home was worth. Piggyback loans – which often required nothing down –
guaranteed that many borrowers would end up with negative equity if house prices fell,
especially if the appraisal had overstated the initial value.
But piggyback lending helped address a significant challenge for companies like New
Century, which were big players in the market for mortgages. Meeting investor demand
required finding new borrowers, and homebuyers without down payments were a
relatively untapped source. Yet among borrowers with mortgages originated in 2004, by
September 2005 those with piggybacks were four times as likely as other mortgage
holders to be 60 or more days delinquent. When senior management at New Century
heard these numbers, the head of the Secondary Marketing Department asked for
“thoughts on what to do with this . . . pretty compelling” information. Nonetheless, New
Century increased mortgages with piggybacks to 35% of loan production by the end of
2005, up from only 9% in 2003. They were not alone. Across securitized subprime
mortgages, the average combined LTV rose from 79% to 86% between 2001 and 2006.
Another way to get people into mortgages – and quickly – was to require less
information of the borrower. “Stated income” or “low-documentation” (or sometimes “nodocumentation”) loans had emerged years earlier for people with fluctuating or hard-toverify incomes, such as the self-employed, or to serve longtime customers with strong
credit. Or lenders might waive information requirements if the loan looked safe in other
respects. “If I’m making a 65%, 75%, 70% loan-to-value, I’m not going to get all of the
documentation,” Sandler of Golden West told the FCIC. The process was too
cumbersome and unnecessary. He already had a good idea how much money teachers,
accountants, and engineers made – and if he didn’t, he could easily find out. All he
needed was to verify that his borrowers worked where they said they did. If he guessed
wrong, the loan-to-value ratio still protected his investment.
Around 2005, however, low- and no-documentation loans took on an entirely different
character. Nonprime lenders now boasted they could offer borrowers the convenience of
quicker decisions and not having to provide tons of paperwork. In return, they charged a
higher interest rate. The idea caught on: from 2000 to 2007, low- and no-doc loans
skyrocketed from less than 2% to roughly 9% of all outstanding loans. Among Alt-A
securitizations, 80% of loans issued in 2006 had limited or no documentation. As William
Black, a former banking regulator, testified before the FCIC, the mortgage industry’s own
fraud specialists described stated income loans as “an open ‘invitation to fraud’ that
justified the industry term ‘liar’s loans.’” Speaking of lending up to 2005 at Citigroup,
Richard Bowen, a veteran banker in the consumer lending group, told the FCIC, “A
decision was made that ‘We’re going to have to hold our nose and start buying the
The Mortgage Machine
stated product if we want to stay in business.’” Jamie Dimon, the CEO of JP Morgan,
told the Commission, “In mortgage underwriting, somehow we just missed, you know,
that home prices don’t go up forever and that it’s not sufficient to have stated income.”
In the end, companies in subprime and Alt-A mortgages had, in essence, placed all their
chips on black: they were betting that home prices would never stop rising. This was the
only scenario that would keep the mortgage machine humming. The evidence is present
in our case study mortgage-backed security, CMLTI 2006-NC2, whose loans have many
of the characteristics just described.
The 4,499 loans bundled in this deal were adjustable-rate and fixed-rate residential
mortgages originated by New Century. They had an average principal balance of
$210,536 – just under the median home price of $221,900 in 2006. The vast majority
had a 30-year maturity, and more than 90% were originated in May, June, and July
2006, just after national home prices had peaked. More than 90% were reportedly for
primary residences, with 43% for home purchases and 48% for cash-out refinancings.
The loans were from all 50 states and the District of Columbia, but more than a fifth
came from California and more than a tenth from Florida.
About 80% of the loans were ARMs, and most of these were 2/28s or 3/27s. In a twist,
many of these hybrid ARMs had other “affordability features” as well. For example, more
than 20% of the ARMs were interest-only – during the first two or three years, not only
would borrowers pay a lower fixed rate, they would not have to pay any principal. In
addition, more than 40% of the ARMs were “2/28 hybrid balloon” loans, in which the
principal would amortize over 40 years – lowering the monthly payments even further,
but as a result leaving the borrower with a final principal payment at the end of the 30year term.
The great majority of the pool was secured by first mortgages; of these, 33% had a
piggyback mortgage on the same property. As a result, more than one-third of the
mortgages in this deal had a combined loan-to-value ratio between 95% and 100%.
Raising the risk a bit more, 42% of the mortgages were no-doc loans. The rest were “fulldoc,” although their documentation was fuller in some cases than in others. In sum, the
loans bundled in this deal mirrored the market: complex products with high LTVs and
little documentation. And even as many warned of this toxic mix, the regulators were not
on the same page.
VI. Federal Regulators: “Immunity From Many State Laws Is a Significant
For years, some states had tried to regulate the mortgage business, especially to clamp
down on the predatory mortgages proliferating in the subprime market. The national
thrifts and banks and their federal regulators – the Office of Thrift Supervision (OTS) and
the Office of the Comptroller of the Currency (OCC), respectively – resisted the states’
efforts to regulate those national banks and thrifts. The companies claimed that without
one uniform set of rules, they could not easily do business across the country, and the
regulators agreed. In August 2003, as the market for riskier subprime and Alt-A loans
grew, and as lenders piled on more risk with smaller down payments, reduced
documentation requirements, interest-only loans, and payment-option loans, the OCC
fired a salvo. The OCC proposed strong preemption rules for national banks, nearly
identical to earlier OTS rules that empowered nationally chartered thrifts to disregard
state consumer laws.
The Mortgage Machine
Back in 1996 the OTS had issued rules saying federal law preempted state predatory
lending laws for federally regulated thrifts. In 2003, the OTS referred to these rules in
issuing four opinion letters declaring that laws in Georgia, New York, New Jersey, and
New Mexico did not apply to national thrifts. In the New Mexico opinion, the regulator
pronounced invalid New Mexico’s bans on balloon payments, negative amortization,
prepayment penalties, loan flipping, and lending without regard to the borrower’s ability
to repay.
The Comptroller of the Currency took the same line on the national banks that it
regulated, offering preemption as an inducement to use a national bank charter. In a
2002 speech, before the final OCC rules were passed, Comptroller John D. Hawke Jr.
pointed to “national banks’ immunity from many state laws” as “a significant benefit of
the national charter – a benefit that the OCC has fought hard over the years to
preserve.” In an interview that year, Hawke explained that the potential loss of
regulatory market share for the OCC “was a matter of concern.”
In August 2003 the OCC issued its first preemptive order, aimed at Georgia’s miniHOEPA statute, and in January 2004 the OCC adopted a sweeping preemption rule
applying to all state laws that interfered with or placed conditions on national banks’
ability to lend. Shortly afterward, three large banks with combined assets of more than
$1 trillion said they would convert from state charters to national charters, which
increased OCC’s annual budget 15%.
State-chartered operating subsidiaries were another point of contention in the
preemption battle. In 2001, the OCC had adopted a regulation preempting state law
regarding state-chartered operating subsidiaries of national banks. In response, several
large national banks moved their mortgage-lending operations into subsidiaries and
asserted that the subsidiaries were exempt from state mortgage lending laws. Four
states challenged the regulation, but the Supreme Court ruled against them in 2007.
Once OCC and OTS preemption was in place, the two federal agencies were the only
regulators with the power to prohibit abusive lending practices by national banks and
thrifts and their direct subsidiaries. Comptroller John Dugan, who succeeded Hawke,
defended preemption, noting that “72% of all nonprime mortgages were made by lenders
that were subject to state law. Well over half were made by mortgage lenders that were
exclusively subject to state law.” Lisa Madigan, the attorney general of Illinois, flipped the
argument around, noting that national banks and thrifts, and their subsidiaries, were
heavily involved in subprime lending. Using different data, she contended: “National
banks and federal thrifts and . . . their subsidiaries . . . were responsible for almost 32
percent of subprime mortgage loans, 40.1 percent of the Alt-A loans, and 51 percent of
the pay-option and interest-only ARMs that were sold.” Madigan told the FCIC:
Even as the Fed was doing little to protect consumers and our financial
system from the effects of predatory lending, the OCC and OTS were
actively engaged in a campaign to thwart state efforts to avert the coming
crisis. . . . In the wake of the federal regulators’ push to curtail state
authority, many of the largest mortgage-lenders shed their state licenses
and sought shelter behind the shield of a national charter. And I think that
it is no coincidence that the era of expanded federal preemption gave rise
to the worst lending abuses in our nation’s history.
The Mortgage Machine
Comptroller Hawke offered the FCIC a different interpretation: “While some critics have
suggested that the OCC’s actions on preemption have been a grab for power, the fact is
that the agency has simply responded to increasingly aggressive initiatives at the state
level to control the banking activities of federally chartered institutions.”
VII. Mortgage Securities Players: “Wall Street Was Very Hungry for Our
Subprime and Alt-A mortgage-backed securities depended on a complex supply chain,
largely funded through short-term lending in the commercial paper and repo market –
which would become critical as the financial crisis began to unfold in 2007. These loans
were increasingly collateralized not by Treasuries and GSE securities but by highly rated
mortgage securities backed by increasingly risky loans. Independent mortgage
originators such as Ameriquest and New Century – without access to deposits – typically
relied on financing to originate mortgages from warehouse lines of credit extended by
banks, from their own commercial paper programs, or from money borrowed in the repo
For commercial banks such as Citigroup, warehouse lending was a multibillion dollar
business. From 2000 to 2010, Citigroup made available at any one time as much as $7
billion in warehouse lines of credit to mortgage originators, including $950 million to New
Century and more than $3.5 billion to Ameriquest. Citigroup CEO Chuck Prince told the
FCIC he would not have approved, had he known. “I found out at the end of my tenure, I
did not know it before, that we had some warehouse lines out to some originators. And I
think getting that close to the origination function – being that involved in the origination
of some of these products – is something that I wasn’t comfortable with and that I did not
view as consistent with the prescription I had laid down for the company not to be
involved in originating these products.”
As early as 1998, Moody’s called the new asset-backed commercial paper (ABCP)
programs “a whole new ball game.” As asset-backed commercial paper became a
popular method to fund the mortgage business, it grew from about one-quarter to about
one-half of commercial paper sold between 1997 and 2001.
In 2001, only five mortgage companies borrowed a total of $4 billion through assetbacked commercial paper; in 2006, 19 entities borrowed $43 billion. For instance,
Countrywide launched the commercial paper programs Park Granada in 2003 and Park
Sienna in 2004. By May 2007, it was borrowing $13 billion through Park Granada and
$5.3 billion through Park Sienna. These programs would house subprime and other
mortgages until they were sold.
Commercial banks used commercial paper, in part, for regulatory arbitrage. When banks
kept mortgages on their balance sheets, regulators required them to hold 4% in capital
to protect against loss. When banks put mortgages into off-balance-sheet entities such
as commercial paper programs, there was no capital charge (in 2004, a small charge
was imposed). But to make the deals work for investors, banks had to provide liquidity
support to these programs, for which they earned a fee. This liquidity support meant that
the bank would purchase, at a previously set price, any commercial paper that investors
were unwilling to buy when it came up for renewal. During the financial crisis these
promises had to be kept, eventually putting substantial pressure on banks’ balance
The Mortgage Machine
When the Financial Accounting Standards Board, the private group that establishes
standards for financial reports, responded to the Enron scandal by making it harder for
companies to get off-balance-sheet treatment for these programs, the favorable capital
rules were in jeopardy. The asset-backed commercial paper market stalled. Banks
protested that their programs differed from the practices at Enron and should be
excluded from the new standards. In 2003, bank regulators responded by proposing to
let banks remove these assets from their balance sheets when calculating regulatory
capital. The proposal would have also introduced for the first time a capital charge
amounting to at most 1.6% of the liquidity support banks provided to the ABCP
programs. However, after strong pushback – the American Securitization Forum, an
industry association, called that charge “arbitrary,” and State Street Bank complained it
was “too conservative” – regulators in 2004 announced a final rule setting the charge at
up to 0.8%, or half the amount of the first proposal. Growth in this market resumed.
Regulatory changes – in this case, changes in the bankruptcy laws – also boosted
growth in the repo market by transforming the types of repo collateral. Prior to 2005,
repo lenders had clear and immediate rights to their collateral following the borrower’s
bankruptcy only if that collateral was Treasury or GSE securities. In the Bankruptcy
Abuse Prevention and Consumer Protection Act of 2005, Congress expanded that
provision to include many other assets, including mortgage loans, mortgage-backed
securities, collateralized debt obligations, and certain derivatives. The result was a shortterm repo market increasingly reliant on highly rated non-agency mortgage-backed
securities; but beginning in mid-2007, when banks and investors became skittish about
the mortgage market, they would prove to be an unstable funding source. Once the
crisis hit, these “illiquid, hard-to-value securities made up a greater share of the tri-party
repo market than most people would have wanted,” Darryll Hendricks, a UBS executive
and chair of a New York Fed task force examining the repo market after the crisis, told
the Commission.
Our sample deal, CMLTI 2006-NC2, shows how these funding and securitization markets
worked in practice. Eight banks and securities firms provided most of the money New
Century needed to make the 4,499 mortgages it would sell to Citigroup. Most of the
funds came through repo agreements from a set of banks – including Morgan Stanley
($424 million); Barclays Capital, a division of a U.K.-based bank ($221 million); Bank of
America ($147 million); and Bear Stearns ($64 million). The financing was provided
when New Century originated these mortgages; so for about two months, New Century
owed these banks approximately $940 million secured by the mortgages. Another $12
million in funding came from New Century itself, including $3 million through its own
commercial paper program. On August 29, 2006, Citigroup paid New Century $979
million for the mortgages (and accrued interest), and New Century repaid the repo
lenders after keeping a $24 million (2.5%) premium.
VIII. The Investors in the Deal
Investors for mortgage-backed securities came from all over the globe; what made
securitization work were the customized tranches catering to every one of them. CMLTI
2006-NC2 had 19 tranches. Fannie Mae bought the entire $155 million triple-A-rated A1
tranche, which paid a better return than super-safe U.S. Treasuries. The other triple-Arated tranches, worth $582 million, went to more than 20 institutional investors around
the world, spreading the risk globally. These triple-A tranches represented 78% of the
deal. Among the buyers were foreign banks and funds in China, Italy, France, and
The Mortgage Machine
Germany; the Federal Home Loan Bank of Chicago; the Kentucky Retirement Systems;
a hospital; and JP Morgan, which purchased part of the tranche using cash from its
securities lending operation. (In other words, JP Morgan lent securities held by its clients
to other financial institutions in exchange for cash collateral, and then put that cash to
work investing in this deal. Securities lending was a large, but ultimately unstable,
source of cash that flowed into this market.)
The middle, mezzanine tranches in this deal constituted about 21% of the total value of
the security. If losses rose above 1% to 3% (by design the threshold would increase over
time), investors in the residual tranches would be wiped out, and the mezzanine
investors would start to lose money. Creators of collateralized debt obligations, or CDOs
– discussed in the next chapter – bought most of the mezzanine tranches rated below
triple-A and nearly all those rated below AA. Only a few of the highest-rated mezzanine
tranches were not put into CDOs. For example, Cheyne Finance Limited purchased $7
million of the top mezzanine tranche. Cheyne – a structured investment vehicle (SIV) –
would be one of the first casualties of the crisis, sparking panic during the summer of
2007. Parvest ABS Euribor, which purchased $20 million of the second mezzanine
tranche, would be one of the BNP Paribas funds which helped ignite the financial crisis
that summer.
Typically, investors seeking high returns, such as hedge funds, would buy the equity
tranches of mortgage-backed securities; they would be the first to lose if there were
problems. These investors anticipated returns of 15%, 20%, or even 30%. Citigroup
retained part of the residual or “first-loss” tranches, sharing the rest with Capmark
Financial Group.
IX. “Compensated Very Well”
The business of structuring, selling, and distributing this deal, and the thousands like it,
was lucrative for the banks. The mortgage originators profited when they sold loans for
securitization. Some of this profit flowed down to employees – particularly those
generating mortgage volume.
Part of the $24 million premium received by New Century for the deal the FCIC analyzed
went to pay the many employees who participated. “The originators, the loan officers,
account executives, basically the salespeople [who] were the reason our loans came in .
. . were compensated very well,” New Century’s Patricia Lindsay told the FCIC. And
volume mattered more than quality. She noted, “Wall Street was very hungry for our
product. We had our loans sold three months in advance, before they were even made
at one point.”
Similar incentives were at work at Long Beach Mortgage, the subprime division of
Washington Mutual, which organized its 2004 Incentive Plan by volume. As WaMu
showed in a 2007 plan, “Home Loans Product Strategy,” the goals were also product
specific: to drive “growth in higher margin products (Option ARM, Alt-A, Home Equity,
Subprime),” “recruit and leverage seasoned Option ARM sales force,” and “maintain a
compensation structure that supports the high margin product strategy.”
After structuring a security, an underwriter, often an investment bank, marketed and sold
it to investors. The bank collected a percentage of the sale (generally between 0.2% and
1.5%) as discounts, concessions, or commissions. For a $1 billion deal like CMLTI 2006-
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NC2, a 1% fee would earn Citigroup $10 million. In this case, though, Citigroup instead
kept parts of the residual tranches. Doing so could yield large profits as long as the deal
performed as expected.
Options Group, which compiles compensation figures for investment banks, examined
the mortgage-backed securities sales and trading desks at 11 commercial and
investment banks from 2005 to 2007. It found that associates had average annual base
salaries of $65,000 to $90,000 from 2005 through 2007, but received bonuses that could
well exceed their salaries. On the next rung, vice presidents averaged base salaries and
bonuses from $200,000 to $1,150,000. Directors averaged $625,000 to $1,625,000. At
the top was the head of the unit. For example, in 2006, Dow Kim, the head of Merrill’s
Global Markets and Investment Banking segment, received a base salary of $350,000
plus a $35 million bonus, a package second only to Merrill Lynch’s CEO.
X. Moody’s: “Given a Blank Check”
The rating agencies were essential to the smooth functioning of the mortgage-backed
securities market. Issuers needed them to approve the structure of their deals; banks
needed their ratings to determine the amount of capital to hold; repo markets needed
their ratings to determine loan terms; some investors could buy only securities with a
triple-A rating; and the rating agencies’ judgment was backed into collateral agreements
and other financial contracts. To examine the rating process, the Commission focused
on Moody’s Investors Service, the largest and oldest of the three rating agencies.
The rating of structured finance products such as mortgage-backed securities made up
close to half of Moody’s rating revenues in 2005, 2006, and 2007. From 2000 to 2007,
revenues from rating such financial instruments increased more than fourfold. But the
rating process involved many conflicts, which would come into focus during the crisis.
To do its work, Moody’s rated mortgage-backed securities using models based, in part,
on periods of relatively strong credit performance. Moody’s did not sufficiently account
for the deterioration in underwriting standards or a dramatic decline in home prices. And
Moody’s did not even develop a model specifically to take into account the layered risks
of subprime securities until late 2006, after it had already rated nearly 19,000 subprime
XI. “In the Business Forevermore”
Credit ratings have been linked to government regulations for three-quarters of a
century. In 1931, the Office of the Comptroller of the Currency let banks report publicly
traded bonds with a rating of BBB or better at book value (that is, the price they paid for
the bonds); lower-rated bonds had to be reported at current market prices, which might
be lower. In 1951, the National Association of Insurance Commissioners adopted higher
capital requirements on lower-rated bonds held by insurers. But the watershed event in
federal regulation occurred in 1975, when the Securities and Exchange Commission
modified its minimum capital requirements for broker-dealers to base them on credit
ratings by a “nationally recognized statistical rating organization” (NRSRO); at the time,
that was Moody’s, S&P, or Fitch. Ratings are also built into banking capital regulations
under the Recourse Rule, which, since 2001, has permitted banks to hold less capital for
higher-rated securities. For example, BBB rated securities require five times as much
capital as AAA and AA rated securities, and BB securities require ten times more capital.
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Banks in some countries were subject to similar requirements under the Basel II
international capital agreement, signed in June 2004, although U.S. banks had not fully
implemented the advanced approaches allowed under those rules.
Credit ratings also determined whether investors could buy certain investments at all.
The SEC restricts money market funds to purchasing “securities that have received
credit ratings from any two NRSROs . . . in one of the two highest short-term rating
categories or comparable unrated securities.” The Department of Labor restricts pension
fund investments to securities rated A or higher. Credit ratings affect even private
transactions: contracts may contain triggers that require the posting of collateral or
immediate repayment, should a security or entity be downgraded. Triggers played an
important role in the financial crisis and helped cripple AIG.
Importantly for the mortgage market, the Secondary Mortgage Market Enhancement Act
of 1984 permitted federal- and state-chartered financial institutions to invest in mortgagerelated securities if the securities had high ratings from at least one rating agency. “Look
at the language of the original bill,” Lewis Ranieri told the FCIC. “It requires a rating. . . .
It put them in the business forevermore. It became one of the biggest, if not the biggest,
business.” As Eric Kolchinsky, a former Moody’s managing director, would summarize
the situation, “the rating agencies were given a blank check.”
The agencies themselves were able to avoid regulation for decades. Beginning in 1975,
the SEC had to approve a company’s application to become an NRSRO – but if
approved, a company faced no further regulation. More than 30 years later, the SEC got
limited authority to oversee NRSROs in the Credit Rating Agency Reform Act of 2006.
That law, taking effect in June 2007, focused on mandatory disclosure of the rating
agencies’ methodologies; however, the law barred the SEC from regulating “the
substance of the credit ratings or the procedures and methodologies.”
Many investors, such as some pension funds and university endowments, relied on
credit ratings because they had neither access to the same data as the rating agencies
nor the capacity or analytical ability to assess the securities they were purchasing. As
Moody’s former managing director Jerome Fons has acknowledged, “Subprime
[residential mortgage-backed securities] and their offshoots offer little transparency
around composition and characteristics of the loan collateral. . . . Loan-by-loan data, the
highest level of detail, is generally not available to investors.” Others, even large
financial institutions, relied on the ratings. Still, some investors who did their homework
were skeptical of these products despite their ratings. Arnold Cattani, chairman of
Mission Bank in Bakersfield, California, described deciding to sell the bank’s holdings of
mortgage-backed securities and CDOs:
At one meeting, when things started getting difficult, maybe in 2006, I
asked the CFO what the mechanical steps were in . . . mortgage-backed
securities, if a borrower in Des Moines, Iowa, defaulted. I know what it is if
a borrower in Bakersfield defaults, and somebody has that mortgage. But
as a packaged security, what happens? And he couldn’t answer the
question. And I told him to sell them, sell all of them, then, because we
didn’t understand it, and I don’t know that we had the capability to
understand the financial complexities; didn’t want any part of it.
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Notably, rating agencies were not liable for misstatements in securities registrations
because courts ruled that their ratings were opinions, protected by the First Amendment.
Moody’s standard disclaimer reads “The ratings . . . are, and must be construed solely
as, statements of opinion and not statements of fact or recommendations to purchase,
sell, or hold any securities.” Gary Witt, a former team managing director at Moody’s, told
the FCIC, “People expect too much from ratings . . . investment decisions should always
be based on much more than just a rating.”
XII. “Everything but the Elephant Sitting on the Table”
The ratings were intended to provide a means of comparing risks across asset classes
and time. In other words, the risk of a triple-A rated mortgage security was supposed to
be similar to the risk of a triple-A rated corporate bond.
Since the mid-1990s, Moody’s has rated tranches of mortgage-backed securities using
three models. The first, developed in 1996, rated residential mortgage-backed securities.
In 2003, Moody’s created a new model, M3 Prime, to rate prime, jumbo, and Alt-A deals.
Only in the fall of 2006, when the housing market had already peaked, did it develop its
model for rating subprime deals, called M3 Subprime.
The models incorporated firm- and security-specific factors, market factors, regulatory
and legal factors, and macroeconomic trends. The M3 Prime model let Moody’s
automate more of the process. Although Moody’s did not sample or review individual
loans, the company used loan-level information from the issuer. Relying on loan-to-value
ratios, borrower credit scores, originator quality, and loan terms and other information,
the model simulated the performance of each loan in 1,250 scenarios, including
variations in interest rates and state-level unemployment as well as home price changes.
On average, across the scenarios, home prices trended upward at approximately 4% per
year. The model put little weight on the possibility prices would fall sharply nationwide.
Jay Siegel, a former Moody’s team managing director involved in developing the model,
told the FCIC, “There may have been [state-level] components of this real estate drop
that the statistics would have covered, but the 38% national drop, staying down over this
short but multiple-year period, is more stressful than the statistics call for.” Even as
housing prices rose to unprecedented levels, Moody’s never adjusted the scenarios to
put greater weight on the possibility of a decline. According to Siegel, in 2005, “Moody’s
position was that there was not a . . . national housing bubble.”
When the initial quantitative analysis was complete, the lead analyst on the deal
convened a rating committee of other analysts and managers to assess it and determine
the overall ratings for the securities. Siegel told the FCIC that qualitative analysis was
also integral: “One common misperception is that Moody’s credit ratings are derived
solely from the application of a mathematical process or model. This is not the case. . . .
The credit rating process involves much more – most importantly, the exercise of
independent judgment by members of the rating committee. Ultimately, ratings are
subjective opinions that reflect the majority view of the committee’s members.” As Roger
Stein, a Moody’s managing director, noted, “Overall, the model has to contemplate
events for which there is no data.”
After rating subprime deals with the 1996 model for years, in 2006 Moody’s introduced a
parallel model for rating subprime mortgage-backed securities. Like M3 Prime, the
subprime model ran the mortgages through 1,250 scenarios. Moody’s officials told the
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FCIC they recognized that stress scenarios were not sufficiently severe, so they applied
additional weight to the most stressful scenario, which reduced the portion of each deal
rated triple-A. Stein, who helped develop the subprime model, said the output was
manually “calibrated” to be more conservative to ensure predicted losses were
consistent with analysts’ “expert views.” Stein also noted Moody’s concern about a
suitably negative stress scenario; for example, as one step, analysts took the “single
worst case” from the M3 Subprime model simulations and multiplied it by a factor in order
to add deterioration.
Moody’s did not, however, sufficiently account for the deteriorating quality of the loans
being securitized. Fons described this problem to the FCIC: “I sat on this high-level
Structured Credit committee, which you’d think would be dealing with such issues [of
declining mortgage-underwriting standards], and never once was it raised to this group
or put on our agenda that the decline in quality that was going into pools, the impact
possibly on ratings, other things. . . . We talked about everything but, you know, the
elephant sitting on the table.”
To rate CMLTI 2006-NC2, our sample deal, Moody’s first used its model to simulate
losses in the mortgage pool. Those estimates, in turn, determined how big the junior
tranches of the deal would have to be in order to protect the senior tranches from losses.
In analyzing the deal, the lead analyst noted it was similar to another Citigroup deal of
New Century loans that Moody’s had rated earlier and recommended the same amount.
Then the deal was tweaked to account for certain riskier types of loans, including
interest-only mortgages. For its efforts, Moody’s was paid an estimated $208,000. (S&P
also rated this deal and received $135,000.)
As we will describe later, three tranches of this deal would be downgraded less than a
year after issuance – part of Moody’s mass downgrade on July 10, 2007, when housing
prices had declined by only 4%. In October 2007, the M4-M11 tranches were downgraded
and by 2008, all the tranches had been downgraded. Of all mortgage-backed securities
it had rated triple-A in 2006, Moody’s downgraded 73% to junk. The consequences
would reverberate throughout the financial system.
XIII. Fannie Mae and Freddie Mac: “Less Competitive in the Marketplace”
In 2004, Fannie and Freddie faced problems on multiple fronts. They had violated
accounting rules and now faced corrections and fines. They were losing market share to
Wall Street, which was beginning to dominate the securitization market. Struggling to
remain dominant, they loosened their underwriting standards, purchasing and
guaranteeing riskier loans, and increasing their securities purchases. Yet their regulator,
the Office of Federal Housing Enterprise Oversight (OFHEO), focused more on
accounting and other operational issues than on Fannie’s and Freddie’s increasing
investments in risky mortgages and securities.
In 2002, Freddie changed accounting firms. The company had been using Arthur
Andersen for many years, but when Andersen got into trouble in the Enron debacle
(which put both Enron and its accountant out of business), Freddie switched to
PricewaterhouseCoopers. The new accountant found the company had understated its
earnings by $5 billion from 2000 through the third quarter of 2002, in an effort to smooth
reported earnings and promote itself as “Steady Freddie,” a company of strong and
steady growth. Bonuses were tied to the reported earnings, and OFHEO found that this
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arrangement contributed to the accounting manipulations. Freddie’s board ousted most
top managers, including Chairman and CEO Leland Brendsel, President and COO David
Glenn, and CFO Vaughn Clarke. In December 2003, Freddie agreed with OFHEO to pay
a $125 million penalty and correct governance, internal controls, accounting, and risk
management. In January 2004, OFHEO directed Freddie to maintain 30% more than its
minimum capital requirement until it reduced operational risk and could produce timely,
certified financial statements. Freddie Mac would settle shareholder lawsuits for $410
million and pay $50 million in penalties to the SEC.
Fannie was next. In September 2004, OFHEO discovered violations of accounting rules
that called into question previous filings. In 2006, OFHEO reported that Fannie had
overstated earnings from 1998 through 2002 by $11 billion and that it, too, had
manipulated accounting in ways influenced by compensation plans. OFHEO made
Fannie improve accounting controls, maintain the same 30% capital surplus imposed on
Freddie, and improve governance and internal controls. Fannie’s board ousted CEO
Franklin Raines and others, and the SEC required Fannie to restate its results for 2001
through mid-2004. Fannie settled SEC and OFHEO enforcement actions for $400 million
in penalties. Donald Bisenius, an executive vice president at Freddie Mac, told the FCIC
that the accounting issues distracted management from the mortgage business, taking
“a tremendous amount of management’s time and attention and probably led to us being
less aggressive or less competitive in the marketplace [than] we otherwise might have
As the scandals unfolded, subprime private label mortgage-backed securities (PLS)
issued by Wall Street increased from $87 billion in 2001 to $465 billion in 2005; the value
of Alt-A mortgage-backed securities increased from $11 billion to $332 billion. Starting in
2001 for Freddie and 2002 for Fannie, the GSEs – particularly Freddie – became buyers
in this market. While private investors always bought the most, the GSEs purchased
10.5% of the private-issued subprime mortgage-backed securities in 2001. The share
peaked at 40% in 2004 and then fell back to 28% in 2008. The share for Alt-A
mortgage–backed securities was always lower. The GSEs almost always bought the
safest, triple-A-rated tranches. From 2005 through 2008, the GSEs’ purchases declined,
both in dollar amount and as a percentage.
These investments were profitable at first, but as delinquencies increased in 2007 and
2008, both GSEs began to take significant losses on their private label mortgage-backed
securities – disproportionately from their purchases of Alt-A securities. By the third
quarter of 2010, total impairments on securities totaled $46 billion at the two companies
– enough to wipe out nearly 60% of their pre-crisis capital.
OFHEO knew about the GSEs’ purchases of subprime and Alt-A mortgage-backed
securities. In its 2004 examination, the regulator noted Freddie’s purchases of these
securities. It also noted that Freddie was purchasing whole mortgages with “higher risk
attributes which exceeded the Enterprise’s modeling and costing capabilities,” including
“No Income/No Asset loans” that introduced “considerable risk.” OFHEO reported that
mortgage insurers were already seeing abuses with these loans. But the regulator
concluded that the purchases of mortgage-backed securities and riskier mortgages were
not a “significant supervisory concern,” and the examination focused more on Freddie’s
efforts to address accounting and internal deficiencies. OFHEO included nothing in
Fannie’s report about its purchases of subprime and Alt-A mortgage-backed securities,
and its credit risk management was deemed satisfactory.
The Mortgage Machine
The reasons for the GSEs’ purchases of subprime and Alt-A mortgage-backed securities
have been debated. Some observers, including Alan Greenspan, have linked the GSEs’
purchases of private mortgage-backed securities to their push to fulfill their higher goals
for affordable housing. The former Fed chairman wrote in a working paper submitted as
part of his testimony to the FCIC that when the GSEs were pressed to “expand
‘affordable housing commitments,’ they chose to meet them by investing heavily in
subprime securities.” Using data provided by Fannie Mae and Freddie Mac, the FCIC
examined how single-family, multifamily, and securities purchases contributed to
meeting the affordable housing goals. In 2003 and 2004, Fannie Mae’s single- and
multifamily purchases alone met each of the goals; in other words, the enterprise would
have met its obligations without buying subprime or Alt-A mortgage-backed securities. In
fact, none of Fannie Mae’s 2004 purchases of subprime or Alt-A securities were ever
submitted to HUD to be counted toward the goals.
Before 2005, 50% or less of the GSEs’ loan purchases had to satisfy the affordable
housing goals. In 2005 the goals were increased above 50%; but even then, single and
multifamily purchases alone met the overall goals. Securities purchases did, in several
cases, help Fannie meet its subgoals – specific targets requiring the GSEs to purchase
or guarantee loans to purchase homes. In 2005, Fannie missed one of these subgoals
and would have missed a second without the securities purchases; in 2006, the
securities purchases helped Fannie meet those two subgoals.
The pattern is the same at Freddie Mac, a larger purchaser of non-agency mortgagebacked securities. Estimates by the FCIC show that from 2003 through 2006, Freddie
would have met the affordable housing goals without any purchases of Alt-A or subprime
securities, but used the securities to help meet subgoals.
Robert Levin, the former chief business officer of Fannie Mae, told the FCIC that buying
private label mortgage-backed securities “was a moneymaking activity – it was all
positive economics. . . . [T]here 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 share.” Mark Winer, the head of Fannie’s Business, Analysis, and
Decisions Group, stated that the purchase of triple-A tranches of mortgage-backed
securities backed by subprime loans was viewed as an attractive opportunity with good
returns. He said that the mortgage-backed securities satisfied housing goals, and that
the goals became a factor in the decision to increase purchases of private label
Overall, while the mortgages behind the subprime mortgage-backed securities were
often issued to borrowers that could help Fannie and Freddie fulfill their goals, the
mortgages behind the Alt-A securities were not. Alt-A mortgages were not generally
extended to lower-income borrowers, and the regulations prohibited mortgages to
borrowers with unstated income levels – a hallmark of Alt-A loans – from counting
toward affordability goals. Levin told the FCIC that they believed that the purchase of AltA securities “did not have a net positive effect on Fannie Mae’s housing goals.” Instead,
they had to be offset with more mortgages for low- and moderate-income borrowers to
meet the goals.
Fannie and Freddie continued to purchase subprime and Alt-A mortgage-backed
securities from 2005 to 2008 and also bought and securitized greater numbers of riskier
mortgages. The results would be disastrous for the companies, their shareholders, and
American taxpayers.
The Mortgage Machine
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. The Federal Reserve failed to raise interest rates from 2003 through 2006.
a) true
b) false
2. Foreign companies and governments are prohibited from purchasing securities
backed by Fannie Mae or Freddie Mac.
a) true
b) false
3. Which of the following statements about hybrid ARM mortgages is incorrect:
a) they forced borrowers to only purchase homes they could afford based on their
monthly income
b) they allowed borrowers to purchase homes they could not really afford
c) payments could often double or triple
d) people who could not otherwise get a mortgage used these vehicles to finance
the purchase of a home
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1. A: True is incorrect. While the Fed kept rates low and flat between 2003 and 2004,
they raised them over the next two years.
B: False is correct. The rates were low between 2003 and 2004 but were then
raised when concerns over possible deflation dissipated.
(See page 7-1 of the course material.)
2. A: True is incorrect. There is no such prohibition. Indeed, during the housing boom
foreign holding of this type of securities ballooned.
B: False is correct. Not only are they allowed, but they grew significantly during the
housing boom.
(See page 7-2 of the course material.)
3. A: Correct. These loans did just the opposite. Many borrowers purchased homes that
under normal circumstances would be well out of their price range. They often lost
those homes when payments ballooned.
B: Incorrect. Artificially low payments initially allowed many people to get in over their
C: Incorrect. This occurred in a short period time if borrowers could not get traditional
D: Incorrect. People who qualified for a standard mortgage generally did not use this
type of vehicle.
(See page 7-4 of the course material.)
The Mortgage Machine
Chapter 8: The CDO Machine
I. Introduction to Collateralized Debt Obligations
In the first decade of the 21st century, a previously obscure financial product called the
collateralized debt obligation, or CDO, transformed the mortgage market by creating a
new source of demand for the lower-rated tranches of mortgage-backed securities.
Despite their relatively high returns, tranches rated other than triple-A could be hard to
sell. If borrowers were delinquent or defaulted, investors in 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.” That is, they built new securities that would buy the tranches that had become
harder to sell. Bankers would take those low investment-grade tranches, largely rated
BBB or A, from many mortgage-backed securities and repackage them into the new
securities – CDOs. Approximately 80% of these CDO tranches would be rated triple-A
despite the fact that they generally comprised the lower-rated tranches of mortgagebacked securities. CDO securities would be sold with their own waterfalls, with the riskaverse investors, again, paid first and the risk-seeking investors paid last. As they did in
the case of mortgage-backed securities, the rating agencies gave their highest, triple-A
ratings to the securities at the top.
Still, it was not obvious that a pool of mortgage-backed securities rated BBB could be
transformed into a new security that is mostly rated triple-A. But math made it so. The
securities firms argued – and the rating agencies agreed – that if they pooled many
BBB-rated mortgage-backed securities, they would create additional diversification
benefits. The rating agencies believed that those diversification benefits were 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 as losses were 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 and other lower-rated
tranches of mortgage-backed securities, growing from a bit player to a multi-hundredbillion-dollar industry. Between 2003 and 2007, as house prices rose 27% nationally and
$4 trillion in mortgage-backed securities were created, Wall Street issued nearly $700
billion in CDOs that included mortgage-backed securities as collateral. With ready
buyers for their own product, mortgage securitizers continued to demand loans for their
pools, and hundreds of billions of dollars flooded the mortgage world. In effect, the CDO
became the engine that powered the mortgage supply chain.
Everyone involved in keeping this machine humming – the CDO managers and
underwriters who packaged and sold the securities, the rating agencies that gave most
of them sterling ratings, and the guarantors who wrote protection against their defaulting
– collected fees based on the dollar volume of securities sold. For the bankers who had
put these deals together, as for the executives of their companies, volume equaled fees
equaled bonuses. And those fees were in the billions of dollars across the market.
The CDO Machine
But when the housing market went south, the models on which CDOs were based
proved tragically wrong. The mortgage-backed securities turned out to be highly
correlated – meaning they performed similarly. Across the country, in regions where
subprime and Alt-A mortgages were heavily concentrated, borrowers would default in
large numbers. This was not how it was supposed to work. Losses in one region were
supposed to be offset by successful loans in another region. In the end, CDOs turned
out to be some of the most ill-fated assets in the financial crisis. The greatest losses
would be experienced by big CDO arrangers such as Citigroup, Merrill Lynch, and UBS,
and by financial guarantors such as AIG, Ambac, and MBIA. These players had believed
their own models and retained exposure to what were understood to be the least risky
tranches of the CDOs: those rated triple-A or even “super-senior,” which were assumed
to be safer than triple-A-rated tranches.
“The whole concept of ABS CDOs had been an abomination,” Patrick Parkinson,
currently the head of banking supervision and regulation at the Federal Reserve Board,
told the FCIC.
II. CDOs: “We Created the Investor”
For the managers who created CDOs, the key to profitability of the CDO was the fee and
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 investors. Throughout the 1990s,
CDO managers generally purchased corporate and emerging market bond and bank
loans. When the liquidity crisis of 1998 drove up returns on asset-backed securities,
Prudential Securities saw an opportunity and launched a series of CDOs that combined
different kinds of asset-backed securities into one CDO. These “multisector” or “ABS”
securities were backed by mortgages, mobile home loans, aircraft leases, mutual fund
fees, and other asset classes with predictable income streams. The diversity was
supposed to provide yet another layer of safety for investors.
Multisector CDOs went through a tough patch when some of the asset-backed securities
in which they invested started to perform poorly in 2002 – particularly those backed by
mobile home loans (after borrowers defaulted in large numbers), aircraft leases (after
9/11), and mutual fund fees (after the dot-com bust). The accepted wisdom among many
investment banks, investors, and rating agencies was that the wide range of assets had
actually contributed to the problem; according to this view, the asset managers who
selected the portfolios could not be experts in sectors as diverse as aircraft leases and
mutual funds.
So the CDO industry turned to nonprime mortgage-backed securities, which CDO
managers believed they understood, which seemed to have a record of good
performance, and which paid relatively high returns for what was considered a safe
investment. CDOs quickly became ubiquitous in the mortgage business. Investors liked
the combination of apparent safety and strong returns, and investment bankers liked
having a new source of demand for the lower tranches of mortgage-backed securities
and other asset-backed securities that they created.
The CDO Machine
By 2004, creators of CDOs were the dominant buyers of the BBB-rated tranches of
mortgage-backed securities, and their bids significantly influenced prices in the market
for these securities. By 2005, they were buying “virtually all” of the BBB tranches. Just as
mortgage-backed securities provided the cash to originate mortgages, now CDOs would
provide the cash to fund mortgage-backed securities. Also by 2004, mortgage-backed
securities accounted for more than half of the collateral in CDOs, up from 35% in 2002.
Sales of these CDOs more than doubled every year, jumping from $30 billion in 2003 to
$225 billion in 2006. Filling this pipeline would require hundreds of billions of dollars of
subprime and Alt-A mortgages.
III. “It Was a Lot of Effort”
Five key types of players were involved in the construction of CDOs: securities firms,
CDO managers, rating agencies, investors, and financial guarantors. Each took varying
degrees of risk and, for a time, profited handsomely.
Securities firms underwrote the CDOs: that is, they approved the selection of collateral,
structured the notes into tranches, and were responsible for selling them to investors.
Three firms – Merrill Lynch, Goldman Sachs, and the securities arm of Citigroup –
accounted for more than 30% of CDOs structured from 2004 to 2007.
The underwriters’ focus was on generating fees and structuring deals that they could
sell. Underwriting did entail risks, however. The securities firm had to hold the assets,
such as the BBB-rated tranches of mortgage-backed securities, during the ramp-up
period – six to nine months when the firm was accumulating the mortgage-backed
securities for the CDOs. Typically, during that period, the securities firm took the risk that
the assets might lose value.
The role of the CDO manager was to select the collateral, such as mortgage-backed
securities, and in some cases manage the portfolio on an ongoing basis. Managers
ranged from independent investment firms such as Chau’s to units of large asset
management companies such as PIMCO and Blackrock.
CDO managers received periodic fees based on the dollar amount of assets in the CDO
and in some cases on performance. On a percentage basis, these may have looked
small – sometimes measured in tenths of a percentage point – but the amounts were far
from trivial. For CDOs that focused on the relatively senior tranches of mortgage-backed
securities, annual manager fees tended to be in the range of $600,000 to a million
dollars per year for a $1 billion dollar deal. For CDOs that focused on the more junior
tranches, which were often smaller, fees would be $750,000 to $1.5 million per year for a
$500 million deal. As managers did more deals, they generated more fees without much
additional cost. CDO managers industry-wide earned at least $1.5 billion in management
fees between 2003 and 2007.
The CDO Machine
The role of the rating agencies was to provide basic guidelines on the collateral and the
structure of the CDOs – that is, the sizes and returns of the various tranches – in close
consultation with the underwriters. For many investors, the triple-A rating made those
products appropriate investments. Rating agency fees were typically between $250,000
and $500,000 for CDOs. 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, like investors in mortgage-backed securities, focused on different
tranches based on their preference for risk and return. CDO underwriters such as
Citigroup, Merrill Lynch, and UBS often retained the super-senior triple-A tranches for
reasons we will see later. They also sold them to commercial paper programs that
invested in CDOs and other highly rated assets. Hedge funds often bought the equity
Eventually, other CDOs became the most important class of investor for the mezzanine
tranches of CDOs. By 2005, CDO underwriters were selling most of the mezzanine
tranches – including those rated A – and, especially, those rated BBB, the lowest and
riskiest investment-grade rating – to other CDO managers, to be packaged into other
CDOs. It was common for CDOs to be structured with 5% or 15% of their cash invested
in other CDOs; CDOs with as much as 80% to 100% of their cash invested in other
CDOs were typically known as “CDOs squared.”
Finally, the issuers of over-the-counter derivatives called credit default swaps, most
notably AIG, played a central role by issuing swaps to investors in CDO tranches,
promising to reimburse them for any losses on the tranches in exchange for a stream of
premium-like payments. This credit default swap protection made the CDOs much 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.
Profit from the creation of CDOs, as is customary on Wall Street, was reflected in
employee bonuses. And, as demand for all types of financial products soared during the
liquidity boom at the beginning of the 21st century, pretax profit for the five largest
investment banks doubled between 2003 and 2006, from $20 billion to $43 billion; total
compensation at these investment banks for their employees across the world rose from
$34 billion to $61 billion. A part of the growth could be credited to mortgage-backed
securities, CDOs, and various derivatives, and thus employees in those areas could be
expected to be compensated accordingly
IV. “Mother’s Milk to the . . . Market”
The growth of CDOs had important impacts on the mortgage market itself. CDO
managers who were eager to expand the assets that they were managing – on which
their income was based – were willing to pay high prices to accumulate BBB-rated
tranches of mortgage-backed securities. This “CDO bid” pushed up market prices on
those tranches, pricing out of the market traditional investors in mortgage-backed
The CDO Machine
Informed institutional investors such as insurance companies had purchased the privatelabel mortgage-backed securities issued in the 1990s. These securities were typically
protected from losses by bond insurers, who had analyzed the deals as well. Beginning
in the late 1990s, mortgage-backed securities that were structured with six or more
tranches and other features to protect the triple-A investors became more common,
replacing the earlier structures that had relied on bond insurance to protect investors. By
2004, the earlier forms of mortgage-backed securities had essentially vanished, leaving
the market increasingly to the multitranche structures and their CDO investors.
This was a critical development, given that the focus of CDO managers differed from
that of traditional investors. Indeed, one CDO manager portrayed his job as creating
structures that rating agencies would approve and investors would buy, and making sure
the mortgage-backed securities that he bought met industry standards.
V. “Leverage Is Inherent in CDOs”
The mortgage pipeline also introduced leverage at every step. Most financial institutions
thrive on leverage – that is, on investing borrowed money. Leverage increases profits in
good times, but also increases losses in bad times. The mortgage itself creates leverage
– particularly when the loan is of the low down payment, high loan-to-value ratio variety.
Mortgage-backed securities and CDOs created further leverage because they were
financed with debt. And the CDOs were often purchased as collateral by those creating
other CDOs with yet another round of debt. Synthetic CDOs consisting of credit default
swaps amplified the leverage. The CDO, backed by securities that were themselves
backed by mortgages, created leverage on leverage, as Dan Sparks, mortgage
department head at Goldman Sachs, explained to the FCIC. “People were looking for
other forms of leverage. . . . You could either take leverage individually, as an institution,
or you could take leverage within the structure,” Citigroup’s Dominguez told the FCIC.
Even the investor that bought the CDOs could use leverage. Structured investment
vehicles (SIVs) – a type of commercial paper program that invested mostly in triple-Arated securities – were leveraged an average of just under 14-to-1: in other words these
SIVs would hold $14 in assets for every dollar of capital. The assets would be financed
with debt. Hedge funds, which were common purchasers, were also often highly
leveraged in the repo market. But it would become clear during the crisis that some of
the highest leverage was created 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 no capital backing.
Thus, in 2004, when the homeownership rate was peaking, and when new mortgages
were increasingly being driven by serial refinancings, by investors and speculators, and
by second home purchases, the value of trillions of dollars of securities rested on just
two things: the ability of millions of homeowners to make the 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 along by some
market participants.
The CDO Machine
VI. Three Large Firms’ Experiences with CDOs
By the middle of the decade, Citigroup was a market leader in selling CDOs, often using
its depositor-based commercial bank to provide liquidity support. For much of this period,
the company was in various types of trouble with its regulators, and then-CEO Charles
Prince told the FCIC that dealing with those troubles took up more than half his time.
After paying the $70 million fine related to subprime mortgage lending, Citigroup again
got into trouble, charged with helping Enron – before that company filed for bankruptcy
in 2001 – use structured finance transactions to manipulate its financial statements. In
July 2003, Citigroup agreed to pay the SEC $120 million to settle these allegations and
also agreed, under formal enforcement actions by the Federal Reserve and Office of the
Comptroller of the Currency, to overhaul its risk management practices.
By March 2005, the Fed had seen enough: it banned Citigroup from making any more
major acquisitions until it improved its governance and legal compliance. According to
Prince, he had already decided to turn “the company’s focus from an acquisition-driven
strategy to more of a balanced strategy involving organic growth.” Robert Rubin, a
former treasury secretary and former Goldman Sachs co-CEO who was at that time
chairman of the Executive Committee of Citigroup’s board of directors, recommended
that Citigroup increase its risk taking – assuming, he told the FCIC, that the firm
managed those risks properly.
Citigroup’s investment bank subsidiary was a natural area for growth after the Fed and
then Congress had done away with restrictions on activities that could be pursued by
investment banks affiliated with commercial banks. One opportunity among many was
the CDO business, which was just then taking off amid the booming mortgage market.
In 2003, Citi’s CDO desk was a tiny unit in the company’s investment banking arm,
“eight guys and a Bloomberg” terminal, in the words of Nestor Dominguez, then co-head
of the desk. Nevertheless, this tiny operation under the command of Thomas Maheras,
co-CEO of the investment bank, had become a leader in the nascent market for CDOs,
creating more than $18 billion in 2003 and 2004 – close to one-fifth of the market in
those years.
The eight guys had picked up on a novel structure pioneered by Goldman Sachs and
WestLB, a German bank. Instead of issuing the triple-A tranches of the CDOs as longterm debt, Citigroup structured them as short-term asset-backed commercial paper. Of
course, using commercial paper introduced liquidity risk (not present when the tranches
were sold as long-term debt), because the CDO would have to reissue the paper to
investors regularly – usually within days or weeks – for the life of the CDO. But assetbacked commercial paper was a cheap form of funding at the time, and it had a large
base of potential investors, particularly among money market mutual funds. To mitigate
the liquidity risk and to ensure that the rating agencies would give it their top ratings,
Citibank (Citigroup’s national bank subsidiary) provided assurances to investors, in the
form of liquidity 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 if there were no buyers when it
matured or if the cost of funding rose by a predetermined amount.
The CDO Machine
The CDO team at Citigroup had jumped into the market in July 2003 with a $1.5 billion
CDO named Grenadier Funding that included a $1.3 billion tranche backed by a liquidity
put from Citibank. Over the next three years, Citi would write liquidity puts on $25 billion
of commercial paper issued by CDOs, more than any other company. BSAM’s three Klio
CDOs, which Citigroup had underwritten, accounted for just over $10 billion of this total,
a large number that would not bode well for the bank. The CDO desk earned roughly 1%
of the total deal value in structuring fees for Citigroup’s investment banking arm, or about
$10 million for a $1 billion deal. In addition, Citigroup would generally charge buyers
0.10% to 0.20% in premiums annually for the liquidity puts. In other words, for a typical
$1 billion deal, Citibank would receive $1 to $2 million annually on the liquidity puts alone
– practically free money, it seemed, because the trading desk believed that these puts
would never be triggered.
In effect, the liquidity put was yet another highly leveraged bet: a contingent liability that
would be triggered in some circumstances. Prior to the 2004 change in the capital rules
regarding liquidity puts, Citigroup did not have to hold any capital against such
contingencies. Rather, it was permitted to use its own risk models to determine the
appropriate capital charge. But Citigroup’s financial models estimated only a remote
possibility that the puts would be triggered. Following the 2004 rule change, Citibank
was required to hold 0.16% in capital against the amount of commercial paper supported
by the liquidity put, or $1.6 million for a $1 billion liquidity put. Given a $1 to $2 million
annual fee for the put, the annual return on that capital could still exceed 100%. No
doubt about it, Dominguez told the FCIC, the triple-A or similar ratings, the multiple fees,
and the low capital requirements made the liquidity puts “a much better trade” for Citi’s
balance sheet. The events of 2007 would reveal the fallacy of those assumptions and
catapult the entire $25 billion in commercial paper straight onto the bank’s balance
sheet, requiring it to come up with $25 billion in cash as well as more capital to satisfy
bank regulators.
Besides Citigroup, only a few large financial institutions, such as AIG Financial Products,
BNP, WestLB of Germany, and Societe Generale of France, wrote significant amounts
of liquidity puts on commercial paper issued by CDOs. Bank of America, the biggest
commercial bank in the United States, wrote small deals through 2006 but did $6 billion
worth in 2007, just before the market crashed. When asked why other market
participants were not writing liquidity puts, Dominguez stated that Societe Generale and
BNP were big players in that market. “You needed to be a bank with a strong balance
sheet, access to collateral, and existing relationships with collateral managers,” he said.
The CDO desk stopped writing liquidity puts in early 2006, when it reached its internal
limits. Citibank’s treasury function had set a $23 billion cap on liquidity puts; it granted
one final exception, bringing the total to $25 billion. Risk management had also set a $25
billion risk limit on top-rated asset-backed securities, which included the liquidity puts.
Later, in an October 2006 memo, Citigroup’s Financial Control Group criticized the firm’s
pricing of the puts, which failed to consider the risk that investors would not buy the
commercial paper protected by the liquidity puts when it came due, thereby creating a
$25 billion cash demand on Citibank. An undated and unattributed internal document
(believed to have been drafted in 2006) also questioned one of the practices of
Citigroup’s investment bank, which paid traders on its CDO desk for generating the
deals without regard to later losses: “There is a potential conflict of interest in pricing the
liquidity put cheep [sic] so that more CDO equities can be sold and more structuring fee
The CDO Machine
to be generated.” The result would be losses so severe that they would help bring the
huge financial conglomerate to the brink of failure, as we will see.
In 2004, American International Group was the largest insurance company in the world
as measured by stock market value: a massive conglomerate with $850 billion in assets,
116,000 employees in 130 countries, and 223 subsidiaries.
But to Wall Street, AIG’s most valuable asset was its credit rating: that it was awarded
the highest possible rating – Aaa by Moody’s since 1986, AAA by S&P since 1983 – was
crucial, because these sterling ratings let it borrow cheaply and deploy the money in
lucrative investments. Only six private-sector companies in the United States in early
2010 carried those ratings.
Starting in 1998, 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 major over-the-counter
derivatives dealer, eventually having a portfolio of $2.7 trillion in notional amount. Among
other derivatives activities, the unit issued credit default swaps guaranteeing debt
obligations held by financial institutions and other investors. In exchange for a stream of
premium-like payments, AIG Financial Products agreed to reimburse the investor in such
a debt obligation in the event of any default. The credit default swap (CDS) is often
compared to insurance, but when an insurance company sells a policy, regulations
require that it set aside a reserve in case of a loss. Because credit default swaps were
not regulated insurance contracts, no such requirement was applicable. In this case, the
unit predicted with 99.85% confidence that there would be no realized economic loss on
the supposedly safest portions of the CDOs on which they wrote CDS protection, and
failed to make any provisions whatsoever for declines in value – or unrealized losses – a
decision that would prove fatal to AIG in 2008.
AIG Financial Products had a huge business selling CDS to European banks on a
variety of financial assets, including bonds, mortgage-backed securities, CDOs, and
other debt securities. For AIG, the fee for selling protection via the swap appeared well
worth the risk. For the banks purchasing protection, the swap enabled them to neutralize
the credit risk and thereby hold less capital against its assets. Purchasing credit default
swaps from AIG could reduce the amount of regulatory capital that the bank needed to
hold against an asset from 8% to 1.6%. By 2005, AIG had written $107 billion in CDS for
such regulatory capital benefits; most were with European banks for a variety of asset
types. That total would rise to $379 billion by 2007.
The same advantages could be enjoyed by banks in the United States, where regulators
had introduced similar capital standards for banks’ holdings of mortgage-backed
securities and other investments under the Recourse Rule in 2001. So a credit default
swap with AIG could also lower American banks’ capital requirements.
In 2004 and 2005, AIG sold protection on super-senior CDO tranches valued at $54
billion, up from just $2 billion in 2003. In an interview with the FCIC, one AIG executive
described AIG Financial Products’ principal swap salesman, Alan Frost, as “the golden
goose for the entire Street.”
The CDO Machine
AIG’s biggest customer in this business was always Goldman Sachs, consistently a
leading CDO underwriter. AIG also wrote billions of dollars of protection for Merrill Lynch,
Societe Generale, and other firms. AIG “looked like the perfect customer for this,” Craig
Broderick, Goldman’s chief risk officer, told the FCIC. “They really ticked all the boxes.
They were among the highest-rated [corporations] around. They had what appeared to
be unquestioned expertise. They had tremendous financial strength. They had huge,
appropriate interest in this space, backed by a long history of trading in it.”
AIG also bestowed the imprimatur of its pristine credit rating on commercial paper
programs by providing liquidity puts, similar to the ones that Citigroup’s bank wrote for
many of its own deals, guaranteeing it would buy commercial paper if no one else
wanted it. It entered this business in 2002; by 2005, it had written more than $6 billion of
liquidity puts on commercial paper issued by CDOs. AIG also wrote more than $7 billion
in CDS to protect Societe Generale against the risks on liquidity puts that the French
bank itself wrote on commercial paper issued by CDOs. “What we would always try to do
is to structure a transaction where the transaction was virtually riskless, and get paid a
small premium,” Gene Park, who was a managing director at AIG Financial Products,
told the FCIC. “And we’re one of the few guys who can do that. Because if you think
about it, no one wants to buy disaster protection from someone who is not going to be
around. . . . That was AIGFP’s sales pitch to the Street or to banks.”
AIG’s business of offering credit protection on assets of many sorts, including mortgagebacked securities and CDOs, grew from $20 billion in 2002 to $211 billion in 2005 and
$533 billion in 2007. This business was a small part of the AIG Financial Services
business unit, which included AIG Financial Products; AIG Financial Services generated
operating income of $4.4 billion in 2005, or 29% of AIG’s total.
AIG did not post any collateral when it wrote these contracts; but unlike monoline
insurers, AIG Financial Products agreed to post collateral if the value of the underlying
securities dropped, or if the rating agencies downgraded AIG’s long-term debt ratings. Its
competitors, the monoline financial guarantors – insurance companies such as MBIA
and Ambac that focused on guaranteeing financial contracts – were forbidden under
insurance regulations from paying out until actual losses occurred. The collateral posting
terms in AIG’s credit default swap contracts would have an enormous impact on the
crisis about to unfold.
But during the boom, these terms didn’t matter. The investors got their triple-A-rated
protection, AIG got its fees for providing that insurance – about 0.12% of the notional
amount of the swap per year – and the managers got their bonuses. In the case of the
London subsidiary that ran the operation, the bonus pool was 30% of new earnings.
Financial Products CEO Joseph J. Cassano made the allocations at the end of the year.
Between 2002 and 2007, the least amount Cassano paid himself in a year was $38
million. In the later years, his compensation was sometimes double that of the parent
company’s CEO.
In the spring of 2005, disaster struck: AIG lost its triple-A rating when auditors
discovered that it had manipulated earnings. By November 2005, the company had
reduced its reported earnings over the five-year period by $3.9 billion. The board forced
out Maurice “Hank” Greenberg, who had been CEO for 38 years. New York Attorney
General Eliot Spitzer prepared to bring fraud charges against him.
The CDO Machine
Greenberg told the FCIC, “When the AAA credit rating disappeared in spring 2005, it
would have been logical for AIG to have exited or reduced its business of writing credit
default swaps.” But that didn’t happen. Instead, AIG Financial Products wrote another
$36 billion in credit default swaps on super-senior tranches of CDOs in 2005. The
company wouldn’t make the decision to stop writing these contracts until 2006.
Henry Paulson, the CEO of Goldman Sachs from 1999 until he became secretary of the
Treasury in 2006, 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 really wasn’t the proper regulatory apparatus to deal with it.” Paulson provided
examples: “Subprime mortgages went from accounting for 5 percent of total mortgages
in 1994 to 20 percent by 2006. Securitization separated originators from the risk of the
products they originated.” The result, Paulson observed, “was a housing bubble that
eventually burst in far more spectacular fashion than most previous bubbles.”
Under Paulson’s leadership, Goldman Sachs had played a central role in the creation
and sale of mortgage securities. From 2004 through 2006, the company provided billions
of dollars in loans to mortgage lenders; most went to the subprime lenders Ameriquest,
Long Beach, Fremont, New Century, and Countrywide through warehouse lines of
credit, often in the form of repos. During the same period, Goldman acquired $53 billion
of loans from these and other subprime loan originators, which it securitized and sold to
investors. From 2004 to 2006, Goldman issued 318 mortgage securitizations totaling
$184 billion (about a quarter were subprime), and 63 CDOs totaling $32 billion; Goldman
also issued 22 synthetic or hybrid CDOs with a face value of $35 billion between 2004
and June 2006.
Synthetic CDOs were complex paper transactions involving credit default swaps. Unlike
the traditional cash CDO, synthetic CDOs contained no actual tranches of mortgagebacked securities, or even tranches of other CDOs. Instead, they simply referenced
these mortgage securities and thus were bets on whether borrowers would pay their
mortgages. In the place of real mortgage assets, these CDOs contained credit default
swaps and did not finance a single home purchase. Investors in these CDOs included
“funded” long investors, who paid cash to purchase actual securities issued by the CDO;
“unfunded” long investors, who entered into swaps with the CDO, making money if the
reference securities performed; and “short” investors, who bought credit default swaps
on the reference securities, making money if the securities failed. While funded investors
received interest if the reference securities performed, they could lose all of their
investment if the reference securities defaulted. Unfunded investors, which were highest
in the payment waterfall, received premium-like payments from the CDO as long as the
reference securities performed, but would have to pay if the reference securities
deteriorated beyond a certain point and if the CDO did not have sufficient funds to pay
the short investors. Short investors, often hedge funds, bought the credit default swaps
from the CDOs and paid those premiums. Hybrid CDOs were a combination of
traditional and synthetic CDOs.
Firms like Goldman found synthetic CDOs cheaper and easier to create 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
The CDO Machine
fraction of the time. They also were easier to customize, because CDO managers and
underwriters could reference any mortgage-backed security – they were not limited to
the universe of securities available for them to buy.
In 2004, Goldman launched its first major synthetic CDO, Abacus 2004-1 – a deal worth
$2 billion. About one-third of the swaps referenced residential mortgage-backed
securities, another third referenced existing CDOs, and the rest, commercial mortgagebacked securities (made up of bundled commercial real estate loans) and other
Goldman was the short investor for the entire $2 billion deal: it purchased credit default
swap protection on these reference securities from the CDO. The funded investors – IKB
(a German bank), the TCW Group, and Wachovia – put up a total of $195 million to
purchase mezzanine tranches of the deal. These investors would receive scheduled
principal and interest payments if the referenced assets performed. If the referenced
assets did not perform, Goldman, as the short investor, would receive the $195 million.
In this sense, IKB, TCW, and Wachovia were “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 and CDOs) – did not put up any money up front; they
received annual premiums from the CDO in return for the promise that they would pay
the CDO if the reference securities failed and the CDO did not have enough funds to pay
the short investors.
Goldman was the largest unfunded investor at the time that the deal was originated,
retaining the $1.8 billion super-senior tranche. Goldman’s $2 billion short position more
than offset that exposure; about one year later, it transferred the unfunded long position
by buying credit protection from AIG, in return for an annual payment of $2.2 million. As
a result, by 2005, AIG was effectively the largest unfunded investor in the super-senior
tranches of the Abacus deal.
All 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 gain nearly $2 billion if the assets
In the end, Goldman, the short investor in the Abacus 2004-1 CDO, has received about
$930 million while the long investors have lost just about all of their investments. In April
2008, GSC paid Goldman $7.3 million as a result of CDS protection sold by GSC to
Goldman on the first and second loss tranches. In June 2009, Goldman received $806
million from AIG Financial Products as a result of the CDS protection it had purchased
against the super-senior tranche. The same month it received $23 million from TCW as
a result of the CDS purchased against the junior mezzanine tranches, and $30 million
from IKB because of the CDS it purchased against the C tranche. In April 2010, IKB paid
Goldman another $40 million as a result of the CDS against the B tranche. Through May
2010, Goldman received $24 million from IKB, Wachovia, and TCW as a result of the
credit default swaps against the A tranche. As was common, some of the tranches of
Abacus 2004-1 found their way into other funds and CDOs; for example, TCW put
tranches of Abacus 2004-1 into three of its own CDOs.
The CDO Machine
In total, between July 1, 2004, and May 31, 2007, Goldman packaged and sold 47
synthetic CDOs, with an aggregate face value of $66 billion. Its underwriting fee was
0.50% to 1.50% of the deal totals, Dan Sparks, the former head of Goldman’s mortgage
desk, told the FCIC. Goldman would earn profits from shorting many of these deals; on
others, it would profit by facilitating the transaction between the buyer and the seller of
credit default swap protection.
As we will see, these new instruments would yield substantial profits for investors that
held a short position in the synthetic CDOs – that is, investors betting that the housing
boom was a bubble about to burst. They also would multiply losses when housing prices
collapsed. When borrowers defaulted on their mortgages, the investors expecting cash
from the mortgage payments lost. And investors betting on these mortgage-backed
securities via synthetic CDOs also lost (while those betting against the mortgages would
gain). As a result, the losses from the housing collapse were multiplied exponentially.
To see this play out, we can return to our illustrative Citigroup mortgage-backed
securities deal, CMLTI 2006-NC2. Credit default swaps made it possible for new market
participants to bet for or against the performance of these securities. Synthetic CDOs
significantly increased the demand for such bets. For example, there were about $12
million worth of bonds in the M9 (BBB-rated) tranche – one of the mezzanine tranches of
the security. Synthetic CDOs such as Auriga, Volans, and Neptune CDO IV all contained
credit default swaps in which the M9 tranche was referenced. As long as the M9 bonds
performed, investors betting that the tranche would fail (short investors) would make
regular payments into the CDO, which would be paid out to other investors banking on it
to succeed (long investors). If the M9 bonds defaulted, then the long investors would
make large payments to the short investors. That is the bet – and there were more than
$50 million in such bets in early 2007 on the M9 tranche of this deal. Thus, on the basis
of the performance of $12 million in bonds, more than $60 million could potentially
change hands. Goldman’s Sparks put it succinctly to the FCIC: if there’s a problem with
a product, synthetics increase the impact.
The amplification of the M9 tranche was not unique. A $15 million tranche of the Glacier
Funding CDO 2006-4A, rated A, was referenced in $85 million worth of synthetic CDOs.
A $28 million tranche of the Soundview Home Equity Loan Trust 2006-EQ1, also rated
A, was referenced in $79 million worth of synthetic CDOs. A $13 million tranche of the
Soundview Home Equity Loan Trust 2006-EQ1, rated BBB, was referenced in $49
million worth of synthetic CDOs.
In total, synthetic CDOs created by Goldman referenced 3,408 mortgage securities,
some of them multiple times. For example, 610 securities were referenced twice. Indeed,
one single mortgage-backed security was referenced in nine different synthetic CDOs
created by Goldman Sachs. Because of such deals, when the housing bubble burst,
billions of dollars changed hands.
Although Goldman executives agreed that synthetic CDOs were “bets” that magnified
overall risk, they also maintained that their creation had “social utility” because it added
liquidity to the market and enabled investors to customize the exposures they wanted in
their portfolios. In testimony before the Commission, Goldman’s President and Chief
Operating Officer Gary Cohn argued: “This is no different than the tens of thousands of
swaps written every day on the U.S. dollar versus another currency. Or, more
importantly, on U.S. Treasuries . . . This is the way that the financial markets work.”
The CDO Machine
Others, however, criticized these deals. Patrick Parkinson, the current director of the
Division of Banking Supervision and Regulation at the Federal Reserve Board, noted
that synthetic CDOs “multiplied the effects of the collapse in subprime.” Other observers
were even harsher in their assessment. “I don’t think they have social value,” Michael
Greenberger, a professor at the University of Maryland School of Law and former
director of the Division of Trading and Markets at the Commodity Futures Trading
Commission, told the FCIC. He characterized the credit default swap market as a
“casino.” And he testified that “the concept of lawful betting of billions of dollars on the
question of whether a homeowner would default on a mortgage that was not owned by
either party, has had a profound effect on the American public and taxpayers.”
VII. 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 three leading rating agencies: Moody’s, S&P, and Fitch.
Investors 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, with caps set at a halfmillion dollars for a “standard” CDO in 2006 and 2007 and as much as $850,000 for a
“complex” CDO.
In rating both synthetic and cash CDOs, Moody’s faced two key challenges: first,
estimating the probability of default for the mortgage-backed securities purchased by the
CDO (or its synthetic equivalent) and, second, gauging the correlation between those
defaults – that is, the likelihood that the securities would default at the same time.
Imagine flipping a coin to see how many times it comes up heads. Each flip is unrelated
to the others; that is, the flips are uncorrelated. Now, imagine a loaf of sliced bread.
When there is one moldy slice, there are likely other moldy slices. The freshness of each
slice is highly correlated with that of the other slices. As investors now understand, the
mortgage-backed securities in CDOs were less like coins than like slices of bread.
To estimate the probability of default, Moody’s relied almost exclusively on its own
ratings of the mortgage-backed securities purchased by the CDOs. At no time did the
agencies “look through” the securities to the underlying subprime mortgages. “We took
the rating that had already been assigned by the [mortgage-backed securities] group,”
Gary Witt, formerly one of Moody’s team managing directors for the CDO unit, told the
FCIC. This approach would lead to problems for Moody’s – and for investors. Witt
testified that the underlying collateral “just completely disintegrated below us and we
didn’t react and we should have. . . . We had to be looking for a problem. And we weren’t
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 out – owing to poor underwriting, fraud, or any
other cause – to poorly reflect the quality of the mortgages in the bonds, the error was
blindly compounded when mortgage-backed securities were packaged into CDOs.
Even more difficult was the estimation of the default correlation between the securities in
the portfolio – always tricky, but particularly so in the case of CDOs consisting of
subprime and Alt-A mortgage-backed securities that had only a short performance
The CDO Machine
history. So the firm explicitly relied on the judgment of its analysts. “In the absence of
meaningful default data, it is impossible to develop empirical default correlation
measures based on actual observations of defaults,” Moody’s acknowledged in one
early explanation of its process.
In plainer English, Witt said, Moody’s didn’t have a good model on which to estimate
correlations between mortgage-backed securities – so they “made them up.” He
recalled, “They went to the analyst in each of the groups and they said, ‘Well, you know,
how related do you think these types of [mortgage-backed securities] are?’” This
problem would become more serious with the rise of CDOs in the middle of the decade.
Witt felt strongly that Moody’s needed to update its CDO rating model to explicitly
address the increasing concentration of risky mortgage-related securities in the collateral
underlying CDOs. He undertook two initiatives to address this issue. First, in mid-2004,
he developed a new rating methodology that directly incorporated correlation into the
model. However, the technique he devised was not applied to CDO ratings for another
year. Second, he proposed a research initiative in early 2005 to “look through” a few
CDO deals at the level of the underlying mortgage-backed securities and to see if “the
assumptions that we’re making for AAA CDOs are consistent . . . with the correlation
assumptions that we’re making for AAA [mortgage-backed securities].” Although Witt
received approval from his superiors for this investigation, contractual disagreements
prevented him from buying the software he needed to conduct the look-through analysis.
In June 2005, Moody’s updated its approach for estimating default correlation, but it
based the new model on trends from the previous 20 years, a period when housing
prices were rising and mortgage delinquencies were very low – and a period in which
nontraditional mortgage products had been a very small niche. Then, Moody’s modified
this optimistic set of “empirical” assumptions with ad hoc adjustments based on factors
such as region, year of origination, and servicer. For example, if two mortgage-backed
securities were issued in the same region – say, Southern California – Moody’s boosted
the correlation; if they shared a common mortgage servicer, Moody’s boosted it further.
But at the same time, it would make other technical choices that lowered the estimated
correlation of default, which would improve the ratings for these securities. Using these
methods, Moody’s estimated that two mortgage-backed securities would be less closely
correlated than two securities backed by other consumer credit assets, such as credit
card or auto loans.
The other major rating agencies followed a similar approach. Academics, including some
who worked at regulatory agencies, cautioned investors that assumption-heavy CDO
credit ratings could be dangerous. “The complexity of structured finance transactions
may lead to situations where investors tend to rely more heavily on ratings than for other
types of rated securities. On this basis, the transformation of risk involved in structured
finance gives rise to a number of questions with important potential implications. One
such question is whether tranched instruments might result in unanticipated
concentrations of risk in institutions’ portfolios,” a report from the Bank for International
Settlements, an international financial organization sponsored by the world’s regulators
and central banks, warned in June 2005.
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CDO managers and underwriters relied on the ratings to promote the bonds. For each
new CDO, they created marketing material, including a pitch book that investors used to
decide whether to subscribe to a new CDO. Each book described the types of assets
that would make up the portfolio without providing details. Without exception, every pitch
book examined by the FCIC staff cited an analysis from either Moody’s or S&P that
contrasted the historical “stability” of these new products’ ratings with the stability of
corporate bonds. Statistics that made this case included the fact that between 1983 and
2006, 92% of these new products did not experience any rating changes over a twelvemonth period while only 78% of corporate bonds maintained their ratings. Over a longer
time period, however, structured finance ratings were not so stable. Between 1983 and
2006, only 56% of triple-A-rated structured finance securities retained their original rating
after five years. Underwriters continued to sell CDOs using these statistics in their pitch
books during 2006 and 2007, after mortgage defaults had started to rise, but before the
rating agencies had downgraded large numbers of mortgage-backed securities. Of
course, each pitch book did include the disclaimer that “past performance is not a
guarantee of future performance” and encouraged investors to perform their own due
When housing prices started to fall nationwide and defaults increased, it turned out that
the mortgage-backed securities were in fact much more highly correlated than the rating
agencies had estimated – that is, they stopped performing at roughly the same time.
These losses led to massive downgrades in the ratings of the CDOs. In 2007, 20% of
U.S. CDO securities would be downgraded. In 2008, 91% would. In late 2008, Moody’s
would throw out its key CDO assumptions and replace them with an asset correlation
assumption two to three times higher than used before the crisis.
1. Lack of Diversification
In retrospect, it is clear that the agencies’ CDO models made two key mistakes. First,
they assumed that securitizers could create safer financial products by diversifying
among many mortgage-backed securities, when in fact these securities weren’t that
different to begin with. “There were a lot of things [the credit rating agencies] did wrong,”
Federal Reserve Chairman Ben Bernanke told the FCIC. “They did not take into account
the appropriate correlation between [and] across the categories of mortgages.”
2. Poor Collateral
Second, the agencies based their CDO ratings on ratings they themselves had assigned
on 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; they only describe a ratings management
process, and a mean and static expectation of security loss.”
Of course, rating CDOs was a profitable business for the rating agencies. Including all
types of CDOs – not just those that were mortgage-related – Moody’s rated 220 deals in
2004, 363 in 2005, 749 in 2006, and 717 in 2007; the value of those deals rose from $90
billion in 2004 to $162 billion in 2005, $337 billion in 2006, and $326 billion in 2007. The
reported revenues of Moody’s Investors Service from structured products – which
included mortgage-backed securities and CDOs – grew from $199 million in 2000, or
33% of Moody’s Corporation’s revenues, to $887 million in 2006 or 44% of overall
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corporate revenue. The rating of asset-backed CDOs alone contributed more than 10%
of the revenue from structured finance. The boom years of structured finance coincided
with a company-wide surge in revenue and profits. From 2000 to 2006, the corporation’s
revenues surged from $602 million to $2 billion and its profit margin climbed from 26% to
Yet the increase in the CDO group’s workload and revenue was not paralleled by a
staffing increase. “We were under-resourced, you know, we were always playing catchup,” Witt said. Moody’s “penny-pinching” and “stingy” management was reluctant to pay
up for experienced employees. “The problem of recruiting and retaining good staff was
insoluble. Investment banks often hired away our best people. As far as I can remember,
we were never allocated funds to make counter offers,” Witt said. “We had almost no
ability to do meaningful research.” Eric Kolchinsky, a former team managing director at
Moody’s, told the FCIC that from 2004 to 2006, the increase in the number of deals rated
was “huge . . . but our personnel did not go up accordingly.” By 2006, Kolchinsky
recalled, “My role as a team leader was crisis management. Each deal was a
crisis.”When personnel worked to create a new methodology, Witt said, “We had to kind
of do it in our spare time.”
The agencies worked closely with CDO underwriters and managers as each new CDO
was devised. And the rating agencies now relied for a substantial amount of their
revenues on a small number of players. Citigroup and Merrill alone accounted for more
than $140 billion of CDO deals between 2005 and 2007.
The ratings agencies’ correlation assumptions had a direct and critical impact on how
CDOs were structured: assumptions of a lower correlation made possible larger easy-tosell triple-A tranches and smaller harder-to-sell BBB tranches. Thus, as is discussed
later, underwriters crafted the structure to earn more favorable ratings from the agencies
– for example, by increasing the size of the senior tranches. Moreover, because issuers
could choose which rating agencies to do business with, and because the agencies
depended on the issuers for their revenues, rating agencies felt pressured to give
favorable ratings so that they might remain competitive.
The pressure on rating agency employees was also intense as a result of the high
turnover – a revolving door that often left raters dealing with their old colleagues, this
time as clients. In her interview with FCIC staff, Yuri Yoshizawa, a Moody’s team
managing director for U.S. derivatives in 2005, was presented with an organization chart
from July 2005. She identified 13 out of 51 analysts – about 25% of the staff – who had
left Moody’s to work for investment or commercial banks.
VIII. SEC: “It’s Going to Be an Awfully Big Mess”
The five major U.S. investment banks expanded their involvement in the mortgage and
mortgage securities industries in the early 21st century with little formal government
regulation beyond their broker-dealer subsidiaries. In 2002, the European Union told
U.S. financial firms that to continue to do business in Europe, they would need a
“consolidated” supervisor by 2004 – that is, one regulator that had responsibility for the
holding company. The U.S. commercial banks already met that criterion – their
consolidated supervisor was the Federal Reserve – and the Office of Thrift Supervision’s
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
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no one supervisor kept track of these companies on a consolidated basis. Thus all five
faced an important decision: what agency would they prefer as their regulator?
By 2004, the combined assets at the five firms totaled $2.5 trillion, more than half of the
$4.7 trillion of assets held by the five largest U.S. bank holding companies. In the next
three years the investment banks’ assets would grow to $4.3 trillion. Goldman Sachs
was the largest, followed by Morgan Stanley and Merrill, then Lehman and Bear. These
large, diverse international firms had transformed their business models over the years.
For their revenues they relied increasingly on trading and OTC derivatives dealing,
investments, securitization, and similar activities on top of their traditional investment
banking functions. Recall that at Bear Stearns, trading and investments accounted for
more than 100% of pretax earnings in some years after 2002.
The investment banks also owned depository institutions through which they could
provide FDIC-insured accounts to their brokerage customers; the deposits provided
cheap but limited funding. These depositories took the form of a thrift (supervised by the
OTS) or an industrial loan company (supervised by the Federal Deposit Insurance
Corporation and a state supervisor). Merrill and Lehman, which had among the largest of
these subsidiaries, used them to finance their mortgage origination activities.
The investment banks’ possession of depository subsidiaries suggested two obvious
choices when they found themselves in need of a consolidated supervisor. If a firm
chartered its depository as a commercial bank, the Fed would be its holding company
supervisor; if as a thrift, the OTS would do the job. But the investment banks came up
with a third option. They lobbied the SEC to devise a system of regulation that would
satisfy the terms of the European directive and keep them from European oversight –
and the SEC was willing to step in, although its historical focus was on investor
In November 2003, almost a year after the Europeans made their announcement, the
SEC suggested the creation of the Consolidated Supervised Entity (CSE) program to
oversee the holding companies of investment banks and all their subsidiaries. The CSE
program was open only to investment banks that had large U.S. broker-dealer
subsidiaries already subject to SEC regulation. However, this was the SEC’s first foray
into supervising firms for safety and soundness. The SEC did not have express
legislative authority to require the investment banks to submit to consolidated regulation,
so it proposed that the CSE program be voluntary; the SEC crafted the new program out
of its authority to make rules for the broker-dealer subsidiaries of investment banks. The
program would apply to broker-dealers that volunteered to be subject to consolidated
supervision under the CSE program, or those that already were subject to supervision by
the Fed at the holding company level, such as JP Morgan and Citigroup. The CSE
program would introduce a limited form of supervision by SEC examiners. CSE firms
were allowed to use a new methodology to calculate the regulatory capital that they were
holding against their securities portfolios – a methodology based on the volatility of
market prices. This methodology, referred to as the “alternative net capital rule,” would
be similar to the standards – based on the 1996 Market Risk Amendment to the Basel
rules – that large commercial banks and bank holding companies used for their
securities portfolios.
The traditional net capital rule that had governed broker-dealers since 1975 had required
straightforward calculations based on asset classes and credit ratings, a bright-line
approach that gave firms little discretion in calculating their capital. The new rules would
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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 its customers’ assets should it experience losses on its securities and
derivatives. All in all, the SEC estimated that the proposed new reliance on proprietary
VaR models would allow broker-dealers to reduce average capital charges by 40%. The
firms would be required to give the SEC an early-warning notice if their tentative net
capital (net capital minus hard-to-sell assets) fell below $5 billion at any time.
Meanwhile, the OTS was already supervising the thrifts owned by several securities
firms and argued that it therefore was the natural supervisor of their holding companies.
In a letter to the SEC, the OTS was harshly critical of the agency’s proposal, which it
said had “the potential to duplicate or conflict with OTS’s supervisory responsibilities”
over savings and loan holding companies that would also be CSEs. The OTS argued
that the SEC was interfering with the intentions of Congress, which, in the GrammLeach-Bliley Act, “carefully kept the responsibility for supervision of the holding company
itself with the OTS or the Federal Reserve Board, depending upon whether the holding
company was a [thrift holding company] or a bank holding company. This was in
recognition of the expertise developed over the years by these regulators in evaluating
the risks posed to depository institutions and the federal deposit insurance funds by
depository institution holding companies and their affiliates.” The OTS declared: “We
believe that the SEC’s proposed assertion of authority over [savings and loan holding
companies] is unfounded and could pose significant risks to these entities, their insured
deposit institution subsidiaries and the federal deposit insurance funds.”
In contrast, the response from the financial services industry to the SEC proposal was
overwhelmingly positive, particularly with regard to the alternative net capital
computation. Lehman Brothers, for example, wrote that it “applauds and supports the
Commission.” JP Morgan was supportive of what it saw as an improvement over the old
net capital rule that still governed securities subsidiaries of the commercial banks: “The
existing capital rule overstates the amount of capital a broker-dealer needs,” the
company wrote. Deutsche Bank found it to be “a great stride towards consistency with
modern comprehensive risk management practices.” In FCIC interviews, SEC officials
and executives at the investment banks stated that the firms preferred the SEC because
it was more familiar with their core securities-related businesses.
In an April 2004 meeting, SEC commissioners voted to adopt the CSE program and the
new net capital calculations that went along with it. Over the following year and a half,
the five largest investment banks volunteered for this supervision, although Merrill’s and
Lehman’s thrifts continued to be supervised by the OTS. Several firms delayed entry to
the program in order to develop systems that could measure their exposures to market
price movements.
The new program was housed primarily in the SEC’s Office of Prudential Supervision
and Risk Analysis, an office with a staff of 10 to 12 within the Division of Market
Regulation. In the beginning, it was supported by the SEC’s much larger examination
staff; by 2008 the staff dedicated to the CSE program had grown to 24. Still, only 10
“monitors” were responsible for the five investment banks; 3 monitors were assigned to
each firm, with some overlap.
The CSE program was based on the bank supervision model, but the SEC did not try to
do exactly what bank examiners did. For one thing, unlike supervisors of large banks,
the SEC never assigned on-site examiners under the CSE program; by comparison, the
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OCC alone assigned more than 60 examiners full-time at Citibank. According to Erik
Sirri, the SEC’s former director of trading and markets, the CSE program was intended
to focus mainly on liquidity because, unlike a commercial bank, a securities firm
traditionally had no access to a lender of last resort. (Of course, that would change
during the crisis.) The investment banks were subject to annual examinations, during
which staff reviewed the firms’ systems and records and verified that the firms had
instituted control processes.
The CSE program was troubled from the start. The SEC conducted an exam for each
investment bank when it entered the program. The result of Bear Stearns’s entrance
exam, in 2005, showed several deficiencies. For example, examiners were concerned
that there were no firm-wide VaR limits and that contingency funding plans relied on
overly optimistic stress scenarios. In addition, the SEC was aware of the firm’s
concentration of mortgage securities and its high leverage. Nonetheless, the SEC did
not ask Bear to change its asset balance, decrease its leverage, or increase its cash
liquidity pool – all actions well within its prerogative, according to SEC officials. Then,
because the CSE program was preoccupied with its own staff reorganization, Bear did
not have its next annual exam, during which the SEC was supposed to be on-site. The
SEC did meet monthly with all CSE firms, including Bear, and it did conduct occasional
targeted examinations across firms. In 2006, the SEC worried that Bear was too reliant
on unsecured commercial paper funding, and Bear reduced its exposure to unsecured
commercial paper and increased its reliance on secured repo lending. Unfortunately,
tens of billions of dollars of that repo lending was overnight funding that could disappear
with no warning. Ironically, in the second week of March 2008, when the firm went into
its four-day death spiral, the SEC was on-site conducting its first CSE exam since Bear’s
entrance exam more than two years earlier.
Leverage at the investment banks increased from 2004 to 2007, growth that some critics
have blamed on the SEC’s change in the net capital rules. Goldschmid told the FCIC
that the increase was owed to “a wild capital time and the firms being irresponsible.” In
fact, leverage had been higher at the five investment banks in the late 1990s, then
dropped before increasing over the life of the CSE program – a history that suggests that
the program was not solely responsible for the changes. In 2009, Sirri noted that under
the CSE program the investment banks’ net capital levels “remained relatively stable . . .
and, in some cases, increased significantly” over the program. Still, Goldschmid, who left
the SEC in 2005, argued that the SEC had the power to do more to rein in the
investment banks. He insisted, “There was much more than enough moral suasion and
kind of practical power that was involved. . . . The SEC has the practical ability to do a lot
if it uses its power.”
Overall, the CSE program was widely viewed as a failure. From 2004 until the financial
crisis, all five investment banks continued their spectacular growth, relying heavily on
short-term funding. Former SEC chairman Christopher Cox called the CSE supervisory
program “fundamentally flawed from the beginning.” Mary Schapiro, the current SEC
chairman, concluded that the program “was not successful in providing prudential
supervision.” And, as we will see in the chapters ahead, the SEC’s inspector general
would be quite critical, too. In September 2008, in the midst of the financial crisis, the
CSE program was discontinued after all five of the largest independent investment
banks had either closed down (Lehman Brothers), merged into other entities (Bear
Stearns and Merrill Lynch), or converted to bank holding companies to be supervised by
the Federal Reserve (Goldman Sachs and Morgan Stanley).
The CDO Machine
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. Collateralized debt obligations are investment instruments that have been around
since the early 1900s.
a) true
b) false
2. What role did securities firms play in the CDO market:
they structured the deals before they went to market
sold the securities to the public
they rated the securities
they personally backed the securities
3. Given their complexity, investors did not typically rely on traditional credit ratings
when purchasing CDOs.
a) true
b) false
4. Which of the following best describes the level of government regulation of
investment banks when they first began expanding their involvement in mortgagebacked securities:
no government regulation
little government regulation
a large amount of government regulation
extensive government regulation
The CDO Machine
1. A: True is incorrect. These products, so-called CDOs, are the product of the early
years of the current century.
B: False is correct. It was not until the last decade or so that these instruments
were created as a way to market and sell off mortgage-backed securities.
(See page 8-1 of the course material.)
2. A: Incorrect. Structuring the deal was the job of the underwriters, not the securities
B: Correct. In addition to selling them, the securities firms selected the collateral and
bundled the notes into tranches.
C: Incorrect. The rating agencies analyzed the collateral for the CDOs and gave
them a rating, hopefully one that made them attractive to investors. D: Incorrect. There was no such backing.
(See page 8-3 of the course material.)
3. A: True is incorrect. To the contrary, despite inherent problems, traditional rating
agencies were instrumental to the sale of CDOs.
B: False is correct. Typically, investors relied on traditional rating houses to put
their stamp of approval on CDOs. They rarely conducted their own analysis.
(See page 8-14 of the course material.)
4. A: Incorrect. There was a small amount of government regulation as these securities
became popular in the first part of the current century.
B: Correct. Other than investment banks with status as a broker-dealer, there was
indeed little regulation.
C: Incorrect. At first, the level of supervision was very small.
D: Incorrect. Nothing could be further from the truth. Investment banks operated with
little supervision in this increasingly popular and profitable area.
(See page 8-16 of the course material.)
The CDO Machine
Chapter 9: All In
In 2003, the Bakersfield, California, homebuilder Warren Peterson was paying as little as
$35,000 for a 10,000-square-foot lot, about the size of three tennis courts. The next year
the cost more than tripled to $120,000, as real estate boomed. Over the previous quarter
century, Peterson had built between 3 and 10 custom and semi-custom homes a year.
For a while, he was building as many as 30. And then came the crash. “I have built
exactly one new home since late 2005,” he told the FCIC five years later.
In 2003, the average price was $155,000 for a new house in Bakersfield, at the southern
end of California’s agricultural center, the San Joaquin Valley. That jumped to almost
$300,000 by June 2006. “By 2004, money seemed to be coming in very fast and from
everywhere,” said Lloyd Plank, a Bakersfield real estate broker. “They would purchase a
house in Bakersfield, keep it for a short period and resell it. Sometimes they would flip
the house while it was still in escrow, and would still make 20% to 30%.”
Nationally, housing prices jumped 152% between 1997 and their peak in 2006, more
than in any decade since at least 1920. It would be catastrophically downhill from there –
yet the mortgage machine kept churning well into 2007, apparently indifferent to the fact
that housing prices were starting to fall and lending standards were starting to
deteriorate. Newspaper stories highlighted the weakness in the housing market – even
suggesting this was a bubble that could burst anytime. Checks were in place, but they
were failing. Loan purchasers and securitizers ignored their own due diligence on what
they were buying. The Federal Reserve and the other regulators increasingly recognized
the impending troubles in housing but thought their impact would be contained.
Increased securitization, lower underwriting standards, and easier access to credit were
common in other markets, too. For example, credit was flowing into commercial real
estate and corporate loans. How to react to what increasingly appeared to be a credit
bubble? Many enterprises, such as Lehman Brothers and Fannie Mae, pushed deeper.
All along the assembly line, from the origination of the mortgages to the creation and
marketing of the mortgage-backed securities and collateralized debt obligations (CDOs),
many understood and the regulators at least suspected that every cog was reliant on the
mortgages themselves, which would not perform as advertised.
I. The Bubble: “A Credit-Induced Boom”
Irvine, California-based New Century – once the nation’s second-largest subprime
lender – ignored early warnings that its own loan quality was deteriorating and stripped
power from two risk-control departments that had noted the evidence. In a June 2004
presentation, the Quality Assurance staff reported they had found severe underwriting
errors, including evidence of predatory lending, legal and state violations, and credit
issues, in 25% of the loans they audited in November and December 2003. In 2004,
Chief Operating Officer and later CEO Brad Morrice recommended these results be
removed from the statistical tools used to track loan performance, and in 2005, the
department was dissolved and its personnel terminated. The same year, the Internal
Audit department identified numerous deficiencies in loan files; out of nine reviews it
conducted in 2005, it gave the company’s loan production department “unsatisfactory”
ratings seven times. Patrick Flanagan, president of New Century’s mortgage-originating
subsidiary, 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.”
All In
This happened as the company struggled with increasing requests that it buy back
soured loans from investors. By December 2006, almost 17% of its loans were going
into default within the first three months after origination. “New Century had a brazen
obsession with increasing loan originations, without due regard to the risks associated
with that business strategy,” New Century’s bankruptcy examiner reported.
The numbers were stark. Nationwide, house prices had never risen so far, so fast. And
national indices masked important variations. House prices in the four sand states,
especially California, had dramatically larger spikes – and subsequent declines – than
did the nation. If there was a bubble, perhaps, as Fed Chairman Alan Greenspan said, it
was only in certain regions. He told a congressional committee in June 2005 that growth
in nonprime mortgages was helping to push home prices in some markets to
unsustainable levels, “although a ‘bubble’ in home prices for the nation as a whole does
not appear likely.”
Globally, prices jumped in many countries around the world during the 2000s. As
Christopher Mayer, an economist from Columbia Business School, noted to the
Commission, “What really sticks out is how unremarkable the United States house price
experience is relative to our European peers.” From 1997 to 2007, price increases in the
United Kingdom and Spain were above those in the United States, while price increases
in Ireland and France were just below. In an International Monetary Fund study from
2009, more than one half of the 21 developed countries analyzed had greater home
price appreciation than the United States from late 2001 through the third quarter of
2006, and yet some of these countries did not suffer sharp price declines. Notably,
Canada had strong home price increases followed by a modest and temporary decline in
2009. Researchers at the Federal Reserve Bank of Cleveland attributed Canada’s
experience to tighter lending standards than in the United States as well as regulatory
and structural differences in the financial system. Other countries, such as the United
Kingdom, Ireland, and Spain, saw steep house price declines.
American economists and policy makers struggled to explain the house price increases.
The good news was the economy was growing and unemployment was low. But, a
Federal Reserve study in May 2005 presented evidence that the cost of owning rather
than renting was much higher than had been the case historically: home prices had risen
from 20 times the annual cost of renting to 25 times. In some cities, the change was
particularly dramatic. From 1997 to 2006, the ratio of house prices to rents rose in Los
Angeles, Miami, and New York City by 147%, 121%, and 98%, respectively.
During a June meeting, the Federal Open Market Committee (FOMC), composed of
Federal Reserve governors, four regional Federal Reserve Bank presidents, and the
Federal Reserve Bank of New York president, heard five presentations on mortgage
risks and the housing market. Members and staff had difficulty developing a consensus
on whether housing prices were overvalued and “it was hard for any FOMC participants
…to ascribe substantial conviction to the proposition that overvaluation in the housing
market posed the major systemic risks that we now know it did,” according to a letter
from Fed Chairman Ben Bernanke to the FCIC. “The national mortgage system might
bend but will likely not break,” and “neither borrowers nor lenders appeared particularly
shaky,” one presentation argued, according to the letter. In discussions about
nontraditional mortgage products, the argument was made that “interest-only mortgages
are not an especially sinister development,” and their risks “could be cushioned by large
down payments.” The presentation also noted that while loan-to-value ratios were rising
All In
on a portion of interest-only loans, the ratios for most remained around 80%. Another
presentation suggested 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 agreed “the probability of spillovers to financial
institutions seemed moderate.”
A couple of months later, Fed economists in an internal memo acknowledged the
possibility that housing prices were overvalued, but downplayed the potential impacts of
a downturn. Even in the face of a large price decline, they argued, defaults would not be
widespread, given the large equity that many borrowers still had in their homes.
Structural changes in the mortgage market made a crisis less likely, and the financial
system seemed well capitalized. “Even historically large declines in house prices would
be small relative to the recent decline in household wealth owing to the stock market,”
the economists concluded. “From a wealth-effects perspective, this seems unlikely to
create substantial macroeconomic problems.”
II. Mortgage Fraud: “Crime-Facilitative Environments”
New Century – where 40% of the mortgages were loans with little or no documentation –
was not the only company that ignored concerns about poor loan quality. Across the
mortgage industry, with the bubble at its peak, standards had declined, documentation
was no longer verified, and warnings from internal audit departments and concerned
employees were ignored. These conditions created an environment ripe for fraud.
William Black, a former banking regulator who analyzed criminal patterns during the
savings and loan crisis, told the Commission that by one estimate, in the mid-2000s, at
least 1.5 million loans annually contained “some sort of fraud,” in part because of the
large percentage of no-doc loans originated then.
Fraud for housing can entail a borrower’s lying or intentionally omitting information on a
loan application. Fraud for profit typically involves a deception to gain financially from the
sale of a house. Illinois Attorney General Lisa Madigan defines fraud more broadly to
include lenders’ “sale of unaffordable or structurally unfair mortgage products to
In 80% of cases, according to the FBI, fraud involves industry insiders. For example,
property flipping can involve buyers, real estate agents, appraisers, and complicit closing
agents. In a “silent second,” the buyer, with the collusion of a loan officer and without 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.
In one instance, two women in South Florida were indicted in 2010 for placing ads
between 2004 and 2007 in Haitian community newspapers offering assistance with
immigration problems; they were accused of then stealing the identities of hundreds of
people who came for help and using the information to buy properties, take title in their
names, and resell at a profit. U.S. Attorney Wilfredo A. Ferrer told the Commission it was
“one of the cruelest schemes” he had seen.
All In
Estimates vary on the extent of fraud, as it is seldom investigated unless properties go
into foreclosure. Ann Fulmer, vice president of business relations at Interthinx, a fraud
detection service, told the FCIC that her firm analyzed a large sample of all loans from
2005 to 2007 and found 13% contained lies or omissions significant enough to rescind
the loan or demand a buyback if it had been securitized. The firm’s analysis indicated
that about $1 trillion of the loans made during the period were fraudulent. Fulmer further
estimated $160 billion worth of fraudulent loans from 2005 to 2007 resulted in
foreclosures, leading to losses of $112 billion for the holders. According to Fulmer,
experts in the field – lenders’ quality assurance officers, attorneys who specialize in loan
loss mitigation, and white-collar criminologists – say the percentage of transactions
involving less significant forms of fraud, such as relatively minor misrepresentations of
fact, could reach 60% of originations. Such loans could stay comfortably under the radar,
because many borrowers made payments on time.
Countrywide, the nation’s largest mortgage lender at the time, had about 5,000 internal
referrals of potentially fraudulent activity in its mortgage business in 2005, 10,000 in
2006, and 20,000 in 2007, according to Francisco San Pedro, the former senior vice
president of special investigations at the company. But it filed only 855 SARs in 2005,
2,895 in 2006, and 2,621 in 2007.
Similarly, in examining Bank of America in 2007, its lead bank regulator, the Office of the
Comptroller of the Currency (OCC), sampled 50 mortgages and found 16 with “quality
assurance referrals” for suspicious activity for which no report had been filed with
FinCEN. All 16 met the legal requirement for a filing. The OCC consequently required
management to refine its processes to ensure that SARs were consistently filed.
Robert Mueller, the FBI’s director since 2001, said mortgage fraud needed to be
considered “in context of other 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 mortgage fraud, but acknowledged that those
resources may have been insufficient. “I am 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 be still to come.
Alberto Gonzales, the nation’s attorney general from February 2005 to September 2007,
told the Commission that while he might have done more on mortgage fraud, in hindsight
he believed that other issues were more pressing: “I don’t think anyone can credibly
argue that [mortgage fraud] is 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 protecting
neighborhoods from dangerous gangs or predators attacking our children.”
In letters to the FCIC, the Department of Justice outlined actions it undertook along with
the FBI to combat mortgage fraud. For example, in 2004, the FBI launched Operation
Continued Action, targeting a variety of financial crimes, including mortgage fraud. In
that same year, the agency started to publish an annual mortgage fraud report. The
following year, the FBI and other federal agencies announced a joint effort combating
mortgage fraud. From July to October 2005, this program, Operation Quick Flip,
produced 156 indictments, 81 arrests, and 89 convictions for mortgage fraud. In 2007,
the FBI started specifically tracking mortgage fraud cases and increased personnel
dedicated to those efforts. And in 2008, Operation Malicious Mortgage resulted in 144
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mortgage fraud cases in which 408 defendants were charged by U.S. Attorneys offices
throughout the country.
As mortgage fraud grew, state agencies took action. In Florida, Ellen Wilcox, a special
agent with the state Department of Law Enforcement, teamed with the Tampa police
department and Hillsborough County Consumer Protection Agency to bring down a
criminal ring scamming homeowners in the Tampa area. Its key member was Orson
Benn, a New York-based vice president of Argent Mortgage Company, a unit of
Ameriquest. Beginning in 2004, 10 investigators and two prosecutors worked for years to
unravel a network of alliances between real estate brokers, appraisers, home repair
contractors, title companies, notaries, and a convicted felon in a case that involved some
130 loans.
According to charging documents in the case, the perpetrators would walk through
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 their names. Members of the ring would prepare
fraudulent loan documents, including false W-2 forms, filled with information about
invented employment and falsified salaries, and take 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 Argent, received a $3,000 kickback for each loan he helped secure.
When the loan was funded, the checks were frequently made out to the bogus home
construction company that had proposed the work, which would then disappear with the
proceeds. Some of the homeowners never received a penny from the refinancing on
their homes. Hillsborough County officials learned of the scam when homeowners
approached them to say that scheduled repairs had never been made to their homes,
and then sometimes learned that they had lost years’ worth of equity as well. Sixteen of
18 defendants, including Benn, have been convicted or have pled guilty.
Wilcox told the Commission that the “cost and length of these investigations make them
less attractive to most investigative agencies and prosecutors trying to justify their
budgets based on investigative statistics.” She said it has been hard to follow up on
other cases because so many of the subprime lenders have gone out of business,
making it difficult to track down perpetrators and witnesses. Ameriquest, for example,
collapsed in 2007, although Argent, and the company’s loan-servicing arm, were bought
by Citigroup that same year.
III. Disclosure and Due Diligence: “A Quality Control Issue in the Factory”
In addition to the rising fraud and egregious lending practices, lending standards
deteriorated in the final years of the bubble. After growing for years, Alt-A lending
increased another 5% from 2005 to 2006. In particular, option ARMs grew 7% during
that period, interest-only mortgages grew 9%, and no-documentation or lowdocumentation loans (measured for borrowers with fixed-rate mortgages) grew 14%.
Overall, by 2006 no-doc or low-doc loans made up 27% of all mortgages originated.
Many of these products would perform only if prices continued to rise and the borrower
could refinance at a low rate.
In theory, every participant along the securitization pipeline should have had an interest
in the quality of every underlying mortgage. In practice, their interests were often not
aligned. Two New York Fed economists have pointed out the “seven deadly frictions” in
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mortgage securitization – places along the pipeline where one party knew more than the
other, creating opportunities to take advantage. For example, the lender who originated
the mortgage for sale, earning a commission, knew a great deal about the loan and the
borrower but had no long-term stake in whether the mortgage was paid, beyond the
lender’s own business reputation. The securitizer who packaged mortgages into
mortgage-backed securities, similarly, was less likely to retain a stake in those
The rating agencies theoretically were also important watchdogs over the securitization
process. They described their role as being “an umpire in the market.” But they did not
review the quality of individual mortgages in a mortgage-backed security, nor did they
check to see that the mortgages were what the securitizers said they were. So the
integrity of the market depended on two critical checks. First, firms purchasing and
securitizing the mortgages would conduct due diligence reviews of the mortgage pools,
either using third-party firms or doing the reviews in-house. Second, following Securities
and Exchange Commission rules, parties in the securitization process were expected to
disclose what they were selling to investors. Neither of these checks performed as they
should have.
IV. Due Diligence Firms: “Waived In”
As subprime mortgage securitization took off, securitizers undertook due diligence on
their own or through third parties on the mortgage pools that originators were selling
them. The originator and the securitizer negotiated the extent of the due diligence
investigation. While the percentage of the pool examined could be as high as 30%, it
was often much lower; according to some observers, as the market grew and originators
became more concentrated, they had more bargaining power over the mortgage
purchasers, and samples were sometimes as low as 2% to 3%. Some securitizers
requested that the due diligence firm analyze a random sample of 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.
Clayton Holdings, a Connecticut-based firm, was a major provider of third-party due
diligence services. As Clayton Vice President 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 loans met the originator’s stated underwriting guidelines and, in some
measure, to enable clients to negotiate better prices on pools of loans.
The review fell into three general areas: credit, compliance, and valuation. Did the loans
meet the underwriting guidelines (generally the originator’s standards, sometimes with
overlays or additional guidelines provided by the financial institutions purchasing the
loans)? Did the loans comply with federal and state laws, notably predatory-lending laws
and truth-in-lending requirements? Were the reported property values accurate? And,
critically: to the degree that a loan was deficient, did it have any “compensating factors”
that offset these deficiencies? For example, if a loan had a higher loan-to-value ratio
than guidelines called for, did another characteristic such as the borrower’s higher
income mitigate that weakness? The due diligence firm would then grade the loan
sample and forward the data to its client. Report in hand, the securitizer would negotiate
a price for the pool and could “kick out” loans that did not meet the stated guidelines.
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When securitizers did kick loans out of the pools, some originators simply put them into
new pools, presumably in hopes that those loans would not be captured in the next
pool’s sampling. The examiner’s report for New Century Financial’s bankruptcy
describes such a practice. Similarly, Fremont Investment & Loan had a policy of putting
loans into subsequent pools until 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.”
Some mortgage securitizers did their own due diligence, but seemed to devote only
limited resources to it. 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 to five
individuals reporting to him directly – and they were actually employees of a personnel
consultant, Equinox. Deutsche Bank and JP Morgan likewise also had only small due
diligence teams.
Banks did not necessarily have better processes for monitoring the mortgages that they
purchased. At an FCIC hearing on the mortgage business, Richard Bowen, a
whistleblower who had been a senior vice president at CitiFinancial Mortgage in charge
of a staff of 200-plus professional underwriters, testified that his team conducted quality
assurance checks on the loans bought by Citigroup from a network of lenders, including
both subprime mortgages that Citigroup intended to hold and prime mortgages that it
intended to sell to Fannie Mae and Freddie Mac.
V. SEC: “The Elephant in the Room Is That We Didn’t Review the
Prospectus Supplements”
By the time the financial crisis hit, investors held more than $2 trillion of non-GSE
mortgage-backed securities and close to $700 billion of CDOs that held mortgagebacked securities. These securities were issued with practically no SEC oversight. And
only a minority were subject to the SEC’s ongoing public reporting requirements. The
SEC’s mandate is to protect investors – generally not by reviewing the quality of
securities, but simply by ensuring adequate disclosures so that investors can make up
their own minds. In the case of initial public offerings of a company’s shares, the work
has historically involved a lengthy review of the issuer’s prospectus and other “offering
materials” prior to sale.
However, with the advent of “shelf registration,” a method of registering securities on an
ongoing basis, the process became much quicker for mortgage-backed securities
ranked in the highest grades by the rating agencies. The process allowed issuers to file
a base prospectus with the SEC, giving investors notice that the issuer intended to offer
securities in the future. The issuer then filed a supplemental prospectus describing each
offering’s terms. “The elephant in the room is that we didn’t review the prospectus
supplements,” the SEC’s deputy director for disclosure in corporation finance, Shelley
Parratt, told the FCIC. To improve disclosures pertaining to mortgage-backed securities
and other asset-backed securities, the SEC issued Regulation AB in late 2004. The
regulation required that every prospectus include “a description of the solicitation, creditgranting or underwriting criteria used to originate or purchase the pool assets, including,
to the extent known, any changes in such criteria and the extent to which such policies
and criteria are or could be overridden.”
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With essentially no review or oversight, how good were disclosures about mortgagebacked securities? Prospectuses usually included disclaimers to the effect that not all
mortgages would comply with the lending policies of the originator: “On a case-by-case
basis [the originator] may determine that, based upon compensating factors, a
prospective mortgage not strictly qualifying under the underwriting risk category or other
guidelines described below warrants an underwriting exception.” The disclosure typically
had a sentence stating that “a substantial number” or perhaps “a substantial portion of
the Mortgage Loans will represent these exceptions.” Citigroup’s Bowen criticized the
extent of information provided on loan pools: “There was no disclosure made to the
investors with regard to the quality of the files they were purchasing.”
Such disclosures were insufficient for investors to know what criteria the mortgages they
were buying actually did meet. Only a small portion – as little as 2% to 3% – of the loans
in any deal were sampled, and evidence from Clayton shows that a significant number
did not meet stated guidelines or have compensating factors. On the loans in the
remainder of the mortgage pool that were not sampled (as much as 97%), Clayton and
the securitizers had no information, but one could reasonably expect them to have many
of the same deficiencies, and at the same rate, as the sampled loans. Prospectuses for
the ultimate investors in the mortgage-backed securities did not contain this information,
or information on how few loans were reviewed, raising the question of whether the
disclosures were materially misleading, in violation of the securities laws.
CDOs were issued under a different regulatory framework from the one that applied to
many mortgage-backed securities, and were not subject even to the minimal shelf
registration rules. Underwriters typically issued CDOs under the SEC’s Rule 144A, which
allows the unregistered resale of certain securities to so-called qualified institutional
buyers (QIBs); these included investors as diverse as insurance companies like MetLife,
pension funds like the California State Teachers’ Retirement System, and investment
banks like Goldman Sachs.
The SEC created Rule 144A in 1990, making securities markets more attractive to
borrowers and U.S. investment banks more competitive with their foreign counterparts;
at the time, market participants viewed U.S. disclosure requirements as more onerous
than those in other countries. The new rule significantly expanded the market for these
securities by declaring that distributions which complied with the rule would no longer be
considered “public offerings” and therefore would not be subject to the SEC’s registration
requirements. In 1996, Congress reinforced this exemption with the National Securities
Markets Improvements Act, legislation that Denise Voigt Crawford, a commissioner on
the Texas Securities Board, characterized to the Commission “as prohibit[ing] the states
from taking preventative actions in areas that we now know have been substantial
contributing factors to the current crisis.” Under this legislation, state securities
regulators were preempted from overseeing private placements such as CDOs. In the
absence of registration requirements, a new debt market developed quickly under Rule
144A. This market was liquid, since qualified investors could freely trade Rule 144A debt
securities. But debt securities when Rule 144A was enacted were mostly corporate
bonds, very different from the CDOs that dominated the private placement market more
than a decade later.
After the crisis unfolded, investors, arguing that disclosure hadn’t been adequate, filed
numerous lawsuits under federal and state securities laws. As we will see, some have
already resulted in substantial settlements.
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VI. Regulators: “Markets Will Always Self-Correct”
Where were the regulators? Declining underwriting standards and new mortgage
products had been on regulators’ radar screens in the years before the crisis, but
disagreements among the agencies and their traditional preference for minimal
interference delayed action.
Supervisors had, since the 1990s, followed a “risk-focused” approach that relied
extensively on banks’ own internal risk management systems. “As internal systems
improve, the basic thrust of the examination process should shift from largely duplicating
many activities already conducted within the bank to providing constructive feedback
that the bank can use to enhance further the quality of its risk-management systems,”
Chairman Greenspan had said in 1999. Across agencies, there was a “historic vision,
historic approach, that a lighter hand at regulation was the appropriate way to regulate,”
Eugene Ludwig, comptroller of the currency from 1993 to 1998, told the FCIC, referring
to the Gramm-Leach-Bliley Act in 1999. The New York Fed, in a “lessons-learned”
analysis after the crisis, pointed to the mistaken belief that “markets will always selfcorrect.” “A deference to the self-correcting property of markets inhibited supervisors
from imposing prescriptive views on banks,” the report concluded.
The reliance on banks’ own risk management would extend to capital standards. Banks
had complained for years that the original 1988 Basel standards did not allow them
sufficient latitude to base their capital on the riskiness of particular assets. After years of
negotiations, international regulators, with strong support from the Fed, introduced the
Basel II capital regime in June 2004, which would allow banks to lower their capital
charges if they could show they had sophisticated internal models for estimating the
riskiness of their assets. While no U.S. bank fully implemented the more sophisticated
approaches that it allowed, Basel II reflected and reinforced the supervisors’ risk-focused
approach. Spillenkothen said that one of the regulators’ biggest mistakes was their
“acceptance of Basel II premises,” which he described as displaying “an excessive faith
in internal bank risk models, an infatuation with the specious accuracy of complex
quantitative risk measurement techniques, and a willingness (at least in the early days of
Basel II) to tolerate a reduction in regulatory capital in return for the prospect of better
risk management and greater risk-sensitivity.”
Regulators had been taking notice of the mortgage market for several years before the
crisis. As early as 2004, they recognized that mortgage products and borrowers had
changed during and following the refinancing boom of the previous year, and they began
work on providing guidance to banks and thrifts. But too little was done, and too late,
because of interagency discord, industry pushback, and a widely held view that market
participants had the situation well in hand.
“Within the board, people understood that many of these loan types had gotten to an
extreme,” Susan Bies, then a Fed governor and chair of the Federal Reserve Board’s
subcommittees on both safety and soundness supervision and consumer protection
supervision, told the FCIC. “So the main debate within the board was how tightly [should
we] rein in the abuses that we were seeing. So it was more of ‘to a degree.’”
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Indeed, in the same June 2005 Federal Open Market Committee meeting described
earlier, one FOMC member noted that “some of the newer, more intricate and untested
credit default instruments had caused some market turmoil.” Another participant was
concerned “that subprime lending was an accident waiting to happen.” A third participant
noted the risks in mortgage securities, the rapid growth of subprime lending, and the fact
that many lenders had “inadequate information on borrowers,” adding, however, that
record profits and high capital levels allayed those concerns. A fourth participant said
that “we could be seeing the final gasps of house price appreciation.” The participant
expressed concern about “creative financing” and was “worried that piggybacks and
other non-traditional loans,” whose risk of default could be higher than suggested by the
securities they 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
In the spring of 2006, the FOMC would again discuss risks in the housing and mortgage
markets and express nervousness about the growing “ingenuity” of the mortgage sector.
One participant noted that negative amortization loans had the pernicious effect of
stripping equity and wealth from homeowners and raised concerns about nontraditional
lending practices that seemed based on the presumption of continued increases in home
John Snow, then treasury secretary, told the FCIC that he called a meeting in late 2004
or early 2005 to urge regulators to address the proliferation of poor lending practices. He
said he was struck that regulators tended not to see a problem at their own institutions.
“Nobody had a full 360-degree view. The basic reaction from financial regulators was,
‘Well, there may be a problem. But it’s not in my field of view,’” Snow told the FCIC.
Regulators responded to Snow’s questions by saying, “Our default rates are very low.
Our institutions are very well capitalized. Our institutions [have] very low delinquencies.
So we don’t see any real big problem.”
In May 2005, the banking agencies did issue guidance on the risks of home equity lines
of credit and home equity loans. It cautioned financial institutions about credit risk
management practices, pointing to interest-only features, low- or no-documentation
loans, high loan-to-value and debt-to-income ratios, lower credit scores, greater use of
automated valuation models, and the increase in transactions generated through a loan
broker or other third party. While this guidance identified many of the problematic lending
practices engaged in by bank lenders, it was limited to home equity loans. It did not
apply to first mortgages.
In 2005, examiners from the Fed and other agencies conducted a confidential “peer
group” study of mortgage practices at six companies that together had originated $1.3
trillion in mortgages in 2005, almost half the national total. In the group were five banks
whose holding companies were under the Fed’s supervisory purview – Bank of America,
Citigroup, Countrywide, National City, and Wells Fargo – as well as the largest thrift,
Washington Mutual. The study “showed a very rapid increase in the volume of these
irresponsible loans, very risky loans,” Sabeth Siddique, then head of credit risk at the
Federal Reserve Board’s Division of Banking Supervision and Regulation, told the FCIC.
A large percentage of their loans issued were subprime and Alt-A mortgages, and the
underwriting standards for these products had deteriorated.
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Once the Fed and other supervisors had identified the mortgage problems, they agreed
to express those concerns to the industry in the form of nonbinding guidance. “There
was among the Board of Governors folks, you know, some who felt that if we just put out
guidance, the banks would get the message,” Bies said.
The federal agencies therefore drafted guidance on nontraditional mortgages such as
option ARMs, issuing it for public comment in late 2005. The draft guidance directed
lenders to consider a borrower’s ability to make the loan payment when rates adjusted,
rather than just the lower starting rate. It warned lenders that low-documentation loans
should be “used with caution.”
Immediately, the industry was up in arms. The American Bankers Association said the
guidance “overstate[d] the risk of non-traditional mortgages.” Other market participants
complained that the guidance required them to assume “a worst case scenario,” that is,
the scenario in which borrowers would have to make the full payment when rates
adjusted. They disputed the warning on low-documentation loans, maintaining that
“almost any form of documentation can be appropriate.” They denied that better
disclosures were required to protect borrowers from the risks of nontraditional
mortgages, arguing that they were “not aware of any empirical evidence that supports
the need for further consumer protection standards.”
The need for guidance was controversial within the agencies, too. “We got tremendous
pushback from the industry as well as Congress as well as, you know, internally,” the
Fed’s Siddique told the FCIC. “Because it was stifling innovation, potentially, and it was
denying the American dream to many people.”
The pressures to weaken and delay the guidance were strong and came from many
sources. Opposition by the Office of Thrift Supervision helped delay the mortgage
guidance for almost a year. Bies said, “There was some real concern about if the Fed
tightened down on [the banks it regulated], whether that would create an unlevel playing
field . . . [for] stand-alone mortgage lenders whom the [Fed] did not regulate.” Another
challenge to regulating the mortgage market was Congress. She recalled an occasion
when she testified about a proposed rule and “members of Congress [said] that we were
going to deny the dream of homeownership to Americans if we put this new stronger
standard in place.”
When guidance was put in place in 2006, regulators policed their guidance through bank
examinations and informal measures such as “voluntary agreements” with supervised
It also appeared some institutions switched regulators in search of more lenient
treatment. In December 2006, Countrywide applied to switch regulators from the Fed
and OCC to the OTS. Countrywide’s move came after several months of evaluation
within the company about the benefits of OTS regulation, many of which were promoted
by the OTS itself over the course of an “outreach effort” initiated in mid-2005 after John
Reich became director of the agency. Publicly, Countrywide stated that the decision to
switch to the OTS was driven by the desire to have one, housing-focused regulator,
rather than separate regulators for the bank and the holding company.
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However, other factors came into play as well. The OCC’s top Countrywide examiner
told the FCIC that Countrywide CEO Angelo Mozilo and President and COO David
Sambol thought the OCC’s position on property appraisals would be “killing the
business.” An internal July 2006 Countrywide briefing paper noted, “The OTS regulation
of holding companies is not as intrusive as that of the Federal Reserve. In particular, the
OTS rarely conducts extensive onsite examinations and when they do conduct an onsite
examination they are generally not considered intrusive to the holding company.” The
briefing paper also noted, “The OTS generally is considered a less sophisticated
regulator than the Federal Reserve.” In August 2006, Mozilo wrote to members of his
executive team, “It appears that the Fed is now troubled by pay options while the OTS is
not. Since pay options are a major component of both our volumes and profitability the
Fed may force us into a decision faster than we would like.” Countrywide Chief Risk
Officer John McMurray responded that “based on my meetings with the FRB and OTS,
the OTS appears to be both more familiar and more comfortable with Option ARMs.”
The OTS approved Countrywide’s application for a thrift charter on March 5, 2007.
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The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. Between 1997 and 2006, what was the percentage of increase in the price of homes
none whatsoever
2. Why were suspicious activity reports (SARs) not a true reflection of the amount of
criminal activity that occurred in financial dealings in the mortgage business:
a) many financial institutions were not mandated to file SARs and did not fall under
the control of FinCEN
b) those mortgage creators who did in fact complete the SARs were few and far
c) SARs were difficult, time-consuming, and complex to complete
d) both a and b were reasons why the amount of SARs was not an accurate picture
of the amount of criminal activity occurring in the mortgage industry
3. The “risk focused” approach was a way for the regulators to control the amount of
risk to the consumers.
a) true
b) false
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1. A: Incorrect. The price of homes increased over one and a half times during that
B: Incorrect. Home prices increased much more than 33%.
C: Incorrect. Home prices increased dramatically, but not as high as 200%.
D: Correct. This percentage represents how much home prices increased during
that time period.
(See page 9-1 of the course material.)
2. A: Incorrect. This is true, however, it is not the best answer.
B: Incorrect. SARs were underreported, but there is a better answer.
C: Incorrect. Nothing is stated concerning the difficulty of completing the SARs.
D: Correct. This is the best answer, as SARS were not mandatory and rarely
completed. Therefore, both are contributing factors as to why SARs were not an
accurate way to assess the criminal activity in regard to mortgages.
(See page 9-4 of the course material.)
3. A: True is incorrect. This approach had nothing to do with the regulators, and in fact
delegated the responsibility over to the banks.
B: False is correct. The “risk focused” approach actually let the banks manage and
control their own risk factors.
(See page 9-9 of the course material.)
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Chapter 10: The Madness
The collateralized debt obligation machine could have sputtered to a natural end by the
spring of 2006. Housing prices peaked, and AIG started to slow down its business of
insuring subprime-mortgage CDOs. But it turned out that Wall Street didn’t need its
golden goose any more. Securities firms were starting to take on a significant share of
the risks from their own deals, without AIG as the ultimate bearer of the risk of losses on
super-senior CDO tranches. The machine kept humming throughout 2006 and into 2007.
“That just seemed kind of odd, given everything we had seen and what we had
concluded,” Gary Gorton, a Yale finance professor who had designed AIG’s model for
analyzing its CDO positions, told the FCIC.
The CDO machine had become self-fueling. Senior executives – particularly at three of
the leading promoters of CDOs, Citigroup, Merrill Lynch, and UBS – apparently did not
accept or perhaps even understand the risks inherent in the products they were creating.
More and more, the senior tranches were retained by the arranging securities firms, the
mezzanine tranches were bought by other CDOs, and the equity tranches were bought
by hedge funds that were often engaged in complex trading strategies: they made
money when the CDOs performed, but could also make money if the market crashed.
These factors helped keep the mortgage market going long after house prices had
begun to fall and created massive exposures on the books of large financial institutions –
exposures that would ultimately bring many of them to the brink of failure.
The subprime mortgage securitization pioneer Lewis Ranieri called the willing
suspension of prudent standards “the madness.” He told the FCIC, “You had the
breakdown of the standards, . . . because you break down the checks and balances that
normally would have stopped them.”
Synthetic CDOs boomed. They provided easier opportunities for bullish and bearish
investors to bet for and against the housing boom and the securities that depended on it.
Synthetic CDOs also made it easier for investment banks and CDO managers to create
CDOs more quickly. But synthetic CDO issuers and managers had two sets of
customers, each with different interests. And managers sometimes had help from
customers in selecting the collateral – including those who were betting against the
collateral, as a high-profile case launched by the Securities and Exchange Commission
against Goldman Sachs would eventually illustrate.
Regulators reacted weakly. As early as 2005, supervisors recognized that CDOs and
credit default swaps (CDS) could actually concentrate rather than diversify risk, but they
concluded that Wall Street knew what it was doing. Supervisors issued guidance in late
2006 warning banks of the risks of complex structured finance transactions – but
excluded mortgage-backed securities and CDOs, because they saw the risks of those
products as relatively straightforward and well understood. Disaster was fast
I. CDO Managers: “We Are Not a Rent-A-Manager”
During the “madness,” when everyone wanted a piece of the action, CDO managers
faced growing competitive pressures. Managers’ compensation declined, as demand for
mortgage-backed securities drove up prices, squeezing the profit they made on CDOs.
The Madness
At the same time, new CDO managers were entering the arena. Wing Chau, a CDO
manager who frequently worked with Merrill Lynch, said the fees fell by half for
mezzanine CDOs over time. And overall compensation could be maintained by creating
and managing more new product.
More than had been the case three or four years earlier, in picking the collateral the
managers were influenced by the underwriters – the securities firms that created and
marketed the deals. An FCIC survey of 40 CDO managers confirmed this point.
Sometimes managers were given a portfolio constructed by the securities firm; the
managers would then choose the mortgage assets from that portfolio. The equity
investors – who often initiated the deal in the first place – also influenced the selection of
assets in many instances. Still, some managers said that they acted independently. “We
are not a rent-a-manager, we actually select our collateral,” said Lloyd Fass, the general
counsel at Vertical Capital. As we will see, securities firms often had particular CDO
managers with whom they preferred to work. Merrill, the market leader, had a
constellation of managers; CDOs underwritten by Merrill frequently bought tranches of
other Merrill CDOs.
According to market participants, CDOs stimulated greater demand for mortgage-backed
securities, particularly those with high yields, and the greater demand in turn affected the
standards for originating mortgages underlying those securities. As standards fell, at
least one firm opted out: PIMCO, one of the largest investment funds in the country,
whose CDO management unit was one of the nation’s largest in 2004. Early in 2005, it
announced that it would not manage any new deals, in part because of the deterioration
in the credit quality of mortgage-backed securities. “There is an awful lot of moral hazard
in the sector,” Scott Simon, a managing director at PIMCO, told the audience at an
industry conference in 2005. “You either take the high road or you don’t – we’re not
going to hurt accounts or damage our reputation for fees.” Simon said the rating
agencies’ methodologies were not sufficiently stringent, particularly because they were
being applied to new types of subprime and Alt-A loans with little or no historical
performance data. Not everyone agreed with this viewpoint. “Managers who are sticking
in this business are doing it right,” Armand Pastine, the chief operating officer at Maxim
Group, responded at that same conference. “To suggest that CDO managers would pull
out of an economically viable deal for moral reasons – that’s a cop-out.” As was typical
for the industry during the crisis, two of Maxim’s eight mortgage-backed CDOs, Maxim
High Grade CDO I and Maxim High Grade CDO II, would default on interest payments to
investors – including investors holding bonds that had originally been rated triple-A – and
the other six would be downgraded to junk status, including all of those originally rated
Another development also changed the CDOs: in 2005 and 2006, CDO managers were
less likely to put their own money into their deals. Early in the decade, investors had
taken the managers’ investment in the equity tranche of their own CDOs to be an
assurance of quality, believing that if the managers were sharing the risk of loss, they
would have an incentive to pick collateral wisely. But this fail-safe lost force as the
amount of managers’ investment per transaction declined over time. ACA Management,
a unit of the financial guarantor ACA Capital, provides a good illustration of this trend.
ACA held 100% of the equity in the CDOs it originated in 2002 and 2003, 52% and 61%
of two deals it originated in 2004, between 10% and 25% of deals in 2005, and between
0% and 11% of deals in 2006.
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And synthetic CDOs, as we will see, had no fail-safe at all with regard to the managers’
incentives. By the very nature of the credit default swaps bundled into these synthetics,
customers on the short side of the deal were betting that the assets would fail.
II. Credit Default Swaps: “Dumb Question”
In June 2005, derivatives dealers introduced the “pay-as-you-go” credit default swap, a
complex instrument that mimicked the timing of the cash flows of real mortgage-backed
securities. Because of this feature, the synthetic CDOs into which these new swaps
were bundled were much easier to issue and sell.
The pay-as-you-go swap also enabled a second major development, introduced in
January 2006: the first index based on the prices of credit default swaps on mortgagebacked securities. Known as the ABX.HE, it was really a series of indices, meant to act
as a sort of Dow Jones Industrial Average for the nonprime mortgage market, and it
became a popular way to bet on the performance of the market. Every six months, a
consortium of securities firms would select 20 credit default swaps on mortgage-backed
securities in each of five ratings-based tranches: AAA, AA, A, BBB, and BBB-. Investors
who believed that the bonds in any given category would fall behind in their payments
could buy protection through credit default swaps. As demand for protection rose, the
index would fall. The index was therefore a barometer recording the confidence of the
Synthetic CDOs proliferated, in part because it was much quicker and easier for
managers to assemble a synthetic portfolio out of pay-as-you-go credit default swaps
than to assemble a regular cash CDO out of mortgage-backed securities. “The beauty in
a way of the synthetic deals is you can look at the entire universe, you don’t have to go
and buy the cash bonds,” said Laura Schwartz of ACA Capital. There were also no
warehousing costs or associated risks. And they tended to offer the potential for higher
returns on the equity tranches: one analyst estimated that the equity tranche on a
synthetic CDO could typically yield about 21%, while the equity tranche of a typical cash
CDO could pay 13%.
An important driver in the growth of synthetic CDOs was the demand for credit default
swaps on mortgage-backed securities. Greg Lippmann, a Deutsche Bank mortgage
trader, told the FCIC that he often brokered these deals, matching the “shorts” with the
“longs” and minimizing any risk for his own bank. Lippmann said that between 2006 and
2007 he brokered deals for at least 50 and maybe as many as 100 hedge funds that
wanted to short the mezzanine tranches of mortgage-backed securities. Meanwhile, on
the long side, “Most of our CDS purchases were from UBS, Merrill, and Citibank,
because they were the most aggressive underwriters of [synthetic] CDOs.” In many
cases, they were buying those positions from Lippmann to put them into synthetic
CDOs; as it would turn out, the banks would retain much of the risk of those synthetic
CDOs by keeping the super-senior and triple-A tranches, selling below-triple-A tranches
largely to other CDOs, and selling equity tranches to hedge funds.
Issuance of synthetic CDOs jumped from $15 billion in 2005 to $61 billion just one year
later. (We include all CDOs with 50% or more synthetic collateral; again, unless
otherwise noted, our data refers to CDOs that include mortgage-backed securities.)
Even CDOs that were labeled as “cash CDOs” increasingly held some credit derivatives.
A total of $225 billion in CDOs were issued in 2006, including those labeled as cash,
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“hybrid,” or synthetic; the FCIC estimates that 27% of the collateral was derivatives,
compared with 9% in 2005 and 7% in 2004.
The advent of synthetic CDOs changed the incentives of CDO managers and hedge
fund investors. Once short investors were involved, the CDO had two types of investors
with opposing interests: those who would benefit if the assets performed, and those who
would benefit if the mortgage borrowers stopped making payments and the assets failed
to perform.
Even the incentives of long investors became conflicted. Synthetic CDOs enabled
sophisticated investors to place bets against the housing market or pursue more
complex trading strategies. Investors, usually hedge funds, often used credit default
swaps to take offsetting positions in different tranches of the same CDO security; that
way, they could make some money as long as the CDOs performed, but they stood to
make more money if the entire market crashed. An FCIC survey of more than 170 hedge
funds encompassing over $1.1 trillion in assets as of early 2010 found this to be a
common strategy among medium-size hedge funds: of all the CDOs issued in the
second half of 2006, more than half of the equity tranches were purchased by hedge
funds that also shorted other tranches. The same approach was being used in the
mortgage-backed securities market as well. The FCIC’s survey found that by June 2007,
the largest hedge funds held $25 billion in equity and other lower-rated tranches of
mortgage-backed securities. These were more than offset by $45 billion in short
These types of trades changed the structured finance market. Investors in the equity and
most junior tranches of CDOs and mortgage-backed securities traditionally had the
greatest incentive to monitor the credit risk of an underlying portfolio. With the advent of
credit default swaps, it was no longer clear who – if anyone – had that incentive.
For one example, consider Merrill Lynch’s $1.5 billion Norma CDO, issued in 2007. The
equity investor, Magnetar Capital, a hedge fund, was executing a common strategy
known as the correlation trade – it bought the equity tranche while shorting other
tranches in Norma and other CDOs. According to court documents, Magnetar was also
involved in selecting assets for Norma. Magnetar received $4.5 million related to this
transaction and NIR Capital Management, the CDO manager, was paid a fee of $75,000
plus additional fees. Magnetar’s counsel told the FCIC that the $4.5 million was a
discount in the form of a rebate on the price of the equity tranche and other long
positions purchased by Magnetar and not a payment received in return for goods or
services. Court documents indicate that Magnetar was involved in selecting collateral,
and that NIR abdicated its asset selection duties to Magnetar with Merrill’s knowledge. In
addition, they show that when one Merrill employee learned that Magnetar had executed
approximately $600 million in trades for Norma without NIR’s apparent involvement or
knowledge, she emailed colleagues, “Dumb question. Is Magnetar allowed to trade for
NIR?” Merrill failed to disclose that Magnetar was paid $4.5 million or that Magnetar was
selecting collateral when it also had a short position that would benefit from losses.
The counsel for Merrill’s new owner, Bank of America, explained to the FCIC that it was
a common industry practice for “the equity investor in a CDO, which had the riskiest
investment, to have input during the collateral selection process[;] . . . however, the
collateral manager made the ultimate decisions regarding portfolio composition.” The
letter did not specifically mention the Norma CDO. Bank of America failed to produce
documents related to this issue requested by the FCIC.
The Madness
Federal regulators have identified abuses that involved short investors influencing the
choice of the instruments inside synthetic CDOs. In April 2010, the SEC charged
Goldman Sachs with fraud for telling investors that an independent CDO manager, ACA
Management, had picked the underlying assets in a CDO when in fact a short investor,
the Paulson & Co. hedge fund, had played a “significant role” in the selection. The SEC
alleged that those misrepresentations were in Goldman’s marketing materials for Abacus
2007-AC1, one of Goldman’s 24 Abacus deals.
Ira Wagner, the head of Bear Stearns’s CDO Group in 2007, told the FCIC that he
rejected the deal when approached by Paulson representatives. When asked about
Goldman’s contention that Paulson’s picking the collateral was immaterial because the
collateral was disclosed and because Paulson was not well-known at that time, Wagner
called the argument “ridiculous.” He said that the structure encouraged Paulson to pick
the worst assets. While acknowledging the point that every synthetic deal necessarily
had long and short investors, Wagner saw having the short investors select the
referenced collateral as a serious conflict and for that reason declined to participate.
ACA executives told the FCIC they were not initially aware that the short investor was
involved in choosing the collateral. CEO Alan Roseman said that he first heard of
Paulson’s role when he reviewed the SEC’s complaint. Laura Schwartz, who was
responsible for the deal at ACA, said she believed that Paulson’s firm was the investor
taking the equity tranche and would therefore have an interest in the deal performing
well. She said she would not have been surprised that Paulson would also have had a
short position, because the correlation trade was common in the market, but added, “To
be honest, [at that time,] until the SEC testimony I did not even know that Paulson was
only short.” Paulson told the FCIC that any synthetic CDO would have to invest in “a
pool that both a buyer and seller of protection could agree on.” He didn’t understand the
objections: “Every [synthetic] CDO has a buyer and seller of protection. So for anyone to
say that they didn’t want to structure a CDO because someone was buying protection in
that CDO, then you wouldn’t do any CDOs.”
In July 2010, Goldman Sachs settled the case, paying a record $550 million fine.
Goldman “acknowledge[d] that the marketing materials for the ABACUS 2007-AC1
transaction contained incomplete information. In particular, it was a mistake for the
Goldman marketing materials to state that the reference portfolio was ‘selected by’ ACA
Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio
selection process and that Paulson’s economic interests were adverse to CDO
The new derivatives provided a golden opportunity for bearish investors to bet against
the housing boom. Home prices in the hottest markets in California and Florida had
blasted into the stratosphere; it was hard for skeptics to believe that their upward
trajectory could continue. And if it did not, the landing would not be a soft one. Some
spoke out publicly. Others bet the bubble would burst. Betting against CDOs was also, in
some cases, a bet against the rating agencies and their models. Jamie Mai and Ben
Hockett, principals at the small investment firm Cornwall Capital, told the FCIC that they
had warned the SEC in 2007 that the agencies were dangerously overoptimistic in their
assessment of mortgage-backed CDOs. Mai and Hockett saw the rating agencies as
“the root of the mess,” because their ratings removed the need for buyers to study prices
and perform due diligence, even as “there was a massive amount of gaming going on.”
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Shorting CDOs was “pretty attractive” because the rating agencies had given too much
credit for diversification, Sihan Shu of Paulson & Co. told the FCIC. Paulson established
a fund in June 2006 that initially focused only on shorting BBB-rated tranches. By the
end of 2007, Paulson & Co.’s Credit Opportunities fund, set up less than a year earlier to
bet exclusively against the subprime housing market, was up 590%. “Each MBS tranche
typically would be 30% mortgages in California, 10% in Florida, 10% in New York, and
when you aggregate 100 MBS positions you still have the same geographic
diversification. To us, there was not much diversification in CDOs.” Shu’s research
convinced him that if home prices were to stop appreciating, BBB-rated mortgagebacked securities would be at risk for downgrades. Should prices drop 5%, CDO losses
would increase 20-fold.
And if a relatively small number of the underlying loans were to go into foreclosure, the
losses would render virtually all of the riskier BBB-rated tranches worthless. “The whole
system worked fine as long as everyone could refinance,” Steve Eisman, the founder of
a fund within FrontPoint Partners, told the FCIC. The minute refinancing stopped,
“losses would explode. . . . By 2006, about half [the mortgages sold] were no-doc or lowdoc. You were at max underwriting weakness at max housing prices. And so the system
imploded. Everyone was so levered there was no ability to take any pain.” On October 6,
2006, James Grant wrote in his newsletter about the “mysterious alchemical processes”
in which “Wall Street transforms BBB-minus-rated mortgages into AAA-rated tranches of
mortgage securities” by creating CDOs. He estimated that even the triple-A tranches of
CDOs would experience some losses if national home prices were to fall just 4% or less
within two years; and if prices were to fall 10%, investors of tranches rated AA- or below
would be completely wiped out.
In 2005, Eisman and others were already looking for the best way to bet on this disaster
by shorting all these shaky mortgage-related securities. Buying credit default swaps was
efficient. Eisman realized that he could pick what he considered the most vulnerable
tranches of the mortgage-backed bonds and bet millions of dollars against them,
relatively cheaply and with considerable leverage. And that’s what he did.
By the end of 2007, Eisman had put millions of dollars into short positions on credit
default swaps. It was, he was sure, just a matter of time. “Everyone really did believe
that things were going to be okay,” Eisman said. “[I] thought they were certifiable
Michael Burry, another short who became well-known after the crisis hit, was a doctorturned-investor whose hedge fund, Scion Capital, in Northern California’s Silicon Valley,
bet big against mortgage-backed securities – reflecting a change of heart, because he
had invested in homebuilder stocks in 2002. But the closer he looked, the more he
wondered about the financing that supported this booming market. Burry decided that
some of the newfangled adjustable rate mortgages were “the most toxic mortgages”
created. He told the FCIC, “I watched those with interest as they migrated down the
credit spectrum to the subprime market. As [home] prices had increased on the back of
virtually no accompanying rise in wages and incomes, I came to the judgment that in two
years there will be a final judgment on housing when those two-year [adjustable rate
mortgages] seek refinancing.” By the middle of 2005, Burry had bought credit default
swaps on billions of dollars of mortgage-backed securities and the bonds of financial
companies in the housing market, including Fannie Mae, Freddie Mac, and AIG.
The Madness
Eisman, Cornwall, Paulson, and Burry were not alone in shorting the housing market. In
fact, on one side of tens of billions of dollars worth of synthetic CDOs were investors
taking short positions. The purchasers of credit default swaps illustrate the impact of
derivatives in introducing new risks and leverage into the system. Although these
investors profited spectacularly from the housing crisis, they never made a single
subprime loan or bought an actual mortgage. In other words, they were not purchasing
insurance against anything they owned. Instead, they merely made side bets on the
risks undertaken by others. Paulson told the FCIC that his research indicated that if
home prices remained flat, losses would wipe out the BBB-rated tranches; meanwhile, at
the time he could purchase default swap protection on them very cheaply.
On the other side of the zero-sum game were often the major U.S. financial institutions
that would eventually be battered. Burry acknowledged to the FCIC, “There is an
argument to be made that you shouldn’t allow what I did.” But the problem, he said, was
not the short positions he was taking; it was the risks that others were accepting. “When
I did the shorts, the whole time I was putting on the positions . . . there were people on
the other side that were just eating them up. I think it’s a catastrophe and I think it was
Credit default swaps greased the CDO machine in several ways. First, they allowed
CDO managers to create synthetic and hybrid CDOs more quickly than they could
create cash CDOs. Second, they enabled investors in the CDOs (including the
originating banks, such as Citigroup and Merrill) to transfer the risk of default to the
issuer of the credit default swap (such as AIG and other insurance companies). Third,
they made correlation trading possible. As the FCIC survey revealed, most hedge fund
purchases of equity and other junior tranches of mortgage-backed securities and CDOs
were done as part of complex trading strategies. As a result, credit default swaps were
critical to facilitate demand from hedge funds for the equity or other junior tranches of
mortgage-backed securities and CDOs. Finally, they allowed speculators to make bets
for or against the housing market without putting up much cash.
On the other hand, it can be argued that credit default swaps helped end the housing
and mortgage-backed securities bubble. Because CDO arrangers could more easily buy
mortgage exposure for their CDOs through credit default swaps than through actual
mortgage-backed securities, demand for credit default swaps may in fact have reduced
the need to originate high-yield mortgages. In addition, some market participants have
contended that without the ability to short the housing market via credit default swaps,
the bubble would have lasted longer. As we will see, the declines in the ABX index in
late 2006 would be one of the first harbingers of market turmoil. “Once [pessimists] can,
in effect, sell short via the CDS, prices must reflect their views and not just the views of
the leveraged optimists,” John Geanakoplos, a Yale economics professor and a partner
in the hedge fund Ellington Capital Management, which both invested in and managed
CDOs, told the FCIC.
III. Regulators: “Are Undue Concentrations of Risk Developing?”
As had happened when they faced the question of guidance on nontraditional mortgages
in dealing with the rapidly changing structured finance market, the regulators failed to
take timely action. They missed a crucial opportunity. On January 2, 2003, one year after
the collapse of Enron, the U.S. Senate Permanent Subcommittee on Investigations
called on the Fed, OCC, and SEC “to immediately initiate a one-time, joint review of
The Madness
banks and securities firms participating in complex structured finance products with U.S.
public companies to identify those structured finance products, transactions, or practices
which facilitate a U.S. company’s use of deceptive accounting in its financial statements
or reports.” The subcommittee recommended the agencies issue joint guidance on
“acceptable and unacceptable structured finance products, transactions and practices”
by June 2003. Four years later, the banking agencies and the SEC issued their
“Interagency Statement on Sound Practices Concerning Elevated Risk Complex
Structured Finance Activities,” a document that was all of nine pages long.
In the intervening years, from 2003 to 2007, the banking agencies and SEC issued two
draft statements for public comment. The 2004 draft, issued the year after the OCC,
Fed, and SEC had brought enforcement actions against Citigroup and JP Morgan for
helping Enron to manipulate its financial statements, focused on the policies and
procedures that financial institutions should have for managing the structured finance
business. The aim was to avoid another Enron – and for that reason, the statement
encouraged financial institutions to look out for customers that, like Enron, were trying to
use structured transactions to circumvent regulatory or financial reporting requirements,
evade tax liabilities, or engage in other illegal or improper behavior.
Industry groups criticized the draft guidance as too broad, prescriptive, and burdensome.
Several said it would cover many structured finance products that did not pose
significant legal or reputational risks. Another said that it “would disrupt the market for
legitimate structured finance products and place U.S. financial institutions at a
competitive disadvantage in the market for [complex structured finance transactions] in
the United States and abroad.”
Two years later, in May 2006, the agencies issued an abbreviated draft that reflected a
more “principles-based” approach, and again requested comments. Most of the
requirements were very similar to those that the OCC and Fed had imposed on Citigroup
and JP Morgan in the 2003 enforcement actions.
When the regulators issued the final guidance in January 2007, the industry was more
supportive. One reason was that mortgage-backed securities and CDOs were
specifically excluded: “Most structured finance transactions, such as standard public
mortgage-backed securities and hedging-type transactions involving ‘plain vanilla’
derivatives or collateralized debt obligations, are familiar to participants in the financial
markets, have well-established track records, and typically would not be considered
[complex structured finance transactions] for purposes of the Final Statement.” Those
exclusions had been added after the regulators received comments on the 2004 draft.
Regulators did take note of the potential risks of CDOs and credit default swaps. In
2005, the Basel Committee on Banking Supervision’s Joint Forum, which includes
banking, securities, and insurance regulators from around the world, issued a
comprehensive report on these products. The report focused on whether banks and
other firms involved in the CDO and credit default swap business understood the credit
risk they were taking. It advised them to make sure that they understood the nature of
the rating agencies’ models, especially for CDOs. And it further advised them to make
sure that counterparties from whom they bought credit protection – such as AIG and the
financial guarantors – would be good for that protection if it was needed.
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The regulators noted that industry participants appeared to have learned from earlier
flare-ups in the CDO sector: “The Working Group believes that it is important for
investors in CDOs to seek to develop a sound understanding of the credit risks involved
and not to rely solely on rating agency assessments. In many respects, the losses and
downgrades experienced on some of the early generation of CDOs have probably been
salutary in highlighting the potential risks involved.”
IV. Moody’s: “It Was All About Revenue”
Like other market participants, Moody’s Investors Service, one of the three dominant
rating agencies, was swept up in the frenzy of the structured products market. The
tranching structure of mortgage-backed securities and CDOs was standardized
according to guidelines set by the agencies; without their models and their generous
allotment of triple-A ratings, there would have been little investor interest and few deals.
Between 2002 and 2006, the volume of Moody’s business devoted to rating residential
mortgage-backed securities more than doubled; the dollar value of that business
increased from $62 million to $169 million; the number of staff rating these deals
doubled. But over the same period, while the volume of CDOs to be rated increased
sevenfold, staffing increased only 24%. From 2003 to 2006, annual revenue tied to
CDOs grew from $12 million to $91 million.
When Moody’s Corporation went public in 2000, the investor Warren Buffett’s Berkshire
Hathaway held 15% of the company. After share repurchases by Moody’s Corporation,
Berkshire Hathaway’s holdings of outstanding shares increased to over 20% by 2008.
As of 2010, Berkshire Hathaway and three other investors owned a combined 50.5% of
Moody’s. When asked whether he was satisfied with the internal controls at Moody’s,
Buffett responded to the FCIC that he knew nothing about the management of Moody’s.
“I had no idea. I’d never been at Moody’s, I don’t know where they are located.” Buffett
said that he invested in the company because the rating agency business was “a natural
duopoly,” which gave it “incredible” pricing power – and “the single-most important
decision in evaluating a business is pricing power.”
Many former employees said that after the public listing, the company culture changed –
it went “from [a culture] resembling a university academic department to one which
values revenues at all costs,” according to Eric Kolchinsky, a former managing director.
Employees also identified a new focus on market share directed by former president of
Moody’s Investors Service Brian Clarkson. Clarkson had joined Moody’s in 1991 as a
senior analyst in the residential mortgage group, and after successive promotions he
became co-chief operating officer of the rating agency in 2004, and then president in
August 2007. Gary Witt, a former team managing director covering U.S. derivatives,
described the cultural transformation under Clarkson: “My kind of working hypothesis
was that [former chairman and CEO] John Rutherford was thinking, ‘I want to remake
the culture of this company to increase profitability dramatically [after Moody’s became
an independent corporation],’ and that he made personnel decisions to make that
happen, and he was successful in that regard. And that was why Brian Clarkson’s rise
was so meteoric: . . . he was the enforcer who could change the culture to have more
focus on market share.” The former managing director Jerome Fons, who was
responsible for assembling an internal history of Moody’s, agreed: “The main problem
was . . . that the firm became so focused, particularly the structured area, on revenues,
on market share, and the ambitions of Brian Clarkson, that they willingly looked the other
way, traded the firm’s reputation for short-term profits.”
The Madness
Moody’s Corporation Chairman and CEO Raymond McDaniel did not agree with this
assessment, telling the FCIC that he didn’t see “any particular difference in culture” after
the spin-off. Clarkson also disputed this version of events, explaining that market share
was important to Moody’s well before it was an independent company. “[The idea that
before Moody’s] was spun off from Dun & Bradstreet, it was a sort of sleepy, academic
kind of company that was in an ivory tower . . . isn’t the case, you know,” he explained. “I
think [the ivory tower] was really a misnomer. I think that Moody’s has always been
focused on business.”
Clarkson and McDaniel also adamantly disagreed with the perception that concerns
about market share trumped ratings quality. Clarkson told the FCIC that it was fine for
Moody’s to lose transactions if it was for the “right reasons”: “If it was an analytical
reason or it was a credit reason, there’s not a lot you can do about that. But if you’re
losing a deal because you’re not communicating, you’re not being transparent, you’re
not picking up the phone, that could be problematic.” McDaniel cited unforeseen market
conditions as the reason that the models did not accurately predict the credit quality. He
testified to the FCIC, “We believed that our ratings were our best opinion at the time that
we assigned them. As we obtained new information and were able to update our
judgments based on the new information and the trends we were seeing in the housing
market, we made what I think are appropriate changes to our ratings.”
Nonetheless, Moody’s president did not seem to have the same enthusiasm for
compliance as he did for market share and profit, according to those who worked with
him. Scott McCleskey, a former chief compliance officer at Moody’s, recounted a story to
the FCIC about an evening when he and Clarkson were dining with the board of
directors after the company had announced strong earnings, particularly in the business
of rating mortgage-backed securities and CDOs. “So Brian Clarkson comes up to me, in
front of everybody at the table, including board members, and says literally, ‘How much
revenue did Compliance bring in this quarter? Nothing. Nothing.’ . . . For him to say that
in front of the board, that’s just so telling of how he felt that he was bulletproof. . . . For
him, it was all about revenue.” Clarkson told the FCIC that he didn’t remember this
conversation transpiring and said, “From my perspective, compliance is a very important
According to some former Moody’s employees, Clarkson’s management style left little
room for discussion or dissent. Witt referred to Clarkson as the “dictator” of Moody’s and
said that if he asked an employee to do something, “either you comply with his request
or you start looking for another job.” “When I joined Moody’s in late 1997, an analyst’s
worst fear was that we would contribute to the assignment of a rating that was wrong,”
Mark Froeba, former senior vice president, testified to the FCIC. “When I left 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.” Clarkson denied having a
“forceful” management style, and his supervisor, Raymond McDaniel, told the FCIC that
Clarkson was a “good manager.”
Former team managing director Gary Witt recalled that he received a monthly email from
Clarkson “that outlined basically my market share in the areas that I was in charge of. . .
I believe it listed the deals that we did, and then it would list the deals like S&P and/or
Fitch did that we didn’t do that was in my area. And at times, I would have to comment
on that verbally or even write a written report about – you know, look into what was it
about that deal, why did we not rate it. So, you know, it was clear that market share was
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important to him.” Witt acknowledged the pressures that he felt as a manager: “When I
was an analyst, I just thought about getting the deals right. . . . Once I [was promoted to
managing director and] had a budget to meet, I had salaries to pay, I started thinking
bigger picture. I started realizing, yes, we do have shareholders and, yes, they deserved
to make some money. We need to get the ratings right first, that’s the most important
thing; but you do have to think about market share.”
Even as far back as 2001, a strong emphasis on market share was evident in employee
performance evaluations. In July 2001, Clarkson circulated a spreadsheet to
subordinates that listed 49 analysts and the number and dollar volume of deals each had
“rated” or “NOT rated.” Clarkson’s instructions: “You should be using this in PE’s
[performance evaluations] and to give people a heads up on where they stand relative to
their peers.” Team managing directors, who oversaw the analysts rating the deals,
received a base salary, cash bonus, and stock options. Their performance goals
generally fell into the categories of market coverage, revenue, market outreach (such as
speeches and publications), ratings quality, and development of analytical tools, only
one of which was impossible to measure in real time as compensation was being
awarded: ratings quality. It might take years for the poor quality of a rating to become
clear as the rated asset failed to perform as expected.
In January 2006, a derivatives manager listed his most important achievements in a
2005 performance evaluation. At the top of the list: “Protected our market share in the
CDO corporate cash flow sector. . . . To my knowledge we missed only one CLO
[collateralized loan obligation] from BofA and that CLO was unratable by us because of
it’s [sic] bizarre structure.”
More evidence of Moody’s emphasis on market share was provided by an email that
circulated in the fall of 2007, in the midst of significant downgrades in the structured
finance market. Group Managing Director of U.S. Derivatives Yuri Yoshizawa asked her
team’s managing directors to explain a market share decrease from 98% to 94%.
Despite this apparent emphasis on market share, Clarkson told the FCIC that “the most
important goal for any managing director would be credibility . . . and performance [of]
the ratings.” McDaniel, the chairman and CEO of Moody’s Corporation, elaborated: “I
disagree that there was a drive for market share. We pay attention to our position in the
market. . . . But ratings quality, getting the ratings to the best possible predictive content,
predictive status, is paramount.”
Whatever McDaniel’s or Clarkson’s intended message, some employees continued to
see an emphasis on Moody’s market share. Former team managing director Witt
recalled that the “smoking gun” moment of his employment at Moody’s occurred during a
“town hall” meeting in the third quarter of 2007 with Moody’s management and its
managing directors, after Moody’s had already announced mass downgrades on
mortgage-related securities. After McDaniel made a presentation about Moody’s
financial outlook for the year ahead, one managing director responded: “I was interested,
Ray, to hear your belief that the first thing in the minds of people in this room is the
financial outlook for the remainder of the year. . . . [M]y thinking is there’s a much greater
concern about the franchise.” He added, “I think that the greater anxiety being felt by the
people in this room and . . . by the analysts is what’s going on with the ratings and what
the outlook is[,] . . . specifically the severe ratings transitions we’re dealing with . . . and
uncertainty about what’s ahead on that, the ratings accuracy.” Witt recalled, “Moody’s
The Madness
reputation was just being absolutely lacerated; and that these people are standing here,
and they’re not even addressing – they’re acting like it’s not even happening, even now
that it’s already happened. . . . [T]hat just made it so clear to me . . . that the balance
was far too much on the side of short-term profitability.”
In an internal memorandum from October 2007 sent to McDaniel, in a section titled
“Conflict of Interest: Market Share,” Chief Credit Officer Andrew Kimball explained that
“Moody’s has erected safeguards to keep teams from too easily solving the market
share problem by lowering standards.” But he observed that these protections were far
from fail-safe, as he detailed in two areas. First, “Ratings are assigned by committee, not
individuals. (However, entire committees, entire departments, are susceptible to market
share objectives.)” Second, “Methodologies & criteria are published and thus put
boundaries on rating committee discretion. (However, there is usually plenty of latitude
within those boundaries to register market influence.)”
Moreover, the pressure for market share, combined with complacency, may have
deterred Moody’s from creating new models or updating its assumptions, as Kimball
wrote: “Organizations often interpret past successes as evidencing their competence
and the adequacy of their procedures rather than a run of good luck. . . . [O]ur 24 years
of success rating RMBS [residential mortgage-backed securities] may have induced
managers to merely fine-tune the existing system – to make it more efficient, more
profitable, cheaper, more versatile. Fine-tuning rarely raises the probability of success; in
fact, it often makes success less certain.”
If an issuer didn’t like a Moody’s rating on a particular deal, it might get a better rating
from another ratings agency. The agencies were compensated only for rated deals – in
effect, only for the deals for which their ratings were accepted by the issuer. So the
pressure came from two directions: in-house insistence on increasing market share and
direct demands from the issuers and investment bankers, who pushed for better ratings
with fewer conditions.
Richard Michalek, a former Moody’s vice president and senior credit officer, testified to
the FCIC, “The threat of losing business to a competitor, even if not realized, absolutely
tilted the balance away from an independent arbiter of risk towards a captive facilitator of
risk transfer.” Witt agreed. When asked if the investment banks frequently threatened to
withdraw their business if they didn’t get their desired rating, Witt replied, “Oh God, are
you kidding? All the time. I mean, that’s routine. I mean, they would threaten you all of
the time. . . . It’s like, ‘Well, next time, we’re just going to go with Fitch and S&P.’”
Clarkson affirmed that “it wouldn’t surprise me to hear people say that” about issuer
pressure on Moody’s employees.
Former managing director Fons suggested that Moody’s was complaisant when it should
have been principled. Moody’s employees told the FCIC that one tactic used by the
investment bankers to apply subtle pressure was to submit a deal for a rating within a
very tight time frame. Kolchinsky, who oversaw ratings on CDOs, recalled the case of a
particular CDO: “What the trouble on this deal was, and this is crucial about the market
share, was that the banker gave us hardly any notice and any documents and any time
to analyze this deal. . . . Because bankers knew that we could not say no to a deal, could
not walk away from the deal because of a market share, they took advantage of that.”
For this CDO deal, the bankers allowed only three or four days for review and final
judgment. Kolchinsky emailed Yoshizawa that the transactions had “egregiously pushed
The Madness
our time limits (and analysts).” Before the frothy days of the peak of the housing boom,
an agency took six weeks or even two months to rate a CDO. By 2006, Kolchinsky
described a very different environment in the CDO group: “Bankers were pushing more
aggressively, so that it became from a quiet little group to more of a machine.” In 2006,
Moody’s gave triple-A ratings to an average of more than 30 mortgage securities each
and every working day.
Such pressure can be seen in an April 2006 email to Yoshizawa from a managing
director in synthetic CDO trading at Credit Suisse, who explained, “I’m going to have a
major political problem if we can’t make this [deal rating] short and sweet because, even
though I always explain to investors that closing is subject to Moody’s timelines, they
often choose not to hear it.”
The external pressure was summed up in Kimball’s October 2007 memorandum:
“Analysts and [managing directors] are continually ‘pitched’ by bankers, issuers,
investors – all with reasonable arguments – whose views can color credit judgment,
sometimes improving it, other times degrading it (we ‘drink the kool-aid’). Coupled with
strong internal emphasis on market share & margin focus, this does constitute a ‘risk’ to
ratings quality.”
The SEC investigated the rating agencies’ ratings of mortgage-backed securities and
CDOs in 2007, reporting its findings to Moody’s in July 2008. The SEC criticized
Moody’s for, among other things, failing to verify the accuracy of mortgage information,
leaving that work to due diligence firms and other parties; failing to retain documentation
about how most deals were rated; allowing ratings quality to be compromised by the
complexity of CDO deals; not hiring sufficient staff to rate CDOs; pushing ratings out the
door with insufficient review; failing to adequately disclose its rating process for
mortgage-backed securities and CDOs; and allowing conflicts of interest to affect rating
So matters stood in 2007, when the machine that had been humming so smoothly and
so lucratively slipped a gear, and then another, and another – and then seized up
The Madness
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. The collateralized debt obligation machine ended quietly in 2006.
a) true
b) false
2. What is not a reason why synthetic CDOs were so popular:
they took less work to put together
the warehousing expenses and accompanied risks were practically non-existent
the return had a higher potential
they were rarely used for credit default swaps on mortgage-backed securities
3. Why were the guidelines of the 2004 draft statements criticized by industry groups:
they were too arduous and evasive
they were too direct and simple to follow
they only referred to a small part of the financial institutions
they did not provide enough structure
The Madness
1. A: True is incorrect. It certainly could have easily come to an end in 2006 when
housing prices reached an all time high, but it didn’t.
B: False is correct. Throughout 2006 and 2007 everyone was still feeding on the
CDO machine, and nobody wanted to see the risks or even think about what could
possibly happen if the market turned.
(See page 10-1 of the course material.)
2. A: Incorrect. Synthetic CDOs were easy to put together as opposed to a cash CDO.
B: Incorrect. Actually, one of the benefits of a synthetic CDO was that it had relatively
no warehousing costs or related risks.
C: Incorrect. The potential for a higher return was a contributing factor to the
popularity of synthetic CDOs.
D: Correct. The demand of synthetic CDOs on mortgage-backed securities is
definitely one of the reasons why they were so popular.
(See page 10-3 of the course material.)
3. A: Correct. One of the primary reasons why the guidelines were criticized was
because they were too cumbersome and extensive.
B: Incorrect. To the contrary, the guidelines were difficult and time consuming.
C: Incorrect. Actually, the guidelines were criticized because they included financial
products that were not related and did not need to be covered.
D: Incorrect. One of the complaints by the industry groups was in fact that the
guidelines were too structured.
(See page 10-8 of the course material.)
The Madness
Chapter 11: The Bust
What happens when a bubble bursts? In early 2007, it became obvious that home prices
were falling in regions that had once boomed, that mortgage originators were
floundering, and that more and more families, especially those with subprime and Alt-A
loans, would be unable to make their mortgage payments.
What was not immediately clear was how the housing crisis would affect the financial
system that had helped inflate the bubble. Were all those mortgage-backed securities
and collateralized debt obligations ticking time bombs on the balance sheets of the
world’s largest financial institutions? “The concerns were just that if people . . . couldn’t
value the assets, then that created . . . questions about the solvency of the firms,”
William C. Dudley, now president of the Federal Reserve Bank of New York, told the
In theory, securitization, over-the-counter derivatives and the many byways of the
shadow banking system were supposed to distribute risk efficiently among investors.
The theory would prove to be wrong. Much of the risk from mortgage-backed securities
had actually been taken by a small group of systemically important companies with
outsized holdings of, or exposure to, the super-senior and triple-A tranches of CDOs.
These companies would ultimately bear great losses, even though those investments
were supposed to be super-safe.
As 2007 went on, increasing mortgage delinquencies and defaults compelled the ratings
agencies to downgrade first mortgage-backed securities, then CDOs. Alarmed investors
sent prices plummeting. Hedge funds faced with margin calls from their repo lenders
were forced to sell at distressed prices; many would shut down. Banks wrote down the
value of their holdings by tens of billions of dollars.
The summer of 2007 also saw a near halt in many securitization markets, including the
market for non-agency mortgage securitizations. For example, a total of $75 billion in
subprime securitizations were issued in the second quarter of 2007 (already down from
prior quarters). That figure dropped precipitously to $27 billion in the third quarter and to
only $12 billion in the fourth quarter of 2007. Alt-A issuance topped $100 billion in the
second quarter, but fell to $13 billion in the fourth quarter of 2007. Once-booming
markets were now gone – only $4 billion in subprime or Alt-A mortgage-backed
securities were issued in the first half of 2008, and almost none after that.
CDOs followed suit. From a high of more than $90 billion in the first quarter of 2007,
worldwide issuance of CDOs with mortgage-backed securities as collateral plummeted
to $29 billion in the third quarter of 2007 and only $5 billion in the fourth quarter. And as
the CDO market ground to a halt, investors no longer trusted other structured products.
Over $80 billion of collateralized loan obligations (CLOs), or securitized leveraged loans,
were issued in 2007; only $10 billion were issued in 2008. The issuance of commercial
real estate mortgage-backed securities plummeted from $232 billion in 2007 to $12
billion in 2008.
Those securitization markets that held up during the turmoil in 2007 eventually suffered
in 2008 as the crisis deepened. Securitization of auto loans, credit cards, small business
loans, and equipment leases all nearly ceased in the third and fourth quarters of 2008.
The Bust
I. Delinquencies: “The Turn of the Housing Market”
Home prices rose 15% nationally in 2005, their third year of double-digit growth. But by
the spring of 2006, as the sales pace slowed, the number of months it would take to sell
off all the homes on the market rose to its highest level in 10 years. Nationwide, home
prices peaked in April 2006.
Members of the Federal Reserve’s Federal Open Market Committee (FOMC) discussed
housing prices in the spring of 2006. Chairman Ben Bernanke and other members
predicted a decline in home prices but were uncertain whether the decline would be slow
or fast. Bernanke believed some correction in the housing market would be healthy and
that the goal of the FOMC should be to ensure the correction did not overly affect the
growth of the rest of the economy.
For 2007, the National Association of Realtors announced that the number of sales of
existing homes had experienced the sharpest fall in 25 years. That year, home prices
declined 9%. In 2008, they would drop a stunning 17%. Overall, by the end of 2009,
prices would drop 28% from their peak in 2006. Some cities saw a particularly large
drop: in Las Vegas, as of August 2010, home prices were down 55% from their peak.
And areas that never saw huge price gains have experienced losses as well: home
prices in Denver have fallen 18% since their peak.
In some areas, home prices started to fall as early as late 2005. For example, in Ocean
City, New Jersey, where many properties are vacation homes, home prices had risen
144% since 2001; they topped out in December 2005 and fell 4% in the first half of 2006.
By mid-2010, they would be 22% below their peak. Prices topped out in Sacramento in
October 2005 and are today down nearly 50%. In most places, prices rose for a bit
longer. For instance, in Tucson, Arizona, prices kept increasing for much of 2006,
climbing 95% from 2001 to their high point in August 2006, and then fell only 3% by the
end of the year.
One of the first signs of the housing crash was an upswing in early payment defaults –
usually defined as borrowers’ being 60 or more days delinquent within the first year.
Figures provided to the FCIC show that by the summer of 2006, 1.5% of loans less than
a year old were in default. The figure would peak in late 2007 at 2.5%, well above the
1.0% peak in the 2000 recession. Even more stunning, first payment defaults – that is,
mortgages taken out by borrowers who never made a single payment – went above
1.5% of loans in early 2007.
Mortgages in serious delinquency, defined as those 90 or more days past due or in
foreclosure, had hovered around 1% during the early part of the decade, jumped in
2006, and kept climbing. By the end of 2009, 9.7% of mortgage loans were seriously
delinquent. By comparison, serious delinquencies peaked at 2.4% in 2002 following the
previous recession. Serious delinquency was highest in areas of the country that had
experienced the biggest housing booms. In the “sand states” – California, Arizona,
Nevada, and Florida – serious delinquencies rose to 3% in mid-2007 and 15% by late
2009, double the rate in other areas of the country.
The Bust
Serious delinquency also varied by type of loan. Subprime adjustable-rate mortgages
began to show increases in serious delinquency in early 2006, even as house prices
were peaking; the rate rose rapidly to 20% in 2007. By late 2009, the delinquency rate
for subprime ARMs was 40%. Prime ARMs did not weaken until 2007, at about the same
time as subprime fixed-rate mortgages. Prime fixed-rate mortgages, which have
historically been the least risky, showed a slow increase in serious delinquency that
coincided with the increasing severity of the recession and of unemployment in 2008.
II. Rating Downgrades: “Never Before”
Prior to 2004, the ratings of mortgage-backed securities at Moody’s were monitored by
the same analysts who had rated them in the first place. In 2004, Nicolas Weill, Moody’s
chief credit officer and team managing director, was charged with creating an
independent surveillance team to monitor previously rated deals.
In November 2006, the surveillance team began to see a rise in early payment defaults
in mortgages originated by Fremont Investment & Loan, and downgraded several
securities with underlying Fremont loans or put them on watch for future downgrades.
“This was a very unusual situation as never before had we put on watch deals rated in
the same calendar year,” Weill later wrote to Raymond McDaniel, the chairman and
CEO of Moody’s Corporation, and Brian Clarkson, the president of Moody’s Investors
In early 2007, a Moody’s special report, overseen by Weill, about the sharp increases in
early payment defaults stated that the foreclosures were concentrated in subprime
mortgage pools. In addition, more than 2.75% of the subprime mortgages securitized in
the second quarter of 2006 were 60 days delinquent within six months, more than
double the rate a year earlier (1.25%). The exact cause of the trouble was still unclear to
the ratings agency, though. “Moody’s is currently assessing whether this represents an
overall worsening of collateral credit quality or merely a shifting forward of eventual
defaults which may not significantly impact a pool’s overall expected loss.”
For the next few months, the company published regular updates about the subprime
mortgage market. Over the next three months, Moody’s took negative rating actions on
4.5% of the outstanding subprime mortgage securities rated Baa. Then, on July 10,
2007, in an unprecedented move, Moody’s downgraded 399 subprime mortgage-backed
securities that had been issued in 2006 and put an additional 32 securities on watch.
The $5.2 billion of securities that were affected, all rated Baa and lower, made up 19% of
the subprime securities that Moody’s rated Baa in 2006. For the time being, there were
no downgrades on higher-rated tranches. Moody’s attributed the downgrades to
“aggressive underwriting combined with prolonged, slowing home price appreciation”
and noted that about 60% of the securities affected contained mortgages from one of
four originators: Fremont Investment & Loan, Long Beach Mortgage Company, New
Century Mortgage Corporation, and WMC Mortgage Corp.
Weill later told the FCIC staff that Moody’s issued a mass announcement, rather than
downgrading a few securities at a time, to avoid creating confusion in the market. A few
days later, Standard & Poor’s downgraded 498 similar tranches. These initial
downgrades were remarkable not only because of the number of securities involved but
also because of the sharp rating cuts – an average of four notches per security, when
one or two notches was more routine (for example, a single notch would be a
downgrade from AA to AA-). Among the tranches downgraded in July 2007 were the
The Bust
bottom three mezzanine tranches (M9, M10, and M11) of the Citigroup deal that we
have been examining, CMLTI 2006-NC2. By that point, nearly 12% of the original loan
pool had prepaid but another 11% were 90 or more days past due or in foreclosure.
Investors across the world were assessing their own exposure, and guessing at that of
others, however indirect, to these assets. A report from Bear Stearns Asset
Management detailed its exposure. One of its CDOs, Tall Ships, had direct exposure to
our sample deal, owning $8 million of the M7 and M8 tranches. BSAM’s High-Grade
hedge fund also had exposure through a $10 million credit default swap position with
Lehman referencing the M8 tranche. And BSAM’s Enhanced Leverage hedge fund
owned parts of the equity in Independence CDO, which in turn owned the M9 tranche of
our sample deal. In addition, these funds had exposure through their holdings of other
CDOs that in turn owned tranches of the Citigroup deal.
Then, on October 11, Moody’s downgraded another 2,506 tranches ($33.4 billion) of
subprime mortgage-backed securities and placed 577 tranches ($23.8 billion) on watch
for potential downgrade. Now the total of securities downgraded and put on watch
represented 13.4% of the original dollar volume of all 2006 subprime mortgage-backed
securities that Moody’s had rated. Of the securities placed on watch in October, 48
tranches ($6.9 billion) were originally Aaa-rated and 529 ($16.9 billion) were Aa-rated.
All told, in the first 10 months of 2007, 92% of the mortgage-backed security deals
issued in 2006 had at least one tranche downgraded or put on watch.
By this point in October, 13% of the loans in our case study deal CMLTI 2006-NC2 were
seriously delinquent and some homes had already been repossessed. The M4 through
M8 tranches were downgraded as part of the second wave of mass downgrades. Five
additional tranches would eventually be downgraded in April 2008.
Before it was over, Moody’s would downgrade 83% of all the 2006 Aaa mortgagebacked securities tranches and all of the Baa tranches. For those securities issued in the
second half of 2007, nearly all Aaa and Baa tranches were downgraded. Of all tranches
initially rated investment grade – that is, rated Baa3 or higher – 76% of those issued in
2006 were downgraded to junk, as were 89% of those from 2007.
III. CDOs: “Climbing the Wall of Subprime Worry”
In March 2007, Moody’s reported that CDOs with high concentrations of subprime
mortgage-backed securities could incur “severe” downgrades. In an internal email sent
five days after the report, Group Managing Director of U.S. Derivatives Yuri Yoshizawa
explained to Moody’s Chairman McDaniel and to Executive Vice President Noel Kirnon
that one managing director at Credit Suisse First Boston “sees banks like Merrill, Citi,
and UBS still furiously doing transactions to clear out their warehouses. . . . He believes
that they are creating and pricing the CDOs in order to remove the assets from the
warehouses, but that they are holding on to the CDOs . . . in hopes that they will be able
to sell them later.” Several months later, in a review of the CDO market titled “Climbing
the Wall of Subprime Worry,” Moody’s noted, “Some of the first quarter’s activity [in
2007] was the result of some arrangers feverishly working to clear inventory and reduce
their balance sheet exposure to the subprime class.” Even though Moody’s was aware
that the investment banks were dumping collateral out of the warehouses and into CDOs
– possibly regardless of quality – the firm continued to rate new CDOs using existing
The Bust
Former Moody’s executive Richard Michalek testified to the FCIC, “It was a case of, with
respect to why didn’t we stop and change our methodology, there is a very conservative
culture at Moody’s, at least while I was there, that suggested that the only thing worse
than quickly getting a new methodology in place is quickly getting the wrong
methodology in place and having to unwind that and to fail to consider the unintended
In July, McDaniel gave a presentation to the board on the company’s 2007 strategic
plan. His slides had such bleak titles as “Spotlight on Mortgages: Quality Continues to
Erode,” “House Prices Are Falling . . . ,” “Mortgage Payment Resets Are Mounting,” and
“1.3 MM Mortgage Defaults Forecast 2007-08.” Despite all the evidence that the quality
of the underlying mortgages was declining, Moody’s did not make any significant
adjustments to its CDO ratings assumptions until late September. Out of $51 billion in
CDOs that Moody’s rated after its mass downgrade of subprime mortgage-backed
securities on July 10, 2007, 88% were rated Aaa.
Moody’s had hoped that rating downgrades could be staved off by mortgage
modifications – if their monthly payments became more affordable, borrowers might stay
current. However, in mid-September, Eric Kolchinsky, a team managing director for
CDOs, learned that a survey of servicers indicated that very few troubled mortgages
were being modified. Worried that continuing to rate CDOs without adjusting for known
deterioration in the underlying securities could expose Moody’s to liability, Kolchinsky
advised Yoshizawa that the company should stop rating CDOs until the securities
downgrades were completed. Kolchinsky told the FCIC that Yoshizawa “admonished”
him for making the suggestion.
By the end of 2008, more than 90% of all tranches of CDOs had been downgraded.
Moody’s downgraded nearly all of the 2006 Aaa and all of the Baa CDO tranches. And,
again, the downgrades were large – more than 80% of Aaa CDO bonds and more than
90% of Baa CDO bonds were eventually downgraded to junk.
IV. Legal Remedies: “On the Basis of the Information”
The housing bust exposed the flaws in the mortgages that had been made and
securitized. After the crisis unfolded, those with exposure to mortgages and structured
products – including investors, financial firms, and private mortgage insurance firms –
closely examined the representations and warranties made by mortgage originators and
securities issuers. When mortgages were securitized, sold, or insured, certain
representations and warranties were made to assure investors and insurers that the
mortgages met stated guidelines. As mortgage securities lost value, investors found
significant deficiencies in securitizers’ due diligence on the mortgage pools underlying
the mortgage-backed securities as well as in their disclosure about the characteristics of
those deals. As private mortgage insurance companies found similar deficiencies in the
loans they insured, they have denied claims to an unprecedented extent.
Fannie and Freddie acquired or guaranteed millions of loans each year. They delegated
underwriting authority to originators subject to a legal agreement – representations and
warranties – that the loans meet specified criteria. They then checked samples of the
loans to ensure that these representations and warranties were not breached. If there
was a breach and the loans were “ineligible” for purchase, the GSE had the right to
require the seller to buy back the loan – assuming, of course, that the seller had not
gone bankrupt.
The Bust
As a result of such sampling, during the three years and eight months ending August 31,
2010, Freddie and Fannie required sellers to repurchase 167,000 loans totaling $34.8
billion. So far, Freddie has received $9.1 billion from sellers, and Fannie has received
$11.8 billion – a total of $20.9 billion. The amount put back is notable in that it represents
21% of $163 billion in credit-related expenses recorded by the GSEs since the beginning
of 2008 through September 2010.
Like Fannie and Freddie, private mortgage insurance (PMI) companies have been
finding significant deficiencies in mortgages. They are refusing to pay claims on some
insured mortgages that have gone into default. This insurance protects the holder of the
mortgage if a homeowner defaults on a loan, even though the responsibility for the
premiums generally lies with the homeowner. By the end of 2006, PMI companies had
insured a total of $668 billion in potential mortgage losses.
As defaults and losses on the insured mortgages have been increasing, the PMI
companies have seen a spike in claims. As of October 2010, the seven largest PMI
companies, which share 98% of the market, had rejected about 25% of the claims (or $6
billion of $24 billion) brought to them, because of violations of origination guidelines,
improper employment and income reporting, and issues with property valuation.
Separate from their purchase and guarantee of mortgages, over the course of the
housing boom the GSEs purchased $690 billion of subprime and Alt-A private-label
securities. The GSEs have recorded $46 billion in charges on securities from January 1,
2008 to September 30, 2010. Frustrated with the lack of information from the securities’
servicers and trustees, in many cases large banks, on July 12, 2010, the GSEs through
their regulator, the Federal Housing Finance Agency, issued 64 subpoenas to various
trustees and servicers in transactions in which the GSEs lost money. Where they find
that the nonperforming loans in the pools have violations, the GSEs intend to demand
that the trustees recognize their rights (including any rights to put loans back to the
originator or wholesaler).
While this strategy being followed by the GSEs is based in contract law, other investors
are relying on securities law to file lawsuits, claiming that they were misled by inaccurate
or incomplete prospectuses; and, in a number of cases, they are winning.
As of mid-2010, court actions embroiled almost all major loan originators and
underwriters – there were more than 400 lawsuits related to breaches of representations
and warranties, by one estimate. These lawsuits filed in the wake of the financial crisis
include those alleging “untrue statements of material fact” or “material
misrepresentations” in the registration statements and prospectuses provided to
investors who purchased securities. They generally allege violations of the Securities
Exchange Act of 1934 and the Securities Act of 1933.
Both private and government entities have gone to court. For example, the investment
brokerage Charles Schwab has sued units of Bank of America, Wells Fargo, and UBS
Securities. The Massachusetts attorney general’s office settled charges against Morgan
Stanley and Goldman Sachs, after accusing the firms of inadequate disclosure relating
to their sales of mortgage-backed securities. Morgan Stanley agreed to pay $102 million
and Goldman Sachs agreed to pay $60 million.
The Bust
V. Losses: “Who Owns Residential Credit Risk?”
Through 2007 and into 2008, as the rating agencies downgraded mortgage-backed
securities and CDOs, and investors began to panic, market prices for these securities
plunged. Both the direct losses as well as the marketwide contagion and panic that
ensued would lead to the failure or near failure of many large financial firms across the
system. The drop in market prices for mortgage-related securities reflected the higher
probability that the underlying mortgages would actually default (meaning that less cash
would flow to the investors) as well as the more generalized fear among investors that
this market had become illiquid. Investors valued liquidity because they wanted the
assurance that they could sell securities quickly to raise cash if necessary. Potential
investors worried they might get stuck holding these securities as market participants
looked to limit their exposure to the collapsing mortgage market.
As market prices dropped, “mark-to-market” accounting rules required firms to write
down their holdings to reflect the lower market prices. In the first quarter of 2007, the
largest banks and investment banks began complying with a new accounting rule and for
the first time reported their assets in one of three valuation categories: “Level 1 assets,”
which had observable market prices, like stocks on the stock exchange; “Level 2
assets,” which were not as easily priced because they were not actively traded; and
“Level 3 assets,” which were illiquid and had no discernible market prices or other inputs.
To determine the value of Level 3 and in some cases Level 2 assets where market
prices were unavailable, firms used models that relied on assumptions. Many financial
institutions reported Level 3 assets that substantially exceeded their capital. For
example, for the first quarter of 2007, Bear Stearns reported about $19 billion in Level 3
assets, compared to $13 billion in capital; Morgan Stanley reported about $60 billion in
Level 3 assets, against capital of $38 billion; and Goldman reported about $48 billion,
and capital of $37 billion.
Mark-to-market write-downs were required on many securities even if there were no
actual realized losses and in some cases even if the firms did not intend to sell the
securities. The charges reflecting unrealized losses were based, in part, on credit rating
agencies’ and investors’ expectations that the mortgages would default. But only when
those defaults came to pass would holders of the securities actually have realized
losses. Determining the market value of securities that did not trade was difficult, was
subjective, and became a contentious issue during the crisis. Why? Because the writedowns reduced earnings and capital, and triggered collateral calls.
These mark-to-market accounting rules received a good deal of criticism in recent years,
as firms argued that the lower market prices did not reflect market values but rather firesale prices driven by forced sales. Joseph Grundfest, when he was a member of the
SEC’s Committee on Improvements to Financial Reporting, noted that at times, marking
securities at market prices “creates situations where you have to go out and raise
physical capital in order to cover losses that as a practical matter were never really
there.” But not valuing assets based on market prices could mean that firms were not
recording losses required by the accounting rules and therefore were overstating
earnings and capital.
As the mortgage market was crashing, some economists and analysts estimated that
actual losses, also known as realized losses, on subprime and Alt-A mortgages would
total $200 to $300 billion; so far, by 2010, the figure has turned out not to be much more
The Bust
than that. As of year-end 2009, the dollar value of all impaired Alt-A and subprime
mortgage-backed securities total about $300 billion. Securities are impaired when they
have suffered realized losses or are expected to suffer realized losses imminently. While
those numbers are small in relation to the $14 trillion U.S. economy, the losses had a
disproportionate impact. “Subprime mortgages themselves are a pretty small asset
class,” Fed Chairman Ben Bernanke told the FCIC, explaining how in 2007 he and
Treasury Secretary Henry Paulson had underestimated the repercussions of the
emerging housing crisis. “You know, the stock market goes up and down every day
more than the entire value of the subprime mortgages in the country. But what created
the contagion, or one of the things that created the contagion, was that the subprime
mortgages were entangled in these huge securitized pools.”
The large drop in market prices of the mortgage securities had large spillover effects to
the financial sector, for a number of reasons. For example, as just discussed, when the
prices of mortgage-backed securities and CDOs fell, many of the holders of those
securities marked down the value of their holdings – before they had experienced any
actual losses.
In addition, rather than spreading the risks of losses among many investors, the
securitization market had concentrated them. “Who owns residential credit risk?” two
Lehman analysts asked in a September 2007 report. The answer: three-quarters of
subprime and Alt-A mortgages had been securitized – and “much of the risk in these
securitizations is in the investment-grade securities and has been almost entirely
transferred to AAA collateralized debt obligation (CDO) holders.” A set of large,
systemically important firms with significant holdings or exposure to these securities
would be found to be holding very little capital to protect against potential losses. And
most of those companies would turn out to be considered by the authorities too big to fail
in the midst of a financial crisis.
The International Monetary Fund’s Global Financial Stability Report published in October
2008 examined where the declining assets were held and estimated how severe the
write-downs would be. All told, the International Monetary Fund (IMF) calculated that
roughly $10 trillion in mortgage assets were held throughout the financial system. Of
these, $3.8 trillion were GSE mortgage-backed securities; the IMF expected losses of
$80 billion, but investors holding these securities would lose no money, because of the
GSEs’ guarantee. Another $4.7 trillion in mortgage assets were estimated to be prime
and nonprime mortgages held largely by the banks and the GSEs. These were expected
to suffer as much as $170 billion in write-downs due to declines in market value. The
remaining $1.5 trillion in assets were estimated to be mortgage-backed securities and
CDOs. Write-downs on those assets were expected to be $500 billion. And, even more
troubling, more than one-half of these losses were expected to be borne by the
investment banks, commercial banks, and thrifts. The rest of the write-downs from nonagency mortgage-backed securities were shared among institutions such as insurance
companies, pension funds, the GSEs, and hedge funds. The October report also
expected another $655 billion in write-downs on commercial mortgage-backed
securities, CLOs, leveraged loans, and other loans and securities – with more than half
coming from commercial mortgage-backed securities. Again, the commercial banks and
thrifts and investment banks were expected to bear much of the brunt.
The Bust
Furthermore, when the crisis began, uncertainty (suggested by the sizable revisions in
the IMF estimates) and leverage would promote contagion. Investors would realize they
did not know as much as they wanted to know about the mortgage assets that banks,
investment banks, and other firms held or to which they were exposed. To an extent not
understood by many before the crisis, financial institutions had leveraged themselves
with commercial paper, with derivatives, and in the short-term repo markets, in part by
using mortgage-backed securities and CDOs as collateral. Lenders would question the
value of the assets that those companies had posted as collateral at the same time that
they were questioning the value of those companies’ balance sheets.
Even the highest-rated tranches of mortgage-backed securities were downgraded, and
large write-downs were recorded on financial institutions’ balance sheets based on
declines in market value. However, although this could not be known in 2007, at the end
of 2010 most of the triple-A tranches of mortgage-backed securities have avoided actual
losses in cash flow through 2010 and may avoid significant realized losses going
Overall, for 2005 to 2007 vintage tranches of mortgage-backed securities originally rated
triple-A, despite the mass downgrades, only about 10% of Alt-A and 4% of subprime
securities had been “materially impaired” – meaning that losses were imminent or had
already been suffered – by the end of 2009. For the lower-rated Baa tranches, 96.5% of
Alt-A and 95.5% of subprime securities were impaired. In all, by the end of 2009, $320
billion worth of subprime and Alt-A tranches had been materially impaired – including
$132.6 billion originally rated triple-A. The outcome would be far worse for CDO
investors, whose fate largely depended on the performance of lower-rated mortgagebacked securities. More than 90% of Baa CDO bonds and 71.3% of Aaa CDO bonds
were ultimately impaired.
The Bust
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. The price of homes dropped dramatically in 2005.
a) true
b) false
2. An early sign that the housing market was in trouble was:
an increase in mortgage interest rates
an increase in early defaults of mortgage payments
continued meteoric rise in housing prices
both a and c above
3. Private Mortgage Insurance protects who against losses:
a) it pays the mortgage of the borrower in the event they lose their main source of
b) it protects the originator of the loan only
c) it protects the holder of mortgage-backed securities against default by the
d) it protects the owner of the mortgage in the event of default
The Bust
1. A: True is incorrect. In 2005, home prices were still on the rise.
B: False is correct. Home prices began to level off in 2006. In 2005, home prices
rose by 15% nationally.
(See page 11-2 of the course material.)
2. A: Incorrect. Interest rates remained static and low during the housing crisis.
B: Correct. Borrowers, many with subprime loans that featured huge payment
escalations, began defaulting in greater and greater numbers.
C: Incorrect. Prices began to fall as defaults increased.
D: Incorrect. Only one of the given responses is correct.
(See page 11-2 of the course material.)
3. A: Incorrect. It does not protect the borrower of the mortgage. It protects the owner of
the mortgage.
B: Incorrect. It protects the owner of the loan, not necessarily the originator.
C: Incorrect. PMI protects the owner of the mortgage in case the homeowner defaults
on the mortgage, not the holder.
D: Correct. PMI protects the owner of the mortgage in case the homeowner defaults
on the mortgage.
(See page 11-6 of course material.)
The Bust
Chapter 12: Early 2007 – Spreading Subprime Worries
Over the course of 2007, the collapse of the housing bubble and the abrupt shutdown of
subprime lending led to losses for many financial institutions, runs on money market
funds, tighter credit, and higher interest rates. Unemployment remained relatively
steady, hovering just below 4.5% until the end of the year, and oil prices rose
dramatically. By the middle of 2007, home prices had declined almost 4% from their
peak in 2006. Early evidence of the coming storm was the 1.5% drop in November 2006
of the ABX Index – a Dow Jones-like index for credit default swaps on BBB tranches of
mortgage-backed securities issued in the first half of 2006.
That drop came after Moody’s and S&P put on negative watch selected tranches in one
deal backed by mortgages from one originator: Fremont Investment & Loan. In
December, the same index fell another 3% after the mortgage companies Ownit
Mortgage Solutions and Sebring Capital ceased operations. Senior risk officers of the
five largest investment banks told the Securities and Exchange Commission that they
expected to see further subprime lender failures in 2007. “There is a broad recognition
that, with the refinancing and real estate booms over, the business model of many of the
smaller subprime originators is no longer viable,” SEC analysts told Director Erik Sirri in
a January 4, 2007, memorandum.
That became more and more evident. In January, Mortgage Lenders Network
announced it had stopped funding mortgages and accepting applications. In February,
New Century reported bigger-than-expected mortgage credit losses and HSBC, the
largest subprime lender in the United States, announced a $1.8 billion increase in its
quarterly provision for losses. In March, Fremont stopped originating subprime loans
after receiving a cease and desist order from the Federal Deposit Insurance Corporation.
In April, New Century filed for bankruptcy.
These institutions had relied for their operating cash on short-term funding through
commercial paper and the repo market. But commercial paper buyers and banks
became unwilling to continue funding them, and repo lenders became less and less
willing to accept subprime and Alt-A mortgages or mortgage-backed securities as
collateral. They also insisted on ever-shorter maturities, eventually of just one day – an
inherently destabilizing demand, because it gave them the option of withholding funding
on short notice if they lost confidence in the borrower.
Another sign of problems in the market came when financial companies began to report
more detail about their assets under the new mark-to-market accounting rule, particularly
about mortgage-related securities that were becoming illiquid and hard to value. The
sum of more illiquid Level 2 and 3 assets at these firms was “eye-popping in terms of the
amount of leverage the banks and investment banks had,” according to Jim Chanos, a
New York hedge fund manager. Chanos said that the new disclosures also revealed for
the first time that many firms retained large exposures from securitizations. “You clearly
didn’t get the magnitude, and the market didn’t grasp the magnitude until spring of ’07,
when the figures began to be published, and then it was as if someone rang a bell,
because almost immediately upon the publication of these numbers, journalists began
writing about it, and hedge funds began talking about it, and people began speaking
about it in the marketplace.”
Spreading Subprime Worries
In late 2006 and early 2007, some banks moved to reduce their subprime exposures by
selling assets and buying protection through credit default swaps. Some, such as
Citigroup and Merrill Lynch, reduced mortgage exposure in some areas of the firm but
increased it in others. Banks that had been busy for nearly four years creating and
selling subprime-backed collateralized debt obligations (CDOs) scrambled in about that
many months to sell or hedge whatever they could. They now dumped these products
into some of the most ill-fated CDOs ever engineered. Citigroup, Merrill Lynch, and UBS,
particularly, were forced to retain larger and larger quantities of the “super-senior”
tranches of these CDOs. The bankers could always hope – and many apparently even
believed – that all would turn out well with these super-seniors, which were, in theory,
the safest of all.
With such uncertainty about the market value of mortgage assets, trades became scarce
and setting prices for these instruments became difficult. Although government officials
knew about the deterioration in the subprime markets, they misjudged the risks posed to
the financial system. In January 2007, SEC officials noted that investment banks had
credit exposure to struggling subprime lenders but argued that “none of these exposures
are material.”
I. Goldman: “Let’s Be Aggressive Distributing Things”
In December 2006, following the initial decline in ABX BBB indices and after 10
consecutive days of trading losses on its mortgage desk, executives at Goldman Sachs
decided to reduce the firm’s subprime exposure. Goldman marked down the value of its
mortgage-related products to reflect the lower ABX prices, and began posting daily
losses for this inventory.
Responding to the volatility in the subprime market, Goldman analysts delivered an
internal report on December 13, 2006, regarding “the major risk in the Mortgage
business” to Chief Financial Officer David Viniar and Chief Risk Officer Craig Broderick.
The next day, executives determined that they would get “closer to home,” meaning that
they wanted to reduce their mortgage exposure: sell what could be sold as is, repackage
and sell everything else. Kevin Gasvoda, the managing director for Goldman’s Fixed
Income, Currency, and Commodities business line, instructed the sales team to sell
asset-backed security and CDO positions, even at a loss: “Pls refocus on retained new
issue bond positions and move them out. There will be big opportunities the next several
months and we don’t want to be hamstrung based on old inventory. Refocus efforts and
move stuff out even if you have to take a small loss.” In a December 15 email, Viniar
described the strategy to Tom Montag, the co-head of global securities: “On ABX, the
position is reasonably sensible but is just too big. Might have to spend a little to size it
appropriately. On everything else my basic message was let’s be aggressive distributing
things because there will be very good opportunities as the market goes into what is
likely to be even greater distress and we want to be in position to take advantage of
Subsequent emails suggest that the “everything else” meant mortgage-related assets.
On December 20, in an internal email with broad distribution, Goldman’s Stacy BashPolley, a partner and the co-head of fixed income sales, noted that the firm, unlike
others, had been able to find buyers for the super-senior and equity tranches of CDOs,
but the mezzanine tranches remained a challenge. The “best target,” she said, would be
to put them in other CDOs: “We have been thinking collectively as a group about how to
Spreading Subprime Worries
help move some of the risk. While we have made great progress moving the tail risks –
[super-senior] and equity – we think it is critical to focus on the mezz risk that has been
built up over the past few months. . . . Given some of the feedback we have received so
far [from investors,] it seems that cdo’s maybe the best target for moving some of this
risk but clearly in limited size (and timing right now not ideal).”
It was becoming harder to find buyers for these securities. Back in October, Goldman
Sachs traders had complained that they were being asked to “distribute junk that nobody
was dumb enough to take first time around.” Despite the first of Goldman’s business
principles—that “our clients’ interests always come first” – documents indicate that the
firm targeted less-sophisticated customers in its efforts to reduce subprime exposure. In
a December 28 email discussing a list of customers to target for the year, Goldman’s
Fabrice Tourre, then a vice president on the structured product correlation trading desk,
said to “focus efforts” on “buy and hold rating-based buyers” rather than “sophisticated
hedge funds” that “will be on the same side of the trade as we will.” The “same of side of
the trade” as Goldman was the selling or shorting side – those who expected the
mortgage market to continue to decline. In January, Daniel Sparks, the head of
Goldman’s mortgage department, extolled Goldman’s success in reducing its subprime
inventory, writing that the team had “structured like mad and traveled the world, and
worked their tails off to make some lemonade from some big old lemons.” Tourre
acknowledged that there was “more and more leverage in the system,” and – writing of
himself in the third person – said he was “standing in middle of all these complex, highly
levered, exotic trades he created without necessarily understanding all the implications
of those monstrosities.”
On February 11, Goldman CEO Lloyd Blankfein questioned Montag about the $20
million in losses on residual positions from old deals, asking, “Could/should we have
cleaned up these books before and are we doing enough right now to sell off cats and
dogs in other books throughout the division?”
The numbers suggest that the answer was yes, they had cleaned up pretty well, even
given a $20 million write-off and billions of dollars of subprime exposure still retained. In
the first quarter of 2007, its mortgage business earned a record $266 million, driven
primarily by short positions, including a $10 billion short position on the bellwether ABX
BBB index, whose drop the previous November had been the red flag that got
Goldman’s attention.
In the following months, Goldman reduced its own mortgage risk while continuing to
create and sell mortgage-related products to its clients. From December 2006 through
August 2007, it created and sold approximately $25.4 billion of CDOs – including $17.6
billion of synthetic CDOs. The firm used the cash CDOs to unload much of its own
remaining inventory of other CDO securities and mortgage-backed securities.
Goldman has been criticized – and sued – for selling its subprime mortgage securities to
clients while simultaneously betting against those securities. Sylvain Raynes, a
structured finance expert at R&R Consulting in New York, reportedly called Goldman’s
practice “the most cynical use of credit information that I have ever seen,” and compared
it to “buying fire insurance on someone else’s house and then committing arson.”
Spreading Subprime Worries
Indeed, Goldman’s short position was not the whole story. The daily mortgage “Value at
Risk” measure, or VaR, which tracked potential losses if the market moved
unexpectedly, increased in the three months through February. By February, Goldman’s
company-wide VaR reached an all-time high, according to SEC reports. The dominant
driver of the increase was the one-sided bet on the mortgage market’s continuing to
decline. Preferring to be relatively neutral, between March and May, the mortgage
securities desk reduced its short position on the ABX Index; between June and August, it
again reversed course, increasing its short position by purchasing protection on
mortgage-related assets.
The Basis Yield Alpha Fund, a hedge fund and Goldman client that claims to have
invested $11.25 million in Goldman’s Timberwolf CDO, sued Goldman for fraud in 2010.
The Timberwolf deal was heavily criticized by Senator Carl Levin and other members of
the Permanent Subcommittee on Investigations during an April 2010 hearing. The Basis
Yield Alpha Fund alleged that Goldman designed Timberwolf to quickly fail so that
Goldman could offload low-quality assets and profit from betting against the CDO. Within
two weeks of the fund’s investment, Goldman began making margin calls on the deal. By
the end of July 2007, it had demanded more than $35 million. According to the hedge
fund, Goldman’s demands forced it into bankruptcy in August 2007 – Goldman received
about $40 million from the liquidation. Goldman denies Basis Yield Alpha Fund’s claims,
and CEO Blankfein dismissed the notion that Goldman misled investors. “I will tell you,
we only dealt with people who knew what they were buying. And of course when you
look after the fact, someone’s going to come along and say they really didn’t know,” he
told the FCIC.
In addition to selling its subprime securities to customers, the firm took short positions
using credit default swaps; it also took short positions on the ABX indices and on some
of the financial firms with which it did business. Like every market participant, Goldman
“marked,” or valued, its securities after considering both actual market trades and
surveys of how other institutions valued the assets. As the crisis unfolded, Goldman
marked mortgage-related securities at prices that were significantly lower than those of
other companies. Goldman knew that those lower marks might hurt those other
companies – including some clients – because they could require marking down those
assets and similar assets. In addition, Goldman’s marks would get picked up by
competitors in dealer surveys. As a result, Goldman’s marks could contribute to other
companies recording “mark-to-market” losses: that is, the reported value of their assets
could fall and their earnings would decline.
The markdowns of these assets could also require that companies reduce their repo
borrowings or post additional collateral to counterparties to whom they had sold credit
default swap protection. In a May 11 email, Craig Broderick, who as Goldman’s chief risk
officer was responsible for tracking how much of the company’s money was at risk,
noted to colleagues that the mortgage group was “in the process of considering making
significant downward adjustments to the marks on their mortgage portfolio [especially]
CDOs and CDO squared. This will potentially have a big [profit and loss] impact on us,
but also to our clients due to the marks and associated margin calls on repos,
derivatives, and other products. We need to survey our clients and take a shot at
determining the most vulnerable clients, knock on implications, etc. This is getting lots of
30th floor attention right now.”
Spreading Subprime Worries
II. Bear Stearns’s Hedge Funds: “Looks Pretty Damn Ugly”
In 2003, Ralph Cioffi and Matthew Tannin, who had structured CDOs at Bear Stearns,
were busy managing BSAM’s High-Grade Structured Credit Strategies Fund. When they
added the higher-leveraged, higher-risk Enhanced Fund in 2006, they became even
By April 2007, internal BSAM risk exposure reports showed about 60% of the HighGrade fund’s collateral to be subprime mortgage-backed CDOs, assets that were
beginning to lose market value. In a diary kept in his personal email account because he
“didn’t want to use [his] work email anymore,” Tannin recounted that in 2006 “a wave of
fear set over [him]” when he realized that the Enhanced Fund “was going to subject
investors to ‘blow up risk’” and “we could not run the leverage as high as I had thought
we could.”
This “blow up risk,” coupled with bad timing, proved fatal for the Enhanced Fund. Shortly
after the fund opened, the ABX BBB- index started to falter, falling 4% in the last three
months of 2006; then another 8% in January and 25% in February. The market’s
confidence fell with the ABX. Investors began to bail out of both Enhanced and HighGrade. Cioffi and Tannin stepped up their marketing. On March 7, 2007, Tannin said in
an email to investors, “we see an opportunity here – not crazy opportunity – but prudent
opportunity – I am putting in additional capital – I think you should as well.” On a March
12 conference call, Tannin and Cioffi assured investors that both funds “have plenty of
liquidity,” and they continued to use the investment of their own money as evidence of
their confidence. Tannin even said he was increasing his personal investment, although,
according to the SEC, he never did.
Despite their avowals of confidence, Cioffi and Tannin were in full red-alert mode. In
April, Cioffi redeemed $2 million of his own $6.1 million investment in Enhanced
Leverage and transferred the funds to a third hedge fund he managed. They tried to sell
the toxic CDO securities held by the hedge funds. They had little success selling them
directly on the market, but there was another way.
In late May, BSAM put together a CDO-squared deal that would take $4 billion of CDO
assets off the hedge funds’ books. The senior-most tranches, worth $3.2 billion, were
sold as commercial paper to short-term investors such as money market mutual funds.
Critically, Bank of America guaranteed those deals with a liquidity put – for a fee. Later,
commercial paper investors would refuse to roll over this particular paper; Bank of
America ultimately lost more than $4 billion on this arrangement.
III. “19% Is Doomsday”
Nearly all hedge funds provide their investors with market value reports, at least
monthly, based on computed mark-to-market prices for the fund’s various investments.
Industry standards generally called for valuing readily traded assets, such as stocks, at
the current trading price, while assets in very slow markets were marked by surveying
price quotes from other dealers, factoring in other pricing information, and then arriving
at a final net asset value. For mortgage-backed investments, marking assets was an
extremely important exercise, because the market values were used to inform investors
and to calculate the hedge fund’s total fund value for internal risk management
purposes, and because these assets were held as collateral for repo and other lenders.
Spreading Subprime Worries
Crucially, if the value of a hedge fund’s portfolio declined, repo and other lenders might
require more collateral. In April, JP Morgan told Alan Schwartz, Bear Stearns’s copresident, that the bank would be asking the BSAM hedge funds to post additional
collateral to support its repo borrowing.
Dealer marks were slow to keep up with movements in the ABX indices. Even as the
ABX BBB- index recovered some in March, rebounding 6%, marks by broker-dealers
finally started to reflect the lower values. On April 2, 2007, Goldman sent BSAM marks
ranging from 65 cents to 100 cents on the dollar – meaning that some securities were
worth as little as 65% of their initial value. On Thursday, April 19, in preparation for an
investor call the following week, BSAM analysts informed Cioffi and Tannin that in their
view, the value of the funds’ portfolios had declined sharply. On Sunday, Tannin sent an
email from his personal account to Cioffi’s personal account arguing that both hedge
funds should be closed and liquidated: “Looks pretty damn ugly. . . . If we believe the
runs [the analyst] has been doing are ANYWHERE CLOSE to accurate, I think we
should close the Funds now. . . . If [the runs] are correct then the entire sub-prime
market is toast.” But by the following Wednesday, Cioffi and Tannin were back on the
same upbeat page. At the beginning of the conference call, Tannin told investors, “The
key sort of big picture point for us at this point is our confidence that the structured credit
market and the sub-prime market in particular, has not systemically broken down; . . .
we’re very comfortable with exactly where we are.” Cioffi also assured investors that the
funds would likely finish the year with positive returns. On May 1, 2007, the two hedge
funds had attracted more than $60 million in new funds, but more than $28 million was
redeemed by investors.
That same day, Goldman sent BSAM marks ranging from 55 cents to 100 cents on the
dollar. Cioffi disputed Goldman’s marks as well as marks from Lehman, Citigroup, and
JP Morgan. On May 16, in a preliminary estimate, Cioffi told investors that the net asset
value of the Enhanced Leverage Fund was down 6.6% in April. In computing the final
numbers later that month, he requested that BSAM’s Pricing Committee instead use fair
value marks based on his team’s modeling, which implied losses that were $25 to $50
million less than losses using Goldman’s marks. On June 4, although Goldman’s marks
were considered low, the Pricing Committee decided to continue to average dealer
marks rather than to use fair value. The committee also noted that the decline in net
asset value would be greater than the 6.6% estimate, because “many of the positions
that were marked down received dealer marks after release of the estimate.” The decline
was revised from 6.6% to 19%. According to Cioffi, a number of factors contributed to
the April revision, and Goldman’s marks were one factor. After these meetings, Cioffi
emailed one committee member: “There is no market . . . its [sic] all academic anyway –
19% [value] is doomsday.” On June 7, BSAM announced the 19% drop and froze
IV. “Canary in the Mine Shaft”
When JP Morgan contacted Bear’s co-president Alan Schwartz in April about its
upcoming margin call, Schwartz convened an executive committee meeting to discuss
how repo lenders were marking down positions and making margin calls on the basis of
those new marks. In early June, Bear met with BSAM’s repo lenders to explain that
BSAM lacked cash to meet margin calls and to negotiate a 60-day reprieve. Some of
these very same firms had sold Enhanced and High-Grade some of the same CDOs and
other securities that were turning out to be such bad assets. Now all 10 refused
Spreading Subprime Worries
Schwartz’s appeal; instead, they made margin calls. As a direct result, the two funds had
to sell collateral at distressed prices to raise cash. Selling the bonds led to a complete
loss of confidence by the investors, whose requests for redemptions accelerated.
Shortly after BSAM froze redemptions, Merrill Lynch seized more than $850 million of its
collateral posted by Bear for its outstanding repo loans. Merrill was able to sell just $181
million of the seized collateral at auction by July 5 – and at discounts to its face value.
Other repo lenders were increasing their collateral requirements or refusing to roll over
their loans. This run on both hedge funds left both BSAM and Bear Stearns with limited
options. Although it owned the asset management business, Bear’s equity positions in
the two BSAM hedge funds were relatively small. On April 26, Bear’s co-president
Warren Spector approved a $25 million investment into the Enhanced Leverage Fund.
Bear Stearns had no legal obligation to rescue either the funds or their repo lenders.
However, those lenders were the same large investment banks that Bear Stearns dealt
with every day. Moreover, any failure of entities related to Bear Stearns could raise
investors’ concerns about the firm itself. Thomas Marano, the head of the mortgage
trading desk, told FCIC staff that the constant barrage of margin calls had created chaos
at Bear. In late June, Bear Stearns dispatched him to engineer a solution with Richard
Marin, BSAM’s CEO. Marano now worked to understand the portfolio, including what it
might be worth in a worst case scenario in which significant amounts of assets had to be
sold. Bear Stearns’s conclusion: High-Grade still had positive value, but Enhanced
Leverage did not.
On the basis of that analysis, Bear Stearns committed up to $3.2 billion – and ultimately
loaned $1.6 billion – to take out the High-Grade Fund repo lenders and become the sole
repo lender to the fund; Enhanced Leverage was on its own.
During a June Federal Open Market Committee (FOMC) meeting, members were
informed about the subprime market and the BSAM hedge funds. The staff reported that
the subprime market was “very unsettled and reflected deteriorating fundamentals in the
housing market.” The liquidation of subprime securities at the two BSAM hedge funds
was compared to the troubles faced by Long-Term Capital Management in 1998.
Chairman Bernanke noted that the problems the hedge funds experienced were a good
example of how leverage can increase liquidity risk, especially in situations in which
counterparties were not willing to give them time to liquidate and possibly realize
whatever value might be in the positions. But it was also noted that the BSAM hedge
funds appeared to be “relatively unique” among sponsored funds in their concentration in
subprime mortgages.
Meanwhile, Bear Stearns executives who supported the High-Grade bailout did not
expect to lose money. However, that support was not universal – CEO James Cayne
and Earl Hedin, the former senior managing director of Bear Stearns and BSAM, were
opposed, because they did not want to increase shareholders’ potential losses. Their
fears proved accurate. By July, the two hedge funds had shrunk to almost nothing: HighGrade Fund was down 91%; Enhanced Leverage Fund, 100%. On July 31, both filed for
bankruptcy. Cioffi and Tannin would be criminally charged with fraud in their
communications with investors, but they were acquitted of all charges in November
2009. Civil charges brought by the SEC were still pending as of the date of this report.
Spreading Subprime Worries
V. Rating Agencies: “It Can’t Be . . . All of a Sudden”
While BSAM was wrestling with its two ailing flagship hedge funds, the major credit
rating agencies finally admitted that subprime mortgage-backed securities would not
perform as advertised. On July 10, 2007, they issued comprehensive rating downgrades
and credit watch warnings on an array of residential mortgage-backed securities. These
announcements foreshadowed the actual losses to come.
S&P announced that it had placed 612 tranches backed by U.S. subprime collateral, or
some $7.35 billion in securities, on negative watch. S&P promised to review every deal
in its ratings database for adverse effects. In the afternoon, Moody’s downgraded 399
mortgage-backed securities issued in 2006 backed by U.S. subprime collateral and put
an additional 32 tranches on watch. These Moody’s downgrades affected about $5.2
billion in securities. The following day, Moody’s placed 184 tranches of CDOs, with
original face value of about $5 billion, on watch for possible downgrade. Two days after
its original announcement, S&P downgraded 498 of the 612 tranches it had placed on
negative watch. Fitch Ratings, the smallest of the three major credit rating agencies,
announced similar downgrades.
These actions were meaningful for all who understood their implications. While the
specific securities downgraded were only a small fraction of the universe (less than 2%
of mortgage-backed securities issued in 2006), investors knew that more downgrades
might come. Many investors were critical of the rating agencies, lambasting them for
their belated reactions. By July 2007, by one measure, housing prices had already fallen
about 4% nationally from their peak at the spring of 2006.
On a July 10 conference call with S&P, the hedge fund manager Steve Eisman
questioned Tom Warrack, the managing director of S&P’s residential mortgage-backed
securities group. Eisman asked, “I’d like to know why now. I mean, the news has been
out on subprime now for many, many months. The delinquencies have been a disaster
now for many, many months. (Your) ratings have been called into question now for
many, many months. I’d like to understand why you’re making this move today when you
– and why didn’t you do this many, many months ago. . . . I mean, it can’t be that all of a
sudden, the performance has reached a level where you’ve woken up.” Warrack
responded that S&P “took action as soon as possible given the information at hand.”
The ratings agencies’ downgrades, in tandem with the problems at Bear Stearns’s
hedge funds, had a further chilling effect on the markets. The ABX BBB- index fell
another 33% in July, confirming and guaranteeing even more problems for holders of
mortgage securities. Enacting the same inexorable dynamic that had taken down the
Bear Stearns funds, repo lenders increasingly required other borrowers that had put up
mortgage-backed securities as collateral to put up more, because their value was
unclear or depressed. Many of these borrowers sold assets to meet these margin calls,
and each sale had the potential to further depress prices. If at all possible, the borrowers
sold other assets in more liquid markets, for which prices were readily available, pushing
prices downward in those markets, too.
Spreading Subprime Worries
VI. AIG: “Well Bigger Than We Ever Planned For”
Of all the possible losers in the looming rout, AIG should have been among the most
concerned. After several years of aggressive growth, AIG’s Financial Products
subsidiary had written $79 billion in over-the-counter credit default swap (CDS)
protection on super-senior tranches of multisector CDOs backed mostly by subprime
In a phone call made July 11, the day after the downgrades, Andrew Forster, the head of
credit trading at AIG Financial Products, told Alan Frost, the executive vice president of
Financial Product’s Marketing Group, that he had to analyze exposures because “every
f***ing . . . rating agency we’ve spoken to . . . [came] out with more downgrades” and
that he was increasingly concerned: “About a month ago I was like, you know, suicidal. .
. . The problem that we’re going to face is that we’re going to have just enormous
downgrades on the stuff that we’ve got. . . . Everyone tells me that it’s trading and it’s
two points lower and all the rest of it and how come you can’t mark your book. So it’s
definitely going to give it renewed focus. I mean we can’t . . . we have to mark it. It’s, it’s,
uh, we’re [unintelligible] f***ed basically.”
Forster was likely worried that most of AIG’s credit default swap contracts required that
collateral be posted to the purchasers, should the market value of the referenced
securities decline by a certain amount, or should rating agencies downgrade AIG’s longterm debt. That is, collateral calls could be triggered even if there were no actual cash
losses in, for example, the super-senior tranches of CDOs upon which the protection
had been written. Remarkably, top AIG executives – including CEO Martin Sullivan, CFO
Steven Bensinger, Chief Risk Officer Robert Lewis, Chief Credit Officer Kevin McGinn,
and Financial Services Division CFO Elias Habayeb – told FCIC investigators that they
did not even know about these terms of the swaps until the collateral calls started rolling
in during July. Office of Thrift Supervision regulators who supervised AIG on a
consolidated basis didn’t know either. Frost, who was the chief credit default swap
salesman at AIG Financial Products, did know about the terms, and he said he believed
they were standard for the industry. Joseph Cassano, the division’s CEO, also knew
about the terms.
And the counterparties knew, of course. On the evening of July 26, Goldman Sachs,
which held $21 billion of AIG’s super-senior credit default swaps, sent news of the first
collateral call in the form of an email from Goldman’s salesman Andrew Davilman to
DAVILMAN: Sorry to bother you on vacation. Margin call coming your way. Want to give
you a heads up.
FROST, 18 minutes later: On what?
DAVILMAN, one minute later: 20bb [$20 billion] of supersenior.
The next day, Goldman made the collateral call official by forwarding an invoice
requesting $1.8 billion. On the same day, Goldman purchased $100 million of five year
protection – in the form of credit default swaps – against the possibility that AIG might
default on its obligations.
Spreading Subprime Worries
Frost never responded to Davilman’s email. And when he returned from vacation, he
was instructed to not have any involvement in the issue, because Cassano wanted
Forster to take the lead on resolving the dispute. AIG’s models showed there would be
no defaults on any of the bond payments that AIG’s swaps insured. The Goldman
executives considered those models irrelevant, because the contracts required collateral
to be posted if market value declined, irrespective of any long term cash losses.
Goldman estimated that the average decline in the market value of the bonds was 15%.
So, first Bear Stearns’s hedge funds and now AIG was getting hit by Goldman’s marks
on mortgage-backed securities. Like Cioffi and his colleagues at Bear Stearns, Frost and
his colleagues at AIG disputed Goldman’s marks. On July 30, Forster was told by
another AIG trader that “[AIG] would be in fine shape if Goldman wasn’t hanging its head
out there.” The margin call was “something that hit out of the blue and it’s a f***ing
number that’s well bigger than we ever planned for.” He acknowledged that dealers
might say the marks “could be anything from 80 to sort of, you know, 95” because of the
lack of trading but said Goldman’s marks were “ridiculous.”
In testimony to the FCIC, Viniar said Goldman had stood ready to sell mortgage-backed
securities to AIG at Goldman’s own marks. AIG’s Forster stated that he would not buy
the bonds at even 90 cents on the dollar, because values might drop further.
Additionally, AIG would be required to value its own portfolio of similar assets at the
same price. Forster said, “In the current environment I still wouldn’t buy them . . .
because they could probably go low . . . we can’t mark any of our positions, and
obviously that’s what saves us having this enormous mark to market. If we start buying
the physical bonds back then any accountant is going to turn around and say, well, John,
you know you traded at 90, you must be able to mark your bonds then.”
Tough, lengthy negotiations followed. Goldman “was not budging” on its collateral
demands, according to Tom Athan, a managing director at AIG Financial Products,
describing a conference call with Goldman executives on August 1. “I played almost
every card I had, legal wording, market practice, intent of the language, meaning of the
[contract], and also stressed the potential damage to the relationship and GS said that
this has gone to the ‘highest levels’ at GS and they feel that . . . this is a ‘test case.’”
Goldman Sachs and AIG would continue to argue about Goldman’s marks, even as AIG
would continue to post collateral that would fall short of Goldman’s demands and
Goldman would continue to purchase CDS contracts against the possibility of AIG’s
default. Over the next 14 months, more such disputes would cost AIG tens of billions of
dollars and help lead to one of the biggest government bailouts in American history.
Spreading Subprime Worries
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. During 2007, many banks experienced losses, interest rates increased, and credit
was harder to come by due to the demise of the housing market and the termination
of subprime lending.
a) true
b) false
2. Because of the “mark-to-market accounting rule,” why were more problems
becoming apparent in the market:
a) it gave financial institutions leniency in reporting their assets
b) it showed that financial institutions were not being generous enough with their
c) it required financial institutions to be more detailed when reporting their assets
d) it revealed that the exposure of large banks from securitizations was minimal
3. In July of 2007, why did many investors criticize the actions of the credit rating
a) the investors thought that the credit rating agencies were overreacting and the
downgrades were unnecessary
b) the subprime mortgage-backed securities were performing exceptionally
c) the investors believed that the credit rating agencies should have taken action
d) none of the above
Spreading Subprime Worries
1. A: True is correct. Because the housing market dropped and subprime lending
ended, many banks reported losses, interest rates increased, and credit was harder
to come by.
B: False is incorrect. Although changes in unemployment were not occurring, 2007
saw many other unfavorable changes in the economy.
(See page 12-1 of the course material.)
2. A: Incorrect. To the contrary, financial institutions were required to be more detailed
in reporting their assets.
B: Incorrect. This is not correct because many financial institutions were actually too
exposed during this time.
C: Correct. They were in fact required to provide more detailed reports in regard to
their assets which revealed the huge risks they were taking.
D: Incorrect. The opposite is true. Many large banks had great exposure from
(See page 12-1 of the course material.)
3. A: Incorrect. They believe the credit rating agencies did not perform soon enough.
B: Incorrect. Actually, sub-prime mortgage-backed securities were failing.
C: Correct. The investors felt that the signs were there and were disappointed that
the credit rating agencies did not act sooner.
D: Incorrect. One of the responses is correct.
(See page 12-8 of the course material.)
Spreading Subprime Worries
Chapter 13: Summer 2007 – Disruptions in Funding
In the summer of 2007, as the prices of some highly rated mortgage securities crashed
and Bear’s hedge funds imploded, broader repercussions from the declining housing
market were still not clear. “I don’t think [the subprime mess] poses any threat to the
overall economy,” Treasury Secretary Henry Paulson told Bloomberg on July 26.
Meanwhile, nervous market participants were looking under every rock for any sign of
hidden or latent subprime exposure. In late July, they found it in the market for assetbacked commercial paper (ABCP), a crucial, usually boring backwater of the financial
This kind of financing allowed companies to raise money by borrowing against highquality, short-term assets. By mid-2007, hundreds of billions out of the $1.2 trillion U.S.
ABCP market were backed by mortgage-related assets, including some with subprime
As noted, the rating agencies had given all of these ABCP programs their top
investment-grade ratings, often because of liquidity puts from commercial banks. When
the mortgage securities market dried up and money market mutual funds became
skittish about broad categories of ABCP, the banks would be required under these
liquidity puts to stand behind the paper and bring the assets onto their balance sheets,
transferring losses back into the commercial banking system. In some cases, to protect
relationships with investors, banks would support programs they had sponsored even
when they had made no prior commitment to do so.
I. IKB of Germany: “Real Money Investors”
The first big casualty of the run on asset-backed commercial paper was a German bank,
IKB Deutsche Industriebank AG. Since its foundation in 1924, IKB had focused on
lending to midsize German businesses, but in the past decade, management diversified.
In 2002, IKB created an off-balance-sheet commercial paper program, called Rhineland,
to purchase a portfolio of structured finance securities backed by credit card receivables,
business loans, auto loans, and mortgages. It made money by using less expensive
short-term commercial paper to purchase higher-yielding long-term securities, a strategy
known as “securities arbitrage.” By the end of June, Rhineland owned €14 billion ($18.9
billion) of assets, 95% of which were CDOs and CLOs (collateralized loan obligations –
that is, securitized leveraged loans). And at least €8 billion ($10.8 billion) of that was
protected by IKB through liquidity puts. Importantly, German regulators at the time did
not require IKB to hold any capital to offset potential Rhineland losses.
As late as June 2007, when so many were bailing out of the structured products market,
IKB was still planning to expand its off-balance-sheet holdings and was willing to take
long positions in mortgage-related derivatives such as synthetic CDOs. This attitude
made IKB a favorite of the investment banks and hedge funds that were desperate to
take the short side of the deal.
In early 2007, when Goldman was looking for buyers for Abacus 2007-AC1, the
synthetic CDO mentioned in Chapter 8, it looked to IKB. An employee of Paulson & Co.,
the hedge fund that was taking the short side of the deal, bluntly said that “real money”
investors such as IKB were outgunned. “The market is not pricing the subprime
[residential mortgage-backed securities] wipeout scenario,” the Paulson employee wrote
in an email. “In my opinion this situation is due to the fact that rating agencies, CDO
Disruptions in Funding
managers and underwriters have all the incentives to keep the game going, while ‘real
money’ investors have neither the analytical tools nor the institutional framework to take
action before the losses that one could anticipate based [on] the ‘news’ available
everywhere are actually realized.” IKB subsequently purchased $150 million of the A1
and A2 tranches of the Abacus CDO and placed them in Rhineland. It would lose 100%
of that investment.
In mid-2007, Rhineland’s asset-backed commercial paper was held by a number of
American investors, including the Montana Board of Investments, the city of Oakland,
California, and the Robbinsdale Area School District in suburban Minneapolis. On July
20, IKB reassured its investors that ratings downgrades of mortgage-backed securities
would have only a limited impact on its business. However, within days, Goldman Sachs,
which regularly helped Rhineland raise money in the commercial paper market, told IKB
that it would not sell any more Rhineland paper to its clients. On Friday, July 27,
Deutsche Bank, recognizing that the ABCP markets would soon abandon Rhineland and
that IKB would have to provide substantial support to the program, decided that doing
business with IKB was too risky and cut off its credit lines. These were necessary for IKB
to continue running its business. Deutsche Bank also alerted the German bank regulator
to IKB’s critical state. With the regulator’s encouragement, IKB’s largest shareholder,
KfW Bankengruppe, announced on July 30 that it would bail out IKB. On August 7,
Rhineland exercised its liquidity puts with IKB. Rhineland’s commercial paper investors
were able to get rid of the paper, and KfW took the hit instead – with its losses expected
to eventually reach 95%.
The IKB episode served notice that exposures to toxic mortgage assets were lurking in
the portfolios of even risk-averse investors. Soon, panic seized the short-term funding
markets – even those that were not exposed to risky mortgages. “There was a
recognition, I’d say an acute recognition, that potentially some of the asset-backed
commercial paper conduits could have exposure to those areas. As a result, investors in
general – without even looking into the underlying assets – decided ‘I don’t want to be in
any asset-backed commercial paper, I don’t want to invest in a fund that may have those
positions,’” Steven Meier, global cash investment officer at State Street Global Advisors,
testified to the FCIC.
From its peak of $1.2 trillion on August 8, the asset-backed commercial paper market
would decline by almost $400 billion by the end of 2007.
II. Countrywide: “That’s Our 9/11”
On August 2, three days after the IKB rescue, Countrywide CEO Angelo Mozilo realized
that his company was unable to roll its commercial paper or borrow on the repo market.
“When we talk about [August 2] at Countrywide, that’s our 9/11,” he said. “We worked
seven days a week trying to figure this thing out and trying to work with the banks. . . .
Our repurchase lines were coming due billions and billions of dollars.”
Mozilo emailed Lyle Gramley, a former Fed governor and a former Countrywide director,
“Fear in the credit markets is now tending towards panic. There is little to no liquidity in
the mortgage market with the exception of Fannie and Freddie. . . . Any mortgage
product that is not deemed to be conforming either cannot be sold into the secondary
markets or are subject to egregious discounts.”
Disruptions in Funding
On August 2, despite the internal turmoil at Countrywide, CFO Eric Sieracki told
investors that Countrywide had “significant short-term funding liquidity cushions” and
“ample liquidity sources of our bank. . . . It is important to note that the company has
experienced no disruption in financing its ongoing daily operations, including placement
of commercial paper.” Moody’s reaffirmed its A3 ratings and stable outlook on the
The ratings agencies and the company itself would quickly reverse their positions. On
August 6, Mozilo reported to the board during a specially convened meeting that, as the
meeting minutes recorded, “the secondary market for virtually all classes of mortgage
securities (both prime and non-prime) had unexpectedly and with almost no warning
seized up and . . . the Company was unable to sell high-quality mortgage[-]backed
securities.” President and COO David Sambol told the board, “Management can only
plan on a week by week basis due to the tenuous nature of the situation.” Mozilo
reported that although he continued to negotiate with banks for alternative sources of
liquidity, the “unprecedented and unanticipated” absence of a secondary market could
force the company to draw down on its backup credit lines.
Shortly after the Countrywide board meeting, the Fed’s Federal Open Market Committee
members discussed the “considerable financial turbulence” in the subprime mortgage
market and that some firms, including Countrywide, were showing some strain. They
noted that the data did not indicate a collapse of the housing market was imminent and
that, if the more optimistic scenarios proved to be accurate, they might look back and be
surprised that the financial events did not have a stronger impact on the real economy.
But the FOMC members also expressed concern that the effects of subprime
developments could spread to other sectors and noted that they had been repeatedly
surprised by the depth and duration of the deterioration of these markets. One
participant, in a paraphrase of a quote he attributed to Winston Churchill, said that no
amount of rewriting of history would exonerate those present if they did not prepare for
the more dire scenarios discussed in the staff presentations.
Several days later, on August 14, Countrywide released its July 2007 operational results,
reporting that foreclosures and delinquencies were up and that loan production had
fallen by 14% during the preceding month. A company spokesman said layoffs would be
considered. On the same day, Fed staff, who had supervised Countrywide’s holding
company until the bank switched to a thrift charter in March 2007, sent a confidential
memo to the Fed’s Board of Governors warning about the company’s condition:
The company is heavily reliant on an originate-to-distribute model, and,
given current market conditions, the firm is unable to securitize or sell any
of its non-conforming mortgages. . . . Countrywide’s short-term funding
strategy relied heavily on commercial paper (CP) and, especially, on
ABCP. In current market conditions, the viability of that strategy is
questionable. . . . The ability of the company to use [mortgage] securities
as collateral in [repo transactions] is consequently uncertain in the current
market environment. . . . As a result, it could face severe liquidity
pressures. Those liquidity pressures conceivably could lead eventually to
possible insolvency.
Disruptions in Funding
Countrywide asked its regulator, the Office of Thrift Supervision, if the Fed could provide
assistance, perhaps by waiving a Fed rule and allowing Countrywide’s thrift subsidiary to
support its holding company by raising money from insured depositors, or perhaps
through discount-window lending, which would require the Fed to accept risky mortgagebacked securities as collateral, something it never had done and would not do – until the
following spring. The Fed did not intervene: “Substantial statutory requirements would
have to be met before the Board could authorize lending to the holding company or
mortgage subsidiary,” staff wrote. “The Federal Reserve had not lent to a nonbank in
many decades; and . . . such lending in the current circumstances seemed highly
The following day, lacking any other funding, Mozilo recommended to his board that the
company notify lenders of its intention to draw down $11.5 billion on backup lines of
credit. Mozilo and his team knew that the decision could lead to ratings downgrades.
“The only option we had was to pull down those lines,” he told the FCIC. “We had a
pipeline of loans and we either had to say to the borrowers, the customers, ‘we’re out of
business, we’re not going to fund’ – and there’s great risk to that, litigation risk, we had
committed to fund. . . . When it’s between your ass and your image, you hold on to your
On the same day that Countrywide’s board approved the $11.5 billion drawdown – but
before the company announced it publicly, the Merrill Lynch analyst Kenneth Bruce, who
had reissued his “buy” rating on the company’s stock two days earlier, switched to “sell”
with a “negative” outlook because of Countrywide’s funding pressures, adding, “if the
market loses confidence in its ability to function properly, then the model can break. . . .
If liquidations occur in a weak market, then it is possible for [Countrywide] to go
The next day, as news of Bruce’s call spread, Countrywide informed markets about the
drawdown. Moody’s downgraded its senior unsecured debt rating to the lowest tier of
investment grade. Countrywide shares fell 11%, closing at $18.95; for the year, the
company’s stock was down 50%. The bad news led to an old-fashioned bank run. Mozilo
singled out an August 16 Los Angeles Times article covering Bruce’s report, which, he
said, “caused a run on our bank of $8 billion on Monday.” The article spurred customers
to withdraw their funds by noting specific addresses of Countrywide branches in
southern California, Mozilo told the FCIC. A reporter “came out with a photographer and,
you know, interviewed the people in line, and he created – it was just horrible. Horrible
for the people, horrible for us. Totally unnecessary,” Mozilo said.
Six days later, on August 22, Bank of America announced it would invest $2 billion for a
16% stake in Countrywide. Both companies denied rumors that the nation’s biggest bank
would soon acquire the mortgage lender. Mozilo told the press, “There was never a
question about our survival”; he said the investment reinforced Countrywide’s position as
one of the “strongest and best-run companies in the country.”
In October, Countrywide reported a net loss of $1.2 billion, its first quarterly loss in 25
years. As charge-offs on its mortgage portfolio grew, Countrywide raised provisions for
loan losses to $934 million from only $38 million one year earlier. On January 11, 2008,
Bank of America issued a press release announcing a “definitive agreement” to
purchase Countrywide for approximately $4 billion. It said the combined entity would
stop originating subprime loans and would expand programs to help distressed
Disruptions in Funding
III. BNP Paribas: “The Ringing of the Bell”
Meanwhile, problems in U.S. financial markets hit the largest French bank. On August 9,
BNP Paribas SA suspended redemptions from three investment funds that had plunged
20% in less than two weeks. Total assets in those funds were $2.2 billion, with a third of
that amount in subprime securities rated AA or higher. The bank said it would also stop
calculating a fair market value for the funds because “the complete evaporation of
liquidity in certain market segments of the US securitization market has made it
impossible to value certain assets fairly regardless of their quality or credit rating.”
In retrospect, many investors regarded the suspension of the French funds as the
beginning of the 2007 liquidity crisis. August 9 “was the ringing of the bell” for short-term
funding markets, Paul McCulley, a managing director at PIMCO, told the FCIC. “The
buyers went on a buyer strike and simply weren’t rolling.” That is, they stopped rolling
over their commercial paper and instead demanded payment on their loans. On August
9, the interest rates for overnight lending of A-1 rated asset-backed commercial paper
rose from 5.39% to 5.75% - the highest level since January 2001. It would continue
rising unevenly, hitting 6.14% in August 10, 2007.
In August alone, the asset-backed commercial paper market shrank by $190 billion, Or
20%. On August 6, subprime lender American Home Mortgage’s asset-backed
commercial paper program invoked its privilege of postponing repayment, trapping
lenders’ money for several months. Lenders quickly withdrew from programs with similar
provisions, which shrank that market from $35 billion to $4 billion between May and
The paper that did sell had significantly shorter maturities, reflecting creditors’ desire to
reassess their counterparties’ creditworthiness as frequently as possible. The average
maturity of all asset-backed commercial paper in the United States fell from about 31
days in late July to about 23 days by mid-September, though the overwhelming majority
was issued for just 1 to 4 days.
Disruptions quickly spread to other parts of the money market. In a flight to quality,
investors dumped their repo and commercial paper holdings and increased their
holdings in seemingly safer money market funds and Treasury bonds. Market
participants, unsure of each other’s potential subprime exposures, scrambled to amass
funds for their own liquidity. Banks became less willing to lend to each other. A closely
watched indicator of interbank lending rates, called the one-month LIBOR-OIS spread,
increased, signifying that banks were concerned about the credit risk involved in lending
to each other. On August 9, it rose sharply, increasing three- to fourfold over historical
values, and by September 7, it climbed by another 150%. In 2008, it would peak much
The panic in the repo, commercial paper, and interbank markets was met by immediate
government action. On August 10, the day after BNP Paribas suspended redemptions,
the Fed announced that it would “provid[e] liquidity as necessary to facilitate the orderly
functioning of financial markets,” and the European Central Bank infused billions of
Euros into overnight lending markets. On August 17, the Fed cut the discount rate by 50
basis points – from 6.25% to 5.75%. This would be the first of many such cuts aimed at
increasing liquidity. The Fed also extended the term of discount-window lending to 30
days (from the usual overnight or very short-term period) to offer banks a more stable
Disruptions in Funding
source of funds. On the same day, the Fed’s FOMC released a statement
acknowledging the continued market deterioration and promising that it was “prepared to
act as needed to mitigate the adverse effects on the economy.”
IV. SIVs: “An Oasis of Calm”
In August, the turmoil in asset-backed commercial paper markets hit the market for
structured investment vehicles, or SIVs, even though most of these programs had little
subprime mortgage exposure. SIVs had a stable history since their introduction in 1988.
These investments had weathered a number of credit crises – even through early
summer of 2007, as noted in a Moody’s report issued on July 20, 2007, titled “SIVs: An
Oasis of Calm in the Sub-prime Maelstrom.”
Unlike typical asset-backed commercial paper programs, SIVs were funded primarily
through medium-term notes – bonds maturing in one to five years. SIVs held significant
amounts of highly liquid assets and marked those assets to market prices daily or
weekly, which allowed them to operate without explicit liquidity support from their
The SIV sector tripled in assets between 2004 and 2007. On the eve of the crisis, there
were 36 SIVs with almost $400 billion in assets. About one-quarter of that money was
invested in mortgage-backed securities or in CDOs, but only 6% was invested in
subprime mortgage-backed securities and CDOs holding mortgage-backed securities.
Not surprisingly, the first SIVs to fail were concentrated in subprime mortgage-backed
securities, mortgage-related CDOs, or both. These included Cheyne Finance (managed
by London-based Cheyne Capital Management), Rhinebridge (another IKB program),
Golden Key, and Mainsail II (both structured by Barclays Capital). Between August and
October, each of these four was forced to restructure or liquidate.
Investors soon ran from even the safer SIVs. “The media was quite happy to
sensationalize the collapse of the next ‘leaking SIV’ or the next ‘SIV-positive’ institution,”
then-Moody’s managing director Henry Tabe told the FCIC. The situation was
complicated by the SIVs’ lack of transparency. “In a context of opacity about where risk
resides, . . . a general distrust has contaminated many asset classes. What had once
been liquid is now illiquid. Good collateral cannot be sold or financed at anything
approaching its true value,” Moody’s wrote on September 5.
Even high-quality assets that had nothing to do with the mortgage market were declining
in value. One SIV marked down a CDO to seven cents on the dollar while it was still
rated triple-A. To raise cash, managers sold assets. But selling high-quality assets into a
declining market depressed the prices of these unimpaired securities and pushed down
the market values of other SIV portfolios.
By the end of November, SIVs still in operation had liquidated 23% of their portfolios, on
average. Sponsors rescued some SIVs. Other SIVs restructured or liquidated; some
investors had to wait a year or more to receive payments and, even then, recouped only
some of their money. In the case of Rhinebridge, investors lost 45% and only gradually
received their payments over the next year. Investors in one SIV, Sigma, lost more than
95%. As of fall 2010, not a single SIV remained in its original form. The subprime crisis
had brought to its knees a historically resilient market in which losses due to subprime
mortgage defaults had been, if anything, modest and localized.
Disruptions in Funding
V. Money Funds and Other Investors: “Drink[ing] from a Fire Hose”
The next dominoes were the money market funds and other funds. Most were
sponsored by investment banks, bank holding companies, or “mutual fund complexes”
such as Fidelity, Vanguard, and Federated. Under SEC regulations, money market funds
that serve retail investors must keep two sets of accounting books, one reflecting the
price they paid for securities and the other the fund’s mark-to-market value (the “shadow
price,” in market parlance). However, funds do not have to disclose the shadow price
unless the fund’s net asset value (NAV) has fallen by 0.5% below $1 (to $0.995) per
share. Such a decline in market value is known as “breaking the buck” and generally
leads to a fund’s collapse. It can happen, for example, if just 5% of a fund’s portfolio is in
an investment that loses just 10% of its value. So a fund manager cannot afford big
But SIVs were considered very safe investments – they always had been – and were
widely held by money market funds. In fall 2007, dozens of money market funds faced
losses on SIVs and other asset-backed commercial paper. To prevent their funds from
breaking the buck, at least 44 sponsors, including large banks such as Bank of America,
US Bancorp, and SunTrust, purchased SIV assets from their money market funds.
Similar dramas played out in the less-regulated realm of the money market sector known
as enhanced cash funds. These funds serve not retail investors but rather “qualified
purchasers,” which may include wealthy investors who invest $25 million or more.
Enhanced cash funds fall outside most SEC regulations and disclosure requirements.
Because they have much higher investment thresholds than retail funds, and because
they face less regulation, investors expect somewhat riskier investing and higher returns.
Nonetheless, these funds also aim to maintain a $1 net asset value.
As the market turned, some of these funds did break the buck, while the sponsors of
others stepped in to support their value. The $5 billion GE Asset Management Trust
Enhanced Cash Trust, a GE-sponsored fund that managed GE’s own pension and
employee benefit assets, ran aground in the summer; it had 50% of its assets in
mortgage-backed securities. When the fund reportedly lost $200 million and closed in
November 2007, investors redeemed their interests at $0.96. Bank of America supported
its Strategic Cash Portfolio – the nation’s largest enhanced cash fund, with $40 billion in
assets at its peak – after one of that fund’s largest investors withdrew $20 billion in
November 2007.
An interesting case study is provided by the meteoric rise and decline of the Credit
Suisse Institutional Money Market Prime Fund. The fund sought to attract investors
through Internet-based trading platforms called “portals,” which supplied an estimated
$300 billion to money market funds and other funds. Investors used these portals to
quickly move their cash to the highest-yielding fund. Posting a higher return could attract
significant funds: one money market fund manager later compared the use of portal
money to “drink[ing] from a fire hose.” But the money could vanish just as quickly. The
Credit Suisse fund posted the highest returns in the industry during the 12 months
before the liquidity crisis, and increased its assets from about $5 billion in the summer of
2006 to more than $25 billion in the summer of 2007. To deliver those high returns and
attract investors, though, it focused on structured finance products, including CDOs and
SIVs such as Cheyne. When investors became concerned about such assets, they
yanked about $10 billion out of the fund in August 2007 alone. Credit Suisse, the Swiss
Disruptions in Funding
bank that sponsored the fund, was forced to bail it out, purchasing $5.7 billion of assets
in August. The episode highlights the risks of money market funds’ relying on “hot
money” – that is, institutional investors who move quickly in and out of funds in search of
the highest returns.
The losses on SIVs and other mortgage-tainted investments also battered local
government investment pools across the country, some of which held billions of dollars
in these securities. Pooling provides municipalities, school districts, and other
government agencies with economies of scale, investment diversification, and liquidity.
In some cases, participation is mandatory.
With $27 billion in assets, Florida’s local government investment pool was the largest in
the country, and “intended to operate like a highly liquid, low-risk money market fund,
with securities like cash, certificates of deposit, . . . U.S. Treasury bills, and bonds issued
by other U.S. government agencies,” as an investigation by the state legislature noted.
But by November 2007, because of ratings downgrades, the fund held at least $1.5
billion in securities that no longer met the state’s requirements. It had more than $2
billion in SIVs and other distressed securities, of which about $725 million had already
defaulted. And it held $650 million in Countrywide certificates of deposit with maturities
that stretched out as far as June 2008. In early November, following a series of news
reports, the fund suffered a run. Local governments withdrew $8 billion in just two
weeks. Orange and Pinellas counties pulled out their entire investments. On November
29, the fund’s managers stopped all withdrawals. Florida’s was the hardest hit, but other
state investment pools also took significant losses on SIVs and other mortgage-related
Disruptions in Funding
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. Which of the following is among the impacts of the financial crisis on the commercial
paper market:
it spurred the market because these assets were seen by investors as safe
the market shrank considerably
investors who did buy commercial paper looked for shorter maturities
both b and c above
2. While the Federal Reserve made many moves to increase liquidity into the financial
markets, there was no action on the part of the European Central Bank.
a) true
b) false
3. Which of the following statements about Structured Investment Vehicles (SIVs) is not
almost all SIV funds were heavily invested in mortgage-backed securities
the SIV market did not have significant exposure to the subprime market
SIVs were funded by mostly medium-term notes
the SIV sector grew significantly between 2004 and 2007
Disruptions in Funding
1. A: Incorrect. To the contrary, investors were skittish about the quality of these assets,
and the market faced a significant deterioration.
B: Incorrect. Indeed, sharp drops were seen throughout the market. However, this is
not the best answer.
C: Incorrect. Investors wanted shorter maturities so they could get out of the
investment sooner if they felt uncomfortable. However, this is not the best answer.
D: Correct. Both shrinking of the market and the interest in shorter maturities were
some of the ways the financial crisis impacted the commercial paper market.
(See page 13-2 of the course material.)
2. A: True is incorrect. The European Central Bank took its own steps to infuse liquidity
back into the marketplace.
B: False is correct. In the face of crisis in the European markets, the European
Central Bank infused cash to help the liquidity crisis.
(See page 13-5 of the course material.)
3. A: Correct. Only a limited number were invested in mortgage-backed securities, and
those were the ones that failed.
B: Incorrect. Few were invested in this area.
C: Incorrect. Indeed, these notes usually had maturities ranging from one to five
D: Incorrect. The sector actually tripled during this time period.
(See pages 13-6 of the course material.)
Disruptions in Funding
Chapter 14: Late 2007 to Early 2008 –
Billions in Subprime Losses
While a handful of banks were bailing out their money market funds and commercial
paper programs in the fall of 2007, the financial sector faced a larger problem: billions of
dollars in mortgage-related losses on loans, securities, and derivatives, with no end in
sight. Among U.S. firms, Citigroup and Merrill Lynch reported the most spectacular
losses, largely because of their extensive collateralized debt obligation (CDO)
businesses, writing down a total of $23.8 billion and $24.7 billion, respectively, by the
end of the year. Billions more in losses were reported by large financial institutions such
as Bank of America ($9.7 billion), Morgan Stanley ($10.3 billion), JP Morgan ($5.3
billion), and Bear Stearns ($2.6 billion). Insurance companies, hedge funds, and other
financial institutions collectively had taken additional mortgage-related losses of about
$100 billion.
The large write-downs strained these firms’ capital and cash reserves. Further, market
participants began discriminating between firms perceived to be relatively healthy and
others about which they were not so sure. Bear Stearns and Lehman Brothers were at
the top of the “suspect” list; by year-end 2007 the cost of five-year protection against
default on their obligations in the credit default swap market stood at, respectively,
$176,000 and $119,000 annually for every $10 million, while the cost for the relatively
stronger Goldman Sachs stood at $68,000.
Meanwhile, the economy was beginning to show signs of stress. Facing turmoil in
financial markets, declining home prices, and oil prices above $75 a barrel, consumer
spending was slowing. The Federal Reserve lowered the overnight bank borrowing rate
from 5.25% earlier in the year to 4.75% in September, 4.5% in October, and then 4.25%
in December.
I. Merrill Lynch: “Dawning Awareness Over the Course of the Summer”
On October 24, Merrill Lynch stunned investors when it announced that third quarter
earnings would include a $6.9 billion loss on CDOs and $1 billion on subprime
mortgages – $7.9 billion in total, the largest Wall Street write-down to that point, and
nearly twice the $4.5 billion loss that the company had warned investors to expect just
three weeks earlier. Six days later, the embattled CEO Stanley O’Neal, a 21-year Merrill
veteran, resigned.
Much of this write-down came from the firm’s holdings of the super-senior tranches of
mortgage-related CDOs that Merrill had previously thought to be extremely safe. As late
as fall 2006, its management had been “bullish on growth” and “bullish on [the subprime]
asset class.” But later that year, the signs of trouble were becoming difficult even for
Merrill to ignore. Two mortgage originators to which the firm had extended credit lines
failed: Ownit, in which Merrill also had a small equity stake, and Mortgage Lenders
Network. Merrill seized the collateral backing those loans: $1.5 billion from Mortgage
Lenders, $1.2 billion from Ownit.
Merrill, like many of its competitors, started to ramp up its sales efforts, packaging its
inventory of mortgage loans and securities into CDOs with new vigor. Its goal was to
reduce the firm’s risk by getting those loans and securities off its balance sheet. Yet it
Billions in Subprime Losses
found that it could not sell the super-senior tranches of those CDOs at acceptable prices;
– it therefore had to “take down senior tranches into inventory in order to execute deals”
– leading to the accumulation of tens of billions of dollars of those tranches on Merrill’s
books. Dow Kim, then the co-president of Merrill’s investment banking segment, told
FCIC staff that the buildup of the retained super-senior tranches in the CDO positions
was actually part of a strategy begun in late 2006 to reduce the firm’s inventory of
subprime and Alt-A mortgages. Sell the lower-rated CDO tranches, retain the supersenior tranches: those had been his instructions to his managers at the end of 2006, Kim
recalled. He believed that this strategy would reduce overall credit risk. After all, the
super-senior tranches were theoretically the safest pieces of those investments. To
some degree, however, the strategy was involuntary: his people were having trouble
selling these investments, and some were even sold at a loss.
On October 21, Merrill executives gave its board a detailed account of how the firm
found itself with what was by that time $15.2 billion in net exposure to the super-senior
tranches – down from a peak in July of $32.2 billion because the firm had increasingly
hedged, written off, and sold its exposure. On October 24, Merrill announced its thirdquarter earnings: a stunning $7.9 billion mortgage-related write-down contributing to a
net loss of $2.3 billion. Merrill also reported – for the first time – its $15.2 billion net
exposure to retained CDO positions. Still, in their conference call with analysts, O’Neal
and Edwards refused to disclose the gross exposures, excluding the hedges from the
monolines and AIG. “I just don’t want to get into the details behind that,” Edwards said.
“Let me just say that what we have provided again we think is an extraordinarily high
level of disclosure and it should be sufficient.” According to the Securities and Exchange
Commission, by September 2007, Merrill had accumulated $55 billion of “gross” retained
CDO positions, almost four times the $15.2 billion of “net” CDO positions reported during
the October 24 conference call.
On October 30, when O’Neal resigned, he left with a severance package worth $161.5
million – on top of the $91.4 million in total compensation he earned in 2006, when his
company was still expanding its mortgage banking operations. Kim, who oversaw the
strategy that left Merrill with billions in losses, had left in May 2007 after being paid $40
million for his work in 2006, which was a profitable year for Merrill as a firm.
By late 2007, the viability of the monoline insurers from which Merrill had purchased
almost $100 billion in hedges had come into question, and the rating agencies were
downgrading them, as we will see in more detail shortly. The SEC had told Merrill that it
would impose a punitive capital charge on the firm if it purchased additional credit default
protection from the financially troubled monolines. Recognizing that the monolines might
not be good for all the protection purchased, Merrill began to put aside loss allowances,
starting with $2.6 billion on January 17, 2008. By the end of 2008, Merrill would put aside
a total of $13 billion related to monolines and had recorded total write-downs on nearly
$44 billion of other mortgage-related exposures.
II. Citigroup: “That Would Not in Any Way Have Excited My Attention”
Five days after O’Neal’s October 30 departure from Merrill Lynch, Citigroup announced
that its total subprime exposure was $55 billion, which was $42 billion more than it had
told investors just three weeks earlier. Citigroup also announced it would be taking an $8
to $11 billion loss on its subprime mortgage-related holdings and that Chuck Prince was
resigning as its CEO. Like O’Neal, Prince had learned late of his company’s subprime-
Billions in Subprime Losses
related CDO exposures. Prince and Robert Rubin, chairman of the Executive Committee
of the board, told the FCIC that before September 2007, they had not known that
Citigroup’s investment banking division had sold some CDOs with liquidity puts and
retained the super-senior tranches of others.
Prince told the FCIC that even in hindsight it was difficult for him to criticize any of his
team’s decisions. “If someone had elevated to my level that we were putting on a $2
trillion balance sheet, $40 billion of triple-A-rated, zero-risk paper, that would not in any
way have excited my attention,” Prince said. “It wouldn’t have been useful for someone
to come to me and say, ‘Now, we have got $2 trillion on the balance sheet of assets. I
want to point out to you there is a one in a billion chance that this $40 billion could go
south.’ That would not have been useful information. There is nothing I can do with that,
because there is that level of chance on everything.” In fact, the odds were much higher
than that. Even before the mass downgrades of CDOs in late 2007, a triple-A tranche of
a CDO had a 1 in 10 chance of being downgraded within 5 years of its original rating.
Certainly, Citigroup was a large and complex organization. That $2 trillion balance sheet
– and $1.2 trillion off-balance sheet – was spread among more than 2,000 operating
subsidiaries in 2007. Prince insisted that Citigroup was not “too big to manage.” But it
was an organization in which one unit would decide to reduce mortgage risk while
another unit increased it. And it was an organization in which senior management would
not be notified of $43 billion in concentrated exposure – 2% of the company’s balance
sheet and more than a third of its capital – because it was perceived to be “zero-risk
Significantly, Citigroup’s Financial Control Group had argued in 2006 that the liquidity
puts that Citigroup had written on its CDOs had been priced for investors too cheaply in
light of the risks. Also, in early 2006, Susan Mills, a managing director in the
securitization unit – which bought mortgages from other companies and bundled them
for sale to investors – took note of rising delinquencies in the subprime market and
created a surveillance group to track loans that her unit purchased. By mid-2006, her
group saw a deterioration in loan quality and an increase in early payment defaults – that
is, more borrowers were defaulting within a few months of getting a loan. From 2005 to
2007, Mills recalled before the FCIC, the early payment default rates nearly tripled from
2% to 5% or 6%. In response, the securitization unit slowed down its purchase of loans,
demanded higher-quality mortgages, and conducted more extensive due diligence on
what it bought. However, neither Mills nor other members of the unit shared any of this
information with other divisions in Citigroup, including the CDO desk. Around March or
April 2007, in contrast with the securitization desk, Citigroup’s CDO desk increased its
purchases of mortgage-backed securities because it saw the distressed market as a
buying opportunity.
Co-head of the CDO desk Janice Warne told the FCIC that she first saw weaknesses in
the underlying market in early 2007. In February, when the ABX.HE.BBB- 06-2 fell to
37% below par, the CDO desk decided to slow down on the financing of mortgage
securities for inventory to produce CDOs. Shortly thereafter, however, the same ABX
index started to rally, rising to 26% below par in March and holding around that level
through May. So, the CDO desk reversed course and accelerated its purchases of
inventory in April, according to Nestor Dominguez, Warne’s co-head on the CDO desk.
Dominguez said he didn’t see the market weakening until the summer, when the index
fell to less than 60% below par.
Billions in Subprime Losses
Murray Barnes, the Citigroup risk officer assigned to the CDO business, approved the
CDO desk’s request to temporarily increase its limits on purchasing collateral. Barnes
observed, in hindsight, that rather than looking at the widening spreads as an
opportunity, Citigroup should have reassessed its assumptions and examined whether
the decline in the ABX was a sign of strain in the mortgage market. He admitted
“complacency” about the desk’s ability to manage its risk.
The risk management division also increased the CDO desk’s limits for retaining the
most senior tranches from $30 billion to $35 billion in the first half of 2007. As at Merrill,
traders and risk managers at Citigroup believed that the super-senior tranches carried
little risk. Citigroup’s regulators later wrote, “An acknowledgement of the risk in its Super
Senior AAA CDO exposure was perhaps Citigroup’s ‘biggest miss.’ . . . As management
felt comfortable with the credit risk of these tranches, it began to retain large positions on
the balance sheet. . . . As the sub-prime market began to deteriorate, the risk perceived
in these tranches increased, causing large write-downs.” Ultimately, losses at Citigroup
from mortgages, Alt-A mortgage-backed securities, and mortgage-related CDOs would
total about $58 billion, nearly half of Citigroup’s capital at the end of 2006. About $8
billion of that loss related to protection purchased from the monoline insurers.
Barnes’s decision to increase the CDO risk limits was approved by his superior, Ellen
Duke. Barnes and Duke reported to David Bushnell, the chief risk officer. Bushnell –
whom Prince called “the best risk manager on Wall Street” – told the FCIC that he did
not remember specifically approving the increase but that, in general, the risk
management function did approve higher risk limits when a business line was growing.
He described a “firm-wide initiative” to increase Citigroup’s structured products business.
III. “That Has Never Happened Since The Depression”
Citigroup and Merrill Lynch executives appeared to believe up until the fall of 2007 that
any downside risk in the CDO business was minuscule. Citigroup’s risk management
function was simply not very concerned about housing market risks. According to Prince,
Bushnell and others told him, in effect, “‘Gosh, housing prices would have to go down
30% nationwide for us to have, not a problem with [mortgage-backed securities] CDOs,
but for us to have problems,’ and that has never happened since the Depression.”
Housing prices would be down much less than 30% when Citigroup began having
problems because of write-downs and the liquidity puts it had written.
By June 2007, national house prices had fallen 4.5%, and about 16% of subprime
adjustable-rate mortgages were delinquent. Yet Citigroup still did not expect that the
liquidity puts could be triggered, and it remained unconcerned about the value of its
retained super-senior tranches of CDOs. On June 4, 2007, Citigroup made a
presentation to the SEC about subprime exposure in its CDO business. The
presentation noted that Citigroup did not factor two positions into this exposure: $14.6
billion in super-senior tranches and $23.2 billion in liquidity puts. The presentation
explained that the liquidity puts were not a concern: “The risk of default is extremely
unlikely . . . [and] certain market events must also occur for us to be required to fund.
Therefore, we view these positions to be even less risky than the Super Senior Book.”
Billions in Subprime Losses
Just a few weeks later, the July 2007 failure of the two Bear Stearns hedge funds
spelled trouble. Commercial paper written against three Citigroup-underwritten CDOs for
which Bear Stearns Asset Management was the asset manager and on which Citigroup
had issued liquidity puts began losing value, and their interest rates began rising. The
liquidity puts would be triggered if interest rates on the asset-backed commercial paper
rose above a certain level.
The Office of the Comptroller of the Currency, the regulator of Citigroup’s national bank
subsidiary, had expressed no apprehensions about the liquidity puts in 2003. But by the
summer of 2007, OCC Examiner-in-Charge John Lyons told the FCIC, the OCC became
concerned. Buying the commercial paper would drain $25 billion of the company’s cash
and expose it to possible balance-sheet losses at a time when markets were
increasingly in distress. But given the rising rates, Lyons also said Citigroup did not have
the option to wait. Over the next six months, Citigroup purchased all $25 billion of the
paper that had been subject to its liquidity puts.
On a July 20 conference call, CFO Gary Crittenden told analysts and investors that the
company’s subprime exposures had fallen from $24 billion at the end of 2006 to $13
billion on June 30. But he made no mention of the super-senior exposures and liquidity
puts. “I think our risk team did a nice job of anticipating that this was going to be a
difficult environment, and so set about in a pretty concentrated effort to reduce our
exposure over the last six months,” he said. A week later, on a July 27 call, Crittenden
reiterated that subprime exposure had been cut: “So I think we’ve had good risk
management that has been anticipating some market dislocation here.”
By August, as market conditions worsened, Citigroup’s CDO desk was revaluing its
super-senior tranches, though it had no effective model for assigning value. However, as
the market congealed, then froze, the paucity of actual market prices for these tranches
demanded a model. The New York Fed later noted that “the model for Super Senior
CDOs, based on fundamental economic factors, could not be fully validated by
Citigroup’s current validation methodologies yet it was relied upon for reporting
Barnes, the CDO risk officer, told the FCIC that sometime that summer he met with the
co-heads of the CDO desk to express his concerns about possible losses on both the
unsold CDO inventory and the retained super-senior tranches. The message got
through. Nestor Dominguez told the FCIC, “We began extensive discussions about the
implications of the . . . dramatic decline of the underlying subprime markets, and how
that would feed into the super-senior positions.” Also at this time – for the first time –
such concerns reached Maheras. He justified his lack of prior knowledge of the billions
of dollars in inventory and super-senior tranches by pointing out “that the business was
appropriately supervised by experienced and highly competent managers and by an
independent risk group and that I was properly apprised of the general nature of our
work in this area and its attendant risks.”
The exact dates are not certain, but according to Bushnell, he remembers a discussion
at a “Business Heads” meeting about the growing mark-to-market volatility on those
super-senior tranches in late August or early September, well after Citigroup started to
buy the commercial paper backing the super-senior tranches of the CDOs that BSAM
managed. This was also when Chairman and CEO Prince first heard about the possible
amount of “open positions” on the super-senior CDO tranches that Citigroup held: “It
Billions in Subprime Losses
wasn’t presented at the time in a startling fashion . . . [but] then it got bigger and bigger
and bigger, obviously, over the next 30 days.” In late August, Citigroup’s valuation
models suggested that losses on the super-senior tranches might range from $15 million
to $2 billion. This number was recalculated as $300 to $500 million in mid-September, as
the valuation methodology was refined. In the weeks ahead, those numbers would
IV. “DEFCON Calls”
To get a handle on potential losses from the CDOs and liquidity puts, starting on
September 9 Prince convened a series of meetings – and later, nightly “DEFCON calls”
– with members of his senior management team; they included Rubin, Maheras,
Crittenden, and Bushnell, as well as Lou Kaden, the chief administrative officer. Rubin
was in Korea during the first meeting but Kaden kept him informed. Rubin later emailed
Prince: “According to Lou, Tom [Maheras] never did provide a clear and direct answer
on the super seniors. If that is so, and the meeting did not bring that to a head, isn’t that
deeply troubling not as to what happened – that is a different question that is also
troubling – but as to providing full and clear information and analysis now.” Prince
disagreed, writing, “I thought, for first mtg, it was good. We weren’t trying to get to final
A second meeting was held September 12, after Rubin was back in the country. This
meeting marked the first time Rubin recalled hearing of the super-senior and liquidity put
exposure. He later commented, “As far as I was concerned they were all one thing,
because if there was a put back to Citi under any circumstance, however remote that
circumstance might be, you hadn’t fully disposed of the risk.” And, of course, the
circumstance was not remote, since billions of dollars in subprime mortgage assets had
already come back onto Citigroup’s books.
Prince told the FCIC that Maheras had assured him throughout the meetings and the
DEFCON calls that the super seniors posed no risk to Citigroup, even as the market
deteriorated; he added that he became increasingly uneasy with Maheras’s assessment.
“Tom had said and said till his last day at work [October 11]: ‘We are never going to lose
a penny on these super seniors. We are never going to lose a penny on these super
seniors. . . . ’ And as we went along and I was more and more uncomfortable with this
and more and more uncomfortable with Tom’s conclusions on ultimate valuations, that is
when I really began to have some very serious concerns about what was going to
Despite Prince’s concerns, Citigroup remained publicly silent about the additional
subprime exposure from the super-senior positions and liquidity puts, even as it
preannounced some details of its third-quarter earnings on October 1, 2007.
On October 11, the rating agencies announced the first in a series of downgrades on
thousands of securities. In Prince’s view, these downgrades were “the precipitating
event in the financial crisis.” On the same day, Prince restructured the investment bank,
a move that led to the resignation of Maheras.
Four days later, the question of the super-senior CDOs and liquidity puts was specifically
raised at the board of directors’ Corporate Audit and Risk Management Committee
meeting and brought up to the full board. A presentation concluded that “total sub-prime
Billions in Subprime Losses
exposure in [the investment bank] was $13bn with an additional $16bn in Direct Super
Senior and $27bn in Liquidity and Par Puts.” Citigroup’s total subprime exposure was
$56 billion, nearly half of its capital. The calculation was straightforward, but during an
analysts’ conference call that day Crittenden omitted any mention of the super-seniorand liquidity-put-related exposure as he told participants that Citigroup had under $13
billion in subprime exposure.
A week later, on Saturday, October 27, Prince learned from Crittenden that the company
would have to report subprime-related losses of $8 to $11 billion; on Monday he
tendered his resignation to the board. He later reflected, “When I drove home and Gary
called me and told me it wasn’t going to be two or 300 million but it was going to be eight
billion – I will never forget that call. I continued driving, and I got home, I walked in the
door, I told my wife, I said here’s what I just heard and if this turns out to be true, I am
On November 4, Citigroup revealed the accurate subprime exposure – now estimated at
$55 billion – and it disclosed the subprime-related losses. Though Prince had resigned,
he remained on Citigroup’s payroll until the end of the year, and the board of directors
gave him a generous parting compensation package: $11.9 million in cash and $24
million in stock, bringing his total compensation to $79 million from 2004 to 2007. The
SEC later sued Citigroup for its delayed disclosures. To resolve the charges, the bank
paid $75 million. The New York Fed would later conclude, “There was little
communications on the extensive level of subprime exposure posed by Super Senior
CDO. . . . Senior management, as well as the independent Risk Management function
charged with monitoring responsibilities, did not properly identify and analyze these risks
in a timely fashion.”
Prince’s replacements as chairman and CEO – Richard Parsons and Vikram Pandit –
were announced in December. Rubin would stay until January 2009, having been paid
more than $115 million from 2000 to 2009 during his tenure at the company, including
his role as chairman of the Executive Committee, a position that carried “no operational
responsibilities,” Rubin told the FCIC. “My agreement with Citi provided that I’d have no
management of personnel or operations.”
John Reed, former co-CEO of Citigroup, attributed the firm’s failures in part to a culture
change that occurred when the bank took on Salomon Brothers as part of the 1998
Travelers merger. He said that Salomon executives “were used to taking big risks” and
“had a history . . . [of] making a lot of money . . . but then getting into trouble.”
V. Federal Reserve: “The Discount Window Wasn’t Working”
Over the course of the fall, the announcements by Citigroup, Merrill, and others made it
clear that financial institutions were going to take serious losses from their exposures to
the mortgage market. Stocks of financial firms fell sharply; by the end of November, the
S&P Financials Index had lost more than 16% for the year. Between July and
November, asset-backed commercial paper declined about 30%, which meant that those
assets had to be sold or funded by other means. Investment banks and other financial
institutions faced tighter funding markets and increasing cash pressures. As a result, the
Federal Reserve decided that its interest rate cuts and other measures since August had
not been sufficient to provide liquidity and stability to financial markets. The Fed’s
discount window hadn’t attracted much bank borrowing because of the stigma attached
Billions in Subprime Losses
to it. “The problem with the discount window is that people don’t like to use it because
they view it as a risk that they will be viewed as weak,” William Dudley, then head of the
capital markets group at the New York Fed and currently its president, told the FCIC.
Banks and thrifts preferred to draw on other sources of liquidity; in particular, during the
second half of 2007, the Federal Home Loan Banks – which are government-sponsored
entities that lend to banks and thrifts, accepting mortgages as collateral – boosted their
lending by $235 billion to $875 billion (a 37% increase) when the securitization market
froze. Between the end of March and the end of December 2007, Washington Mutual,
the largest thrift, increased its borrowing from the Federal Home Loan Banks from $28
billion to $73 billion; Countrywide increased its borrowing from $27 billion to $48 billion;
Bank of America increased its borrowing from $38 billion to $56 billion. The Federal
Home Loan Banks could thus be seen as the lender of next to last resort for commercial
banks and thrifts – the Fed being the last resort.
In addition, the loss of liquidity in the financial sector was making it more difficult for
businesses and consumers to get credit, raising the Fed’s concerns. From July to
October, the percentage of loan officers reporting tightening standards on prime
mortgages increased from 15% to about 40%. Over that time, the percentage of loan
officers reporting tightening standards on loans to large and midsize companies
increased from 8% to 19%, its highest level since 2003. “The Federal Reserve pursued a
whole slew of nonconventional policies . . . very creative measures when the discount
window wasn’t working as hoped,” Frederic Mishkin, a Fed governor from 2006 to 2008,
told the FCIC. “These actions were very aggressive, [and] they were extremely
controversial.” The first of these measures, announced on December 12, was the
creation of the Term Auction Facility (TAF). The idea was to reduce the discount window
stigma by making the money available to all banks at once through a regular auction.
The program had some success, with banks borrowing $40 billion by the end of the year.
Over time, the Fed would continue to tweak the TAF auctions, offering more credit and
longer maturities.
Another Fed concern was that banks and others who did have cash would hoard it.
Hoarding meant foreign banks had difficulty borrowing in dollars and were therefore
under pressure to sell dollar-denominated assets such as mortgage-backed securities.
Those sales and fears of more sales to come weighed on the market prices of U.S.
securities. In response, the Fed and other central banks around the world announced
(also on December 12) new “currency swap lines” to help foreign banks borrow dollars.
Under this mechanism, foreign central banks swapped currencies with the Federal
Reserve – local currency for U.S. dollars – and lent these dollars to foreign banks.
“During the crisis, the U.S. banks were very reluctant to extend liquidity to European
banks,” Dudley said. Central banks had used similar arrangements in the aftermath of
the 9/11 attacks to bolster the global financial markets. In late 2001, the swap lines
totaled $88 billion. During the financial crisis seven years later, they would reach $580
The Fed hoped the TAF and the swap lines would reduce strains in short-term money
markets, easing some of the funding pressure on other struggling participants such as
investment banks. Importantly, it wasn’t just the commercial banks and thrifts but the
“broader financial system” that concerned the Fed, Dudley said. “Historically, the Federal
Reserve has always tended to supply liquidity to the banks with the idea that liquidity
provided to the banking system can be [lent on] to solvent institutions in the nonbank
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sector. What we saw in this crisis was that didn’t always take place to the extent that it
had in the past. . . . I don’t think people going in really had a full understanding of the
complexity of the shadow banking system, the role of [structured investment vehicles]
and conduits, the backstops that banks were providing SIV conduits either explicitly or
Burdened with capital losses and desperate to cover their own funding commitments, the
banks were not stable enough to fill the void, even after the Fed lowered interest rates
and began the TAF auctions. In January 2008, the Fed cut rates again – and then again,
twice within two weeks, a highly unusual move that brought the federal funds rate from
4.25% to 3.0%.
The Fed also started plans for a new program that would use its emergency authority,
the Term Securities Lending Facility, though it wasn’t launched until March. “The TSLF
was more a view that the liquidity that we were providing to the banks through the TAF
was not leading to a significant diminishment of financing pressures elsewhere,” Dudley
told the FCIC. “So maybe we should think about bypassing the banking system and [try]
to come up with a vehicle to provide liquidity support to the primary dealer community
more directly.”
On March 7, the Fed increased the total available in each of the biweekly TAF auctions
from $30 billion to $50 billion, and guaranteed at least that amount for six months. The
Fed also liberalized its standard for collateral. Primary dealers – mainly the investment
banks and the broker-dealer affiliates of large commercial banks – could post debt of
government-sponsored enterprises, including GSE mortgage-backed securities, as
collateral. The Fed expected to have $100 billion in such loans outstanding at any given
Also at this time, the U.S. central bank began contemplating a step that was
revolutionary: a program that would allow investment banks – institutions over which the
Fed had no supervisory or regulatory responsibility – to borrow from the discount window
on terms similar to those available to commercial banks.
VI. Monoline Insurers: “We Never Expected Losses”
Meanwhile, the rating agencies continued to downgrade mortgage-backed securities and
CDOs through 2007. By January 2008, as a result of the stress in the mortgage market,
S&P had downgraded 3,389 tranches of residential mortgage-backed securities and
1,383 tranches from 420 CDOs. MBIA and Ambac, the two largest monoline insurers,
had taken on a combined $265 billion of guarantees on mortgage securities and other
structured products. Downgrades on the products that they insured brought the financial
strength of these companies into question. After conducting stress analysis, S&P
estimated in February 2008 that Ambac would need up to $400 million in capital to cover
potential losses on structured products. Such charges would affect the monolines’ own
credit ratings, which in turn could lead to more downgrades of the products they had
Like many of the monolines, ACA, the smallest of them, kept razor-thin capital – less
than $700 million – against its obligations that included $69 billion in credit default swaps
on CDOs. In late 2007, ACA reported a net loss of $1.7 billion, almost entirely due to
credit default swaps.
Billions in Subprime Losses
This was news. The notion of “zero-loss tolerance” was central to the viability of the
monoline business model, and they and various stakeholders – the rating agencies,
investors, and monoline creditors—had traditionally assumed that the monolines never
would have to take a loss. As Alan Roseman, CEO of ACA, told FCIC staff: “We never
expected losses. . . . We were providing hedges on market volatility to institutional
counterparties. . . . We were positioned, we believed, to take the volatility because we
didn’t have to post collateral against the changes in market value to our counterparty,
number one. Number two, we were told by the rating agencies that rated us that that
mark-to-market variation was not important to our rating, from a financial strength point
of view at the insurance company.”
In early November, the SEC called the growing concern about Merrill’s use of the
monolines for hedging “a concern that we also share.” The large Wall Street firms
attempted to minimize their exposure to the monolines, particularly ACA. On December
19, S&P downgraded ACA to junk status, rating the company CCC, which was fatal for a
company whose CEO said that its “rating is the franchise.” Firms like Merrill Lynch would
get virtually nothing for the guarantees they had purchased from ACA.
Despite the stresses in the market, the SEC saw the monoline problems as largely
confined to ACA. A January 2008 internal SEC document said, “While there is a clear
sentiment that capital raising will need to continue, the fact that the guarantors (with the
exception of ACA) are relatively insulated from liquidity driven failures provides hope that
event[s] in this sector will unfold in a manageable manner.”
Still, the rating agencies told the monolines that if they wanted to retain their stellar
ratings, they would have to raise capital. MBIA and Ambac ultimately did raise $1.65
billion and $1.5 billion, respectively. Nonetheless, S&P downgraded both to AA in June
2008. As the crisis unfolded, most of the monolines stopped writing new coverage.
The subprime contagion spread through the monolines and into a previously unimpaired
market: municipal bonds. The path of these falling dominoes is easy to follow: in
anticipation of the monoline downgrades, investors devalued the protection the
monolines provided for other securities – even those that had nothing to do with the
mortgage-backed markets, including a set of investments known as auction rate
securities, or ARS. An ARS is a long-term bond whose interest rate is reset at regularly
scheduled auctions held every one to seven weeks. Existing investors can choose to
rebid for the bonds and new investors can come in. The debt is frequently municipal
bonds. As of December 13, 2007, state and local governments had issued $165 billion in
ARS, accounting for half of the $330 billion market. The other half were primarily bundles
of student loans and debt of nonprofits such as museums and hospitals.
The key point: these entities wanted to borrow long-term but get the benefit of lower
short-term rates, and investors wanted to get the safety of investing in these securities
without tying up their money for a long time. Unlike commercial paper, this market had
no explicit liquidity backstop from a bank, but there was an implicit backstop: often, if
there were not enough new buyers to replace the previous investors, the dealers running
these auctions, including firms like UBS, Citigroup, and Merrill Lynch, would step in and
pick up the shortfall. Because of these interventions, there were only 13 failures between
1984 and early 2007 in more than 100,000 auctions. Dealers highlighted those
minuscule failure rates to convince clients that ARS were very liquid, short-term
instruments, even in times of stress.
Billions in Subprime Losses
However, if an auction did fail, the previous ARS investors would be obligated to retain
their investments. In compensation, the interest rates on the debt would reset, often
much higher, but investors’ funds would be trapped until new investors or the dealer
stepped up or the borrower paid off the loan. ARS investors were typically very risk
averse and valued liquidity, and so they were willing to pay a premium for guarantees on
the ARS investments from monolines. It necessarily followed that the monolines’ growing
problems in the latter half of 2007 affected the ARS market. Fearing that the monolines
would not be able to perform on their guarantees, investors fled. The dealers’
interventions were all that kept the market going, but the stress became too great. With
their own problems to contend with, the dealers were unable to step in and ensure
successful auctions. In February, en masse, they pulled up stakes. The market
collapsed almost instantaneously. On February 14, in one of the starkest market
dislocations of the financial crisis, 80% of the ARS auctions failed; the following week,
67% failed.
Hundreds of billions of dollars were trapped by ARS instruments as investors were
obligated to retain their investments. And retail investors – individuals investing less than
$1 million, small businesses, and charities – constituted more than $110 billion of this
$330 billion market. Moreover, investors who chose to remain in the market demanded a
premium to take on the risk. Between investor demands and interest rate resets,
countless governments, infrastructure projects, and nonprofits on tight budgets were
slammed with interest rates of 10% or higher.
In 2008 alone, the SEC received more than 1,000 investor complaints regarding the
failed ARS auctions. Investors argued that brokers had led them to believe that ARS
were safe and liquid, essentially the equivalent of money market accounts but with the
potential for a slightly higher interest rate. Investors also reported that the frozen market
blocked their access to money for short-term needs such as medical expenses, college
tuition, and, for some small businesses and charities, payroll. By 2009, the SEC had
settled with financial institutions including Bank of America, RBC Capital Markets, and
Deutsche Bank to resolve charges that the firms misled investors. As a result, these and
other banks made more than $50 billion available to pay off tens of thousands of ARS
Billions in Subprime Losses
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. In 2007, Citigroup and Merrill Lynch both experienced huge losses. What was the
main reason for those losses:
a) the increase in home prices
b) their overly conservative approach to financing mortgages
c) many of the other notable financial institutions were thriving and getting all of the
d) their wide-spread business dealings with collateralized debt obligations
2. The prices of homes had dropped 4.5% nationally by the middle of 2007.
a) true
b) false
3. Which of the following measures was created to popularize the discount window idea
by making money accessible to all financial institutions at the same time through an
Term Securities Lending Facility
Term Auction Facility
DEFCON calls
The Federal Reserve Act of 2007
Billions in Subprime Losses
1. A: Incorrect. The opposite was true. Home prices were actually dropping.
B: Incorrect. They were certainly not overly conservative in their business dealings.
C. is incorrect. Many of the other large banks were suffering greatly as well.
D: Correct. Both financial institutions suffered huge losses as a result of their many
business dealings with collateralized debt obligations.
(See page 14-1 of the course material.)
2. A: True is correct. Housing prices had dropped significantly and more and more
mortgage payments were late. These were additional signs that the economy was
beginning to unravel.
B: False is incorrect. Home prices had in fact dropped.
(See page 14-4 of the course material.)
3. A: Incorrect. The Term Securities Lending Facility was a program which determined
that the Term Auction Facility was not very successful.
B: Correct. The Term Auction Facility was created to decrease the negative opinion
regarding discount windows by making money accessible to all banks at the same
C: Incorrect. These were actually a series of calls among Citigroup executives to
discuss their losses in an attempt to get their finances under control.
D: Incorrect. There is no such act.
(See page 14-8 of the course material.)
Billions in Subprime Losses
Chapter 15: The Fall of Bear Stearns
After its hedge funds failed in July 2007, Bear Stearns faced more challenges in the
second half of the year. Taking out the repo lenders to the High-Grade Fund brought
nearly $1.6 billion in subprime assets onto Bear’s books, contributing to a $1.9 billion
write-down on mortgage-related assets in November. That prompted investors to
scrutinize Bear Stearns’s finances. Over the fall, Bear’s repo lenders – mostly money
market mutual funds – increasingly required Bear to post more collateral and pay higher
interest rates. Then, in just one week in March 2008, a run by these lenders, hedge fund
customers, and derivatives counterparties led to Bear having to be taken over in a
government-backed rescue.
Mortgage securitization was the biggest piece of Bear Stearns’s most-profitable division,
its fixed-income business, which generated 45% of the firm’s total revenues. Growing
fast was the Global Client Services division, which included Bear’s prime brokerage
operation. Bear Stearns was the second-biggest prime broker in the country, with a 21%
market share in 2006, trailing Morgan Stanley’s 23%. This business would figure
prominently in the crisis.
In mortgage securitization, Bear followed a vertically integrated model that made money
at every step, from loan origination through securitization and sale. It both acquired and
created its own captive originators to generate mortgages that Bear bundled, turned into
securities, and sold to investors. The smallest of the five large investment banks, it was
still a top-three underwriter of private-label mortgage-backed securities from 2000 to
2007. In 2006, it underwrote $36 billion in collateralized debt obligations of all kinds,
more than double its 2005 figure of $14.5 billion. The total included $6.3 billion in CDOs
that included mortgage-backed securities, putting it in the top 12 in that business. As
was typical on Wall Street, the company’s view was that Bear was in the moving
business, not the storage business – that is, it sought to provide services to clients rather
than take on long-term exposures of its own.
Bear expanded its mortgage business despite evidence that the market was beginning
to falter, as did other firms such as Citigroup and Merrill. As early as May 2006, Bear
had lost $3 million relating to defaults on mortgages which occurred within 90 days of
origination, which had been rare in the decade. But Bear persisted, assuming the
setback would be temporary. In February 2007, Bear even acquired Encore Credit, its
third captive mortgage originator in the United States, doubling its capacity. The
purchase was consistent with Bear’s contrarian business model – buying into distressed
markets and waiting for them to turn around.
Only a month after the purchase of Encore, the Securities and Exchange Commission
wrote in an internal report, “Bear’s mortgage business incurred significant market risk
losses” on its Alt-A mortgage assets. The losses were small, but the SEC reported that
“risk managers note[d] that these events reflect a more rapid and severe deterioration in
collateral performance than anticipated in ex ante models of stress events.”
I. “I Requested Some Forbearance”
Vacationing on Nantucket Island when the two Bear-sponsored hedge funds declared
bankruptcy on July 31, 2007, former Bear treasurer Robert Upton anticipated that the
rating agencies would downgrade the company, raising borrowing costs. Bear funded
much of its operations borrowing short-term in the repo market; it borrowed between $50
The Fall of Bear Stearns
and $70 billion overnight. Even a threat of a downgrade by a rating agency would make
financing more expensive, starting the next morning. Investors, analysts, and the credit
rating agencies closely scrutinized leverage ratios, available at the end of each quarter.
By November 2007, Bear’s leverage ratio had reached nearly 38 to 1. By the end of
2007, Bear’s Level 3 assets – illiquid assets difficult to value and to sell – were 269% of
its tangible common equity; thus, writing down these illiquid assets by 37% would wipe
out tangible common equity.
At the end of each quarter, Bear would lower its leverage ratio by selling assets, only to
buy them back at the beginning of the next quarter. Bear and other firms booked these
transactions as sales – even though the assets didn’t stay off the balance sheet for long
– in order to reduce the amount of the company’s assets and lower its leverage ratio.
Bear’s former treasurer Upton called the move “window dressing” and said it ensured
that creditors and rating agencies were happy. Bear’s public filings reflected this, to
some degree: for example, its 2007 annual report said the balance sheet was
approximately 12% lower than the average month-end balance over the previous twelve
To forestall a downgrade, Upton spoke with the three main rating agencies, Moody’s,
Standard & Poor’s, and Fitch, in early August. Several times in 2007 – including April 9
and June 22 – S&P had confirmed Bear’s strong ratings, noting in April that “Bear’s risk
profile is relatively conservative” and “strong senior management oversight and a strong
culture throughout the firm are the foundation of Bear’s risk management process.” On
June 22, Moody’s had also confirmed its A1 rating, and Fitch had confirmed its “stable”
Now, in early August, Upton provided them information about Bear and argued that
management had learned its lesson about governance and risk management from the
failure of the two hedge funds and was going to rely less on short-term unsecured
funding and more on the repo market. Bear and other market participants did not foresee
that Bear’s own repo lenders might refuse to lend against risky mortgage assets and
eventually not even against Treasuries.
To reassure investors that no more shoes would drop, Bear invited them on a
conference call that same day. The call did not go well. By the end of the day, Bear’s
stock slid 6%, to $108.35, 36% below its all-time high of $169.61, reached earlier in
II. “We Were Suitably Skeptical”
On Sunday, August 5, two days after the conference call, Bear had another opportunity
to make its case: this time, with the SEC. The two SEC supervisors who visited the
company that Sunday were Michael Macchiaroli and Matthew Eichner, respectively,
associate director and assistant director of the division of market regulation. The
regulators reviewed Bear’s exposures to the mortgage market, including the $13 billion
in adjustable-rate mortgages on the firm’s books that were waiting to be securitized.
Bear executives gave assurances that inventory would shrink once investors returned in
September from their retreats in the Hamptons. “Obviously, regulators are not supposed
to listen to happy talk and go away smiling,” Eichner told the FCIC. “Thirteen billion in
ARMs is no joke.” Still, Eichner did not believe the Bear executives were being
disingenuous. He thought they were just emphasizing the upside.
The Fall of Bear Stearns
Alan Schwartz, the co-president who later succeeded Jimmy Cayne as CEO, and
Thomas Marano, head of Global Mortgages and Asset Backed Securities, seemed
unconcerned. But other executives were leery. Wendy de Monchaux, the head of
proprietary trading, urged Marano to trim the mortgage portfolio, as did Steven Meyer,
the co-head of stock sales and trading. According to Chief Risk Officer Michael Alix,
former chairman Alan Greenberg would say, “the best hedge is a sale.” Bear finally
reduced the portfolio from $56 billion in the third quarter of 2007 to $46.1 billion in the
fourth quarter, but it was too little too late.
That summer, the SEC felt Bear’s liquidity was adequate for the immediate future, but
supervisors “were suitably skeptical,” Eichner insisted. After the August 5 meeting, the
SEC required that Bear Stearns report daily on Bear’s liquidity. However, Eichner
admitted that he and his agency had grossly underestimated the possibility of a liquidity
crisis down the road.
Every weeknight Upton updated the SEC on Bear’s $400 billion balance sheet, with
specifics on repo and commercial paper. On September 27, Bear Stearns raised
approximately $2.5 billion in unsecured 10-year bonds. The reports slowed to once a
week. The SEC’s inspector general later criticized the regulators, writing that they did not
push Bear to reduce leverage or “make any efforts to limit Bear Stearns’ mortgage
securities concentration,” despite “aware[ness] that risk management of mortgages at
Bear Stearns had numerous shortcomings, including lack of expertise by risk managers
in mortgage backed securities” and “persistent understaffing; a proximity of risk
managers to traders suggesting a lack of independence; turnover of key personnel
during times of crisis; and the inability or unwillingness to update models to reflect
changing circumstances.”
Michael Halloran, a senior adviser to SEC Chairman Christopher Cox, told the FCIC the
SEC had ample information and authority to require Bear Stearns to decrease leverage
and sell mortgage-backed securities, as other financial institutions were doing. Halloran
said that as early as the first quarter of 2007, he had asked Erik Sirri, in charge of the
SEC’s Consolidated Supervised Entities program, about Bear Stearns (and Lehman
Brothers), “Why can’t we make them reduce risk?” According to Halloran, Sirri said the
SEC’s job was not to tell the banks how to run their companies but to protect their
customers’ assets.
III. “Turn Into a Death Spiral”
In August, after the rating agencies revised their outlook on Bear, Cayne tried to obtain
lines of credit from Citigroup and JP Morgan. Both banks acknowledged Bear had
always been a very good customer and maintained they were interested in helping. “We
wanted to try to be belts-and-suspenders,” said CFO Samuel Molinaro, as Bear
attempted both to obtain lines of credit with banks and to reinforce traditional sources of
short-term liquidity such as money market funds. But, Cayne told the FCIC, nothing
happened. “Why the [large] banks were not more willing to participate and provide lines
during that period of time, I can’t tell you,” Molinaro said.
A major money market fund manager, Federated Investors, had decided on October 1 to
drop Bear Stearns from its list of approved counterparties for unsecured commercial
paper, illustrating why unsecured commercial paper was traditionally seen as a riskier
lifeline than repo. Throughout 2007, Bear Stearns reduced its unsecured commercial
The Fall of Bear Stearns
paper (from $20.7 billion at the end of 2006 to only $3.9 billion at the end of 2007) and
replaced it with secured repo borrowing (which rose from $69 billion to $102 billion). But
Bear Stearns’s growing dependence on overnight repo would create a different set of
The tri-party repo market used two clearing banks, JP Morgan and BNY Mellon. During
every business day, these clearing banks return cash to lenders; take possession of
borrowers’ collateral, essentially keeping it in escrow; and then lend their own cash to
borrowers during the day. This is referred to as “unwinding” the repo transaction; it
allows borrowers to change the assets posted as collateral every day. The transaction is
then “rewound” at the end of the day, when the lenders post cash to the clearing banks
in return for the new collateral.
The little-regulated tri-party repo market had grown from $800 billion in average daily
volume in 2002 to $1.7 trillion in 2005, $2.4 trillion in 2007, and $2.8 trillion by early
2008. It had become a very deep and liquid market. Even though most borrowers rolled
repo overnight, it was also considered a very safe market, because transactions were
overcollateralized (loans were made for less than the collateral was worth). That was the
general view before the onset of the financial crisis.
As Bear increased its tri-party repo borrowing, it became more dependent on JP
Morgan, the clearing bank. A risk that was little appreciated before 2007 was that JP
Morgan and BNY Mellon could face large losses if a counterparty such as Bear
defaulted during the day. Essentially, JP Morgan served as Bear’s daytime repo lender.
Even long-term repo loans have to be unwound every day by the clearing bank, if not by
the lender. Seth Carpenter, an officer at the Federal Reserve Board, compared it to a
mortgage that has to be refinanced every week: “Imagine that your mortgage is only a
week. Instead of a 30-year mortgage, you’ve got a one-week mortgage. If everything’s
going fine, you get to the end of the week, you go out and you refinance that mortgage
because you don’t have enough cash on hand to pay off the whole mortgage. And then
you get to the end of another week and you refinance that mortgage. And that’s, for all
intents and purposes, what repos are like for many institutions.”
During the fall, Federated Investors, which had taken Bear Stearns off its list of approved
commercial paper counterparties, continued to provide secured repo loans. Fidelity
Investments, another major lender, limited its overall exposure to Bear, and shortened
the maturities. In October, State Street Global Advisors refused any repo lending to Bear
other than overnight.
In the fourth quarter of 2007, Bear Stearns reported its first quarterly loss, $379 million.
Still, the SEC saw “no evidence of any deterioration in the firm’s liquidity position
following the release and related negative press coverage.” The SEC concluded, “Bear
Stearns’ liquidity pool remains stable.”
In the fall of 2007, Bear’s board had commissioned the consultant Oliver Wyman to
review the firm’s risk management. The report, “Risk Governance Diagnostic:
Recommendations and Case for Economic Capital Development,” was presented on
February 5, 2008, to the management committee. Among its conclusions: risk
assessment was “infrequent and ad hoc” and “hampered by insufficient and poorly
aligned resources,” “risk managers [were] not effectively positioned to challenge front
The Fall of Bear Stearns
office decisions,” and risk management was “understaffed” and considered a “low
priority.” Schwartz told the FCIC the findings did not indicate substantial deficiencies. He
wasn’t looking for positive feedback from the consultants, because the Wyman report
was meant to provide a road map of what “the gold standard” in risk management would
In January 2008, before the report was completed, Cayne resigned as CEO, after
receiving $93.6 million in compensation from 2004 through 2007. When asked if he had
made mistakes while at Bear Stearns, Cayne told the FCIC, “I take responsibility for
what happened. I’m not going to walk away from the responsibility.”
At Bear, compensation was based largely on the return on equity in a given year. For
senior executives, about half of each bonus was paid in cash, and about half in restricted
stock that vested over three years and had to be held for five. The formula for the size of
each year’s compensation pool was determined by a subcommittee of the board.
Stockholders approved the performance compensation plan and capital accumulation
plan for senior managing directors. Cayne told the FCIC he set his own compensation
and the compensation for all five members of the Executive Committee. According to
Cayne, no one, including the board, questioned his decisions.
For 2007, even with its losses, Bear Stearns paid out 58% of revenues in compensation.
Alix, who sat on the Compensation Committee, told FCIC staff the firm typically paid
50% but that the percentage increased in 2007 because revenues fell – if management
had lowered compensation proportionately, he said, many employees might have quit.
Base salaries for senior managers were capped at $250,000, with the remainder of
compensation a discretionary mix of cash, restricted stock, and options. From 2000
through 2008, the top five executives at Bear Stearns took home over $326.5 million in
cash and over $1.1 billion from stock sales, for more than a total of $1.4 billion. This
exceeded the annual budget for the SEC.
Cayne was out, Schwartz was in, and Bear Stearns continued hanging on in early 2008.
Bear was still able to fund its balance sheet through repo loans, though the interest rates
the firm had to pay had increased. Marano said he worried this increased cost would
signal to the market that Bear was distressed, which could “make our problems turn into
a death spiral.”
IV. “Duty to Protect Their Investors”
On Wednesday, January 30, 2008, Treasurer Upton reported an internal accounting
error that showed Bear Stearns to have less than $5 billion in liquidity – triggering a
report to the SEC. While the company identified the error, the SEC reinstituted daily
reporting by the company of its liquidity.
Lenders and customers were more and more reluctant to do business with the company.
On February 15, Bear Stearns had $36.7 billion in mortgages, mortgage-backed
securities, and asset-backed securities on its balance sheet, down almost $10 billion
from November. Nearly $26 billion were subprime or Alt-A mortgage-backed securities
and CDOs.
The Fall of Bear Stearns
The hedge funds that were clients of Bear’s prime brokerage services were particularly
concerned that Bear would be unable to return their cash and securities. Lou Lebedin,
the head of Bear’s prime brokerage, told the FCIC that hedge fund clients occasionally
inquired about the bank’s financial condition in the latter half of 2007, but that such
inquiries picked up at the beginning of 2008, particularly as the cost increased of
purchasing credit default swap protection on Bear. The inquiries became withdrawals –
hedge funds started taking their business elsewhere. “They felt there were too many
concerns about us and felt that this was a short-term move,” Lebedin said. “Often they
would tell us they’d be happy to bring the business back, but that they had the duty to
protect their investors.” Renaissance Technologies, one of Bear’s biggest prime
brokerage clients, pulled out all of its business. By April, Lebedin’s prime brokerage
operation would be holding $90 billion in assets under management, down more than
40% from $160 billion in January.
Nonetheless, during the week of March 3, when SEC staff inspected Bear’s liquidity
pool, they identified “no significant issues.” The SEC found Bear’s liquidity pool ranged
from $18 billion to $20 billion.
Bear opened for business on Monday, March 10, with approximately $18 billion in cash
reserves. The same day, Moody’s downgraded 15 mortgage-backed securities issued by
Bear Stearns Alt-A Trust, a special purpose entity. News reports on the downgrades
carried abbreviated headlines stating, “Moody’s Downgrades Bear Stearns,” Upton said.
Rumors flew and counterparties panicked. Bear’s liquidity pool began to dry up, and the
SEC was now concerned that Bear was being squeezed from all directions. While
“everything rolled” during the day – that is, Bear’s repo lenders renewed their
commitments – SEC officials worried that this would “probably not continue.”
On Tuesday, the Fed announced it would lend to investment banks and other “primary
dealers.” The Term Securities Lending Facility (TSLF) would make available up to $200
billion in Treasury securities, accepting as collateral GSE mortgage-backed securities
and non-GSE mortgage-backed securities rated triple-A. The hope was that lenders
would lend to investment banks if the collateral was Treasuries rather than other highly
rated but now suspect assets such as mortgage-backed securities. The Fed also
announced it would extend loans from overnight to 28 days, giving investment banks an
added breather from the relentless need to unwind repos every morning.
With the TSLF, the Fed would be setting a new precedent by extending emergency
credit to institutions other than commercial banks. To do so, the Federal Reserve Board
was required under section 13(3) of the Federal Reserve Act to determine that there
were “unusual and exigent circumstances.” The Fed had not invoked its section 13(3)
authority since the Great Depression; it was the Fed’s first use of the authority since
Congress had expanded the language of the act in 1991 to allow the Fed to lend to
investment banks. The Fed was taking the unusual step of declaring its willingness to
soon open its checkbook to institutions it did not regulate and whose financial condition it
had never examined.
But the Fed would not launch the TSLF until March 27, more than two weeks later – and
it was not clear that Bear could last that long. The following day, Jim Embersit of the
Federal Reserve Board checked on Bear’s liquidity with the SEC. The SEC said Bear
had $12.5 billion in cash – down from about $18 billion at the start of the week – and
was able to finance all its bank loans and most of its equity securities through the repo
The Fall of Bear Stearns
market. He summarized, “The SEC indicates that no notable losses have been
sustained and that the capital position of the firm is ‘fine.’”
Derivatives counterparties were increasingly reluctant to be exposed to Bear. In some
cases they unwound trades in which they faced Bear, and in others they made margin or
collateral calls. In Bear’s last few years as an independent company, it had substantially
increased its exposure to derivatives. At the end of fiscal year 2007, Bear had $13.4
trillion in notional exposure on derivatives contracts, compared with $8.7 trillion at 2006
fiscal year-end and $5.5 trillion at the end of 2005.
Derivatives counterparties who worried about Bear’s ability to make good on their
payments could get out of their derivative positions with Bear through assignments or
novations. Assignments allow counterparties to assign their positions to someone else: if
firm X has a derivatives contract with firm Y, then firm X can assign its position to firm Z,
so that Z now is the one that has a derivatives contract with Y. Novations also allow
counterparties to get out of their exposure to each other, but by bringing in a third party:
instead of X facing Y, X faces Z and Z faces Y. Both assignments and novations are
routine transactions on Wall Street. But on Tuesday, Brian Peters of the New York Fed
advised Eichner at the SEC that the New York Fed was “seeing some HFs [hedge funds]
wishing to assign trades the clients had done with Bear to other CPs [counterparties] so
that Bear ‘steps out.’” Counterparties did not want to have Bear Stearns as a derivatives
counterparty any more.
Bear Stearns also encountered difficulties stepping into trades. Hayman Capital
Partners, a hedge fund in Texas wanting to decrease its exposure to subprime
mortgages, had decided to close out a relatively small $5 million subprime derivative
position with Goldman Sachs. Bear Stearns offered the best bid, so Hayman expected to
assign its position to Bear, which would then become Goldman’s counterparty in the
derivative. Hayman notified Goldman by a routine email on Tuesday, March 11, at 4:06
P.M. The reply 41 minutes later was unexpected: “GS does not consent to this trade.”
That startled Kyle Bass, Hayman’s managing partner. He told the FCIC he could not
recall any counterparty rejecting a routine novation. Pressed for an explanation,
Goldman the next morning offered no details: “Our trading desk would prefer to stay
facing Hayman. We do not want to face Bear.” Adding to the mystery, 16 minutes later
Goldman agreed to accept Bear Sterns as the counterparty after all. But the damage
was done. The news hit the street that Goldman had refused a routine transaction with
one of the other big five investment banks. The message: don’t rely on Bear Stearns.
CEO Alan Schwartz hoped an appearance on CNBC would reassure markets.
Questioned about this incident, Schwartz said he had no knowledge of such a refusal
and rhetorically asked, “Why do rumors start?” SEC Chairman Cox told reporters his
agency was monitoring capital levels at Bear Stearns and other securities firms “on a
constant basis” and has “a good deal of comfort about the capital cushions at these firms
at the moment.”
Still, the run on Bear accelerated. Many investors believed the Fed’s announcement
about its new loan program was directed at Bear Stearns, and they worried about the
facility’s not being available for several weeks. On Wednesday, March 12, the SEC
noted that Bear paid another $1.1 billion for margin calls from 142 nervous derivatives
The Fall of Bear Stearns
Repo lenders who had already tightened the terms for their contracts over the preceding
four or five months shortened the leash again, demanding more collateral from Bear
Stearns. Worries about a default quickly mounted.
By that evening, Bear’s ability to borrow in the repo market was drying up. The SEC
noted that some large and important money funds, including Fidelity and Mellon, had
told Bear after the close of business Wednesday they “might be hesitant to roll some
funding tomorrow.” The SEC said that though they believed the amounts were “very
manageable (between $1 and $2 billion),” the withdrawals would not send a helpful
signal to the market. But the issue was almost moot. Schwartz called New York Fed
President Timothy Geithner that night to discuss possible Fed flexibility in the event that
some repo lenders did pull away.
Upton, the treasurer, said that before that week, he had never worried about the
disappearance of repo lending. By Thursday, he believed the end was near. Bear
executives informed the board that the rumors were dissuading counterparties from
doing business with Bear, that Bear was receiving and meeting significant margin calls,
that $14 billion in repo was not going to roll over, and that “there was a reasonable
chance that there would not be enough cash to meet [Bear’s] needs.” Some repo
lenders were already so averse to Bear that they stopped lending to the company at all,
not even against Treasury collateral, Upton told the FCIC. Derivatives counterparties
continued to run from Bear. By that night, liquidity had dwindled to a mere $2 billion.
Bear had run out of cash in one week. Executives and regulators continued to believe
the firm was solvent, however. Former SEC Chairman Cox testified before the FCIC, “At
all times during the week of March 10 to 17, up to and including the time of its
agreement to be acquired by JP Morgan, Bear Stearns had a capital cushion well above
what is required.”
V. “The Government Would Not Permit a Higher Number”
On Thursday evening, March 13, Bear Stearns informed the SEC that it would be
“unable to operate normally on Friday.” CEO Alan Schwartz called JP Morgan CEO
Jamie Dimon to request a $30 billion credit line. Dimon turned him down, citing,
according to Schwartz, JP Morgan’s own significant exposure to the mortgage market.
Because Bear also had a large, illiquid portfolio of mortgage assets, JP Morgan would
not render assistance without government support. Schwartz spoke with Geithner again.
Schwartz insisted Bear’s problem was liquidity, not insufficient capital. A series of calls
between Schwartz, Dimon, Geithner, and Treasury Secretary Henry Paulson followed.
To address Bear’s liquidity needs, the New York Fed made a $12.9 billion loan to Bear
Stearns through JP Morgan on the morning of Friday, March 14. Standard & Poor’s
lowered Bear’s rating three levels to BBB. Moody’s and Fitch also downgraded the
company. By the end of the day, Bear was out of cash. Its stock plummeted 47%,
closing below $30.
The markets evidently viewed the loan as a sign of terminal weakness. After markets
closed on Friday, Paulson and Geithner informed Bear CEO Schwartz that the Fed loan
to JP Morgan would not be available after the weekend. Without that loan, Bear could
not conduct business. In fact, Bear Stearns had to find a buyer before the Asian markets
opened Sunday night or the game would be over. Schwartz, Molinaro, Alix, and others
spent the weekend in due diligence meetings with JP Morgan and other potential buyers,
The Fall of Bear Stearns
including the private equity firm J.C. Flowers and Co. According to Schwartz, the
participants determined JP Morgan was the only candidate with the size and stature to
make a credible offer within 48 hours. As Bear Stearns’s clearing bank for repo trades,
JP Morgan held much of Bear Stearns’s assets as collateral and had been assessing
their value daily. This knowledge let JP Morgan move more quickly.
On Sunday, March 16, JP Morgan informed the New York Fed and the Treasury that it
was interested in a deal if it included financial support from the Fed. The Federal
Reserve Board, again finding “unusual and exigent circumstances” as required under
section 13(3) of the Federal Reserve Act, agreed to purchase $29.97 billion of Bear’s
assets to get them off the firm’s books through a new entity called Maiden Lane LLC
(named for a street alongside the New York Fed). Those assets – mostly mortgagerelated securities, other assets, and hedges from Bear’s mortgage trading desk – would
be under New York Fed management. To finance the purchases, JP Morgan made a
$1.15 billion subordinated loan and the New York Fed lent $28.82 billion. Because of its
loan, JP Morgan bore the risk of the first $1.15 billion of losses; the Fed would bear any
further losses up to $28.82 billion. The Fed’s loan would be repaid as Maiden Lane sold
the collateral.
On Sunday night, with Maiden Lane in place, JP Morgan publicly announced a deal to
buy Bear Stearns for $2 a share. Minutes of Bear’s board meeting indicate that JP
Morgan had considered $4 but cut it to $2 “because the government would not permit a
higher number. . . . The Fed and the Treasury Department would not support a
transaction where [Bear Stearns] equity holders received any significant consideration
because of the ‘moral hazard’ of the federal government using taxpayer money to ‘bail
out’ the investment bank’s stockholders.”
Eight days later, on March 24, Bear Stearns and JP Morgan agreed to increase the price
to $10. John Chrin, co-head of the financial institutions mergers and acquisitions group
at JP Morgan, told the FCIC they increased the price to make Bear shareholders’
approval more likely. Bear CEO Schwartz told the FCIC the increase let Bear preserve
the company’s value “to the greatest extent possible under the circumstances for our
shareholders, our 14,000 employees, and our creditors.”
VI. “It Was Heading to a Black Hole”
The SEC regulators Macchiaroli and Eichner were as stunned as everyone else by the
speed of Bear’s collapse. Macchiaroli had had doubts as far back as August, he told the
FCIC, but he and his colleagues expected Bear would be able to fund itself through the
repo market, albeit at higher margins.
Fed Chairman Ben Bernanke later called the Bear Stearns decision the toughest of the
financial crisis. The $2.8 trillion tri-party repo market had “really [begun] to break down,”
Bernanke said. “As the fear increased,” short-term lenders began demanding more
collateral, “which was making it more and more difficult for the financial firms to finance
themselves and creating more and more liquidity pressure on them. And, it was heading
sort of to a black hole.” He saw the collapse of Bear Stearns as threatening to freeze the
tri-party repo market, leaving the short-term lenders with collateral they would try to
“dump on the market. You would have a big crunch in asset prices.”
The Fall of Bear Stearns
“Bear Stearns, which is not that big a firm, our view on why it was important to save it –
you may disagree – but our view was that because it was so essentially involved in this
critical repo financing market, that its failure would have brought down that market,
which would have had implications for other firms,” Bernanke told the FCIC.
Geithner explained the need for government support for Bear’s acquisition by JP Morgan
as follows: “The sudden discovery by Bear’s derivative counterparties that important
financial positions they had put in place to protect themselves from financial risk were no
longer operative would have triggered substantial further dislocation in markets. This
would have precipitated a rush by Bear’s counterparties to liquidate the collateral they
held against those positions and to attempt to replicate those positions in already very
fragile markets.”
Paulson told the FCIC that Bear had both a liquidity problem and a capital problem.
“Could you just imagine the mess we would have had? If Bear had gone there were
hundreds, maybe thousands of counterparties that all would have grabbed their
collateral, would have started trying to sell their collateral, drove down prices, create
even bigger losses. There was huge fear about the investment banking model at that
time.” Paulson believed that if Bear had filed for bankruptcy, “you would have had
Lehman going . . . almost immediately if Bear had gone, and just the whole process
would have just started earlier.”
The Fall of Bear Stearns
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. In 2006, Bear Stearns was the largest prime brokerage company in the country.
a) true
b) false
2. Initially, why was the tri-party repo market considered a secure investment for
financial institutions:
the market was small, and there was not much liquidity
it was tightly regulated
the amount of the loan was greater than the value of the collateral
the collateral was worth more than the amount of the loan
3. What did section 13(3) allow the Feds to do:
a) it allowed them to not only help commercial banks but also financial institutions
that were experiencing a crisis
b) for the first time, their financial support was expanded to include commercial
banks as well
c) it permitted the Feds to decide if the company was going to be profitable or not
d) it required them to only extend credit to those companies that were very
profitable at the time
The Fall of Bear Stearns
1. A: True is incorrect. Bear Stearns was not the largest prime brokerage company in
the country. The largest was actually Morgan Stanley.
B: False is correct. Bear Stearns had the second largest prime brokerage
operation with 21% of the market, and Morgan Stanley had 23%.
(See page 15-1 of the course material.)
2. A: Incorrect. This market was in fact large and had lots of liquidity.
B: Incorrect. To the contrary, this market was very loosely regulated.
C: Incorrect. The opposite is true. The loans were for less than the collateral.
D: Correct. This is true, as the value of the collateral was higher than the amount of
the loan.
(See page 15-4 of the course material.)
3. A: Correct. This enabled the Feds to not just help commercial banks, but also
financial institutions who were in dire need.
B: Incorrect. The Feds had been extending credit to commercial banks all along.
C: Incorrect. The Feds’ actions had nothing to do with whether or not the company
was going to be profitable.
D: Incorrect. To the contrary, the financial institutions had to be experiencing an
emergency before the Fed would even consider extending credit.
(See page 15-6 of the course material.)
The Fall of Bear Stearns
Chapter 16: March to August 2008 – Systemic Risk Concerns
JP Morgan’s federally assisted acquisition of Bear Stearns averted catastrophe – for the
time being. The Federal Reserve had found new ways to lend cash to the financial
system, and some investors and lenders believed the Bear episode had set a precedent
for extraordinary government intervention. Investors began to worry less about a
recession and more about inflation, as the price of oil continued to rise (hitting almost
$144 per barrel in July). At the beginning of 2008, the stock market had fallen almost
15% from its peak in the fall of 2007. Then, in May 2008, the Dow Jones climbed to
13,058, within 8% of the record 14,164 set in October 2007. The cost of protecting
against the risk of default by financial institutions – reflected in the prices of credit default
swaps – declined from the highs of March and April. Taking advantage of the brief
respite in investor concern, the top ten American banks and the four remaining big
investment banks, anticipating losses, raised just under $100 billion and $40 billion,
respectively, in new equity by the end of June.
Despite this good news, bankers and their regulators were haunted by the speed of Bear
Stearns’s demise. And the word on the street – despite the assurances of Lehman CEO
Dick Fuld at an April shareholder meeting that “the worst is behind us” – was that Bear
would not be the only failure.
I. The Federal Reserve: “When People Got Scared”
The most pressing danger was the potential failure of the repo market. Market
participants believed that the tri-party repo market was a relatively safe and durable
source of collateralized short-term financing. It was on precisely this understanding that
Bear had shifted approximately $30 billion of its unsecured funding into repos in 2007.
But now it was clear that repo funding could be just as vulnerable to runs as were other
forms of short-term financing.
The repo runs of 2007, which had devastated hedge funds such as the two Bear Stearns
Asset Management funds and mortgage originators such as Countrywide, had seized
the attention of the financial community, and the run on Bear Stearns was similarly eyeopening. Market participants and regulators now better appreciated how the quality of
repo collateral had shifted over time from Treasury notes and securities issued by
Fannie Mae and Freddie Mac to highly rated non-GSE mortgage-backed securities and
collateralized debt obligations (CDOs). At its peak before the crisis, this riskier collateral
accounted for as much as 30% of the total posted. In April 2005, the Bankruptcy Abuse
Prevention and Consumer Protection Act of 2005 had dramatically expanded protections
for repo lenders holding collateral, such as mortgage-related securities, that was riskier
than government or highly rated corporate debt. These protections gave lenders
confidence that they had clear, immediate rights to collateral if a borrower should declare
bankruptcy. Nonetheless, Jamie Dimon, the CEO of JP Morgan, told the FCIC, “When
people got scared, they wouldn’t finance the nonstandard stuff at all.”
To the surprise of both borrowers and regulators, high-quality collateral was not enough
to ensure access to the repo market. Repo lenders cared just as much about the
financial health of the borrower as about the quality of the collateral. In fact, even for the
same collateral, repo lenders demanded different haircuts from different borrowers.
Despite the bankruptcy provisions in the 2005 Act, lenders were reluctant to risk the
Systemic Risk Concerns
hassle of seizing collateral, even good collateral, from a bankrupt borrower. Moreover, if
a borrower in the repo market defaults, money market funds – frequent lenders in this
market – may have to seize collateral that they cannot legally own. For example, a
money market fund cannot hold long-term securities, such as agency mortgage-backed
securities. Typically, if a fund takes possession of such collateral, it liquidates the
securities immediately, even – as was the case during the crisis – into a declining
market. As a result, funds simply avoided lending against mortgage-related securities. In
the crisis, investors didn’t consider secured funding to be much better than unsecured.
As noted, the Fed had announced a new program, the Term Securities Lending Facility
(TSLF), on the Tuesday before Bear’s collapse, but it would not be available until March
27. The TSLF would lend a total of up to $200 billion of Treasury securities at any one
time to the investment banks and other primary dealers – the securities affiliates of the
large commercial banks and investment banks that trade with the New York Fed, such
as Citigroup, Morgan Stanley, or Merrill Lynch – for up to 28 days. The borrowers would
trade highly rated securities, including debt in government-sponsored enterprises, in
return for Treasuries. The primary dealers could then use those Treasuries as collateral
to borrow cash in the repo market. Like the Term Auction Facility for commercial banks,
described earlier, the TSLF would run as a regular auction to reduce the stigma of
borrowing from the Fed. However, after Bear’s collapse, Fed officials recognized that the
situation called for a program that could be up and running right away. And they
concluded that the TSLF alone would not be enough.
So, the Fed would create another program first. On the Sunday of Bear’s collapse, the
Fed announced the new Primary Dealer Credit Facility (PDCF) – again invoking its
authority under 13(3) of the Federal Reserve Act – to provide cash, not Treasuries, to
investment banks and other primary dealers on terms close to those that depository
institutions – banks and thrifts – received through the Fed’s discount window. The move
came “just about 45 minutes” too late for Bear, Jimmy Cayne, its former CEO, told the
Unlike the TSLF, which would offer Treasuries for 28 days, the PDCF offered overnight
cash loans in exchange for collateral. In effect, this program could serve as an
alternative to the overnight tri-party repo lenders, potentially providing hundreds of
billions of dollars of credit.
By charging the Federal Reserve’s discount rate and adding additional fees for regular
use, the Federal Reserve encouraged dealers to use the PDCF only as a last resort. In
its first week of operation, this program immediately provided over $340 billion in cash to
Bear Stearns (as bridge financing until the JP Morgan deal officially closed), Lehman
Brothers, and the securities affiliate of Citigroup, among others. However, as the
immediate post-Bear concerns subsided, use of the facility declined after April and
ceased completely by late July. Because the dealers feared that markets would see
reliance on the PDCF as an indication of severe distress, the facility carried a stigma
similar to the Fed’s discount window. “Paradoxically, while the PDCF was created to
mitigate the liquidity flight caused by the loss of confidence in an investment bank, use of
the PDCF was seen both within Lehman, and possibly by the broader market, as an
event that could trigger a loss of confidence,” noted the Lehman bankruptcy examiner.
On May 2, the Fed broadened the kinds of collateral allowed in the TSLF to include other
triple-A-rated asset-backed securities, such as auto and credit card loans. In June, the
Fed’s Dudley urged in an internal email that both programs be extended at least through
Systemic Risk Concerns
the end of the year. “PDCF remains critical to the stability of some of the [investment
banks],” he wrote. “Amounts don’t matter here, it is the fact that the PDCF underpins the
tri-party repo system.” On July 30, the Fed extended both programs through January 30,
II. JP Morgan: “Refusing to Unwind . . .Would Be Unforgivable”
The repo run on Bear also alerted the two repo clearing banks – JP Morgan, the main
clearing bank for Lehman and Merrill Lynch, as it had been for Bear Stearns, and BNY
Mellon, the main clearing bank for Goldman Sachs and Morgan Stanley – to the risks
they were taking.
Before Bear’s collapse, the market had not really understood the colossal exposures that
the tri-party repo market created for these clearing banks. As explained earlier, the
“unwind/rewind” mechanism could leave JP Morgan and BNY Mellon with an enormous
“intraday” exposure – an interim exposure, but no less real for its brevity. In an interview
with the FCIC, Dimon said that he had not become fully aware of the risks stemming
from his bank’s tri-party repo clearing business until the Bear crisis in 2008. A clearing
bank had two concerns: First, if repo lenders abandoned an investment bank, it could be
pressured into taking over the role of the lenders. Second, and worse – if the investment
bank defaulted, it could be stuck with unwanted securities. “If they defaulted intraday, we
own the securities and we have to liquidate them. That’s a huge risk to us,” Dimon
To address those risks in 2008, for the first time both JP Morgan and BNY Mellon started
to demand that intraday loans to tri-party repo borrowers – mostly the large investment
banks – be overcollateralized.
The Fed increasingly focused on the systemic risk posed by the two repo clearing banks.
In the chain-reaction scenario that it envisioned, if either JP Morgan or BNY Mellon
chose not to unwind its trades one morning, the money funds and other repo lenders
could be stuck with billions of dollars in repo collateral. Those lenders would then be in
the difficult position of having to sell off large amounts of collateral in order to meet their
own cash needs, an action that in turn might lead to widespread fire sales of repo
collateral and runs by lenders.
The PDCF provided overnight funding, in case money market funds and other repo
lenders refused to lend as they had in the case of Bear Stearns, but it did not protect
against clearing banks’ refusing exposure to an investment bank during the day.
On July 11, Fed officials circulated a plan, ultimately never implemented, that addressed
the possibility that one of the two clearing banks would become unwilling or unable to
unwind its trades. The plan would allow the Fed to provide troubled investment banks,
such as Lehman Brothers, with $200 billion in tri-party repo financing during the day –
essentially covering for JP Morgan or BNY Mellon if the two clearing banks would not or
could not provide that level of financing. Fed officials made a case for the proposal in an
internal memo: “Should a dealer lose the confidence of its investors or clearing bank,
their efforts to pull away from providing credit could be disastrous for the firm and also
cast widespread doubt about the instrument as a nearly risk free, liquid overnight
Systemic Risk Concerns
But the New York Fed’s new plan shouldn’t be necessary as long as the PDCF was
there to back up the overnight lenders, argued Patrick Parkinson, then deputy director of
the Federal Reserve Board’s Division of Research and Statistics. “We should tell [JP
Morgan] that with the PDCF in place refusing to unwind is unnecessary and would be
unforgiveable,” he emailed Dudley and others.
A week later, on July 20, Parkinson wrote to Fed Governor Kevin Warsh and Fed
General Counsel Scott Alvarez that JP Morgan, because of its clearing role, was “likely
to be the first to realize that the money funds and other investors that provide tri-party
financing to [Lehman Brothers] are pulling back significantly.” Parkinson described the
chain-reaction scenario, in which a clearing bank’s refusal to unwind would lead to a
widespread fire sale and market panic. “Fear of these consequences is, of course, why
we facilitated Bear’s acquisition by JPMC,” he said.
Still, it was possible that the PDCF could prove insufficient to dissuade JP Morgan from
refusing to unwind Lehman’s repos, Parkinson said. Because a large portion of
Lehman’s collateral was ineligible to be funded by the PDCF, and because Lehman
could fail during the day (before the repos were settled), JP Morgan still faced significant
risks. Parkinson noted that even if the Fed lent as much as $200 billion to Lehman, the
sum might not be enough to ensure the firm’s survival in the absence of an acquirer: if
the stigma associated with PDCF borrowing caused other funding counterparties to stop
providing funding to Lehman, the company would fail.
III. The Fed and the SEC: “Weak Liquidity Position”
Among the four remaining investment banks, one key measure of liquidity risk was the
portion of total liabilities that the firms funded through the repo market: 15% to 20% for
Lehman and Merrill Lynch, 10% to 15% for Morgan Stanley, and about 10% for Goldman
Sachs. Another metric was the reliance on overnight repo (which mature in one day) or
open repo (which can be terminated at any time). Despite efforts among the investment
banks to reduce the portion of their repo financing that was overnight or open, the ratio
of overnight and open repo funding to total repo funding still exceeded 40% for all but
Goldman Sachs. Comparing the period between March and May to the period between
July and August, Lehman’s percentage fell from 45% to 40%, Merrill Lynch’s fell from
46% to 43%, Morgan Stanley’s fell from 70% to 55%, and Goldman’s fell from 18% to
10%. Another measure of risk was the haircuts on repo loans – that is, the amount of
excess collateral that lenders demanded for a given loan. Fed officials kept tabs on the
haircuts demanded of investment banks, hedge funds, and other repo borrowers. As Fed
analysts later noted, “With lenders worrying that they could lose money on the securities
they held as collateral, haircuts increased – doubling for some agency mortgage
securities and increasing significantly even for borrowers with high credit ratings and on
relatively safe collateral such as Treasury securities.”
On the day of Bear’s demise, in an effort to get a better understanding of the investment
banks, the New York Fed and the SEC sent teams to work on-site at Lehman Brothers,
Merrill Lynch, Goldman Sachs, and Morgan Stanley. According to Erik Sirri, director of
the SEC’s Division of Trading and Markets, the initial rounds of meetings covered the
quality of assets, funding, and capital.
Systemic Risk Concerns
Fed Chairman Ben Bernanke would testify before a House committee that the Fed’s
primary role at the investment banks in 2008 was not as a regulator but as a lender
through the new emergency lending facilities. Two questions guided the Fed’s analyses:
First, was each investment bank liquid – did it have access to the cash needed to meet
its commitments? Second, was it solvent – was its net equity (the value of assets minus
the value of liabilities) sufficient to cover probable losses?
The U.S. Treasury also dispatched so-called SWAT teams to the investment banks in
the spring of 2008. The arrival of officials from the Treasury and the Fed created a fulltime on-site presence – something the SEC had never had. Historically, the SEC’s
primary concern with the investment banks had been liquidity risk, because these firms
were entirely dependent on the credit markets for funding. The SEC already required
these firms to implement so-called liquidity models, designed to ensure that they had
sufficient cash available to sustain themselves on a stand-alone basis for a minimum of
one year without access to unsecured funding and without having to sell a substantial
amount of assets. Before the run on Bear in the repo market, the SEC’s liquidity stress
scenarios – also known as stress tests – had not taken account of the possibility that a
firm would lose access to secured funding. According to the SEC’s Sirri, the SEC never
thought that a situation would arise where an investment bank couldn’t enter into a repo
transaction backed by high-quality collateral including Treasuries. He told the FCIC that
as the financial crisis worsened, the SEC began to see liquidity and funding risks as the
most critical for the investment banks, and the SEC encouraged a reduction in reliance
on unsecured commercial paper and an extension of the maturities of repo loans.
The Fed and the SEC collaborated in developing two new stress tests to determine the
investment banks’ ability to withstand a potential run or a systemwide disruption in the
repo market. The stress scenarios, called “Bear Stearns” and “Bear Stearns Light,” were
developed jointly with the remaining investment banks. In May, Lehman, for example,
would be $84 billion short of cash in the more stringent Bear Stearns scenario and $15
billion short under Bear Stearns Light.
The Fed conducted another liquidity stress analysis in June. While each firm ran
different scenarios that matched its risk profile, the supervisors tried to maintain
comparability between the tests. The tests assumed that each firm would lose 100% of
unsecured funding and a fraction of repo funding that would vary with the quality of its
collateral. The stress tests, under just one estimated scenario, concluded that Goldman
Sachs and Morgan Stanley were relatively sound. Merrill Lynch and Lehman Brothers
failed: the two banks came out $22 billion and $15 billion short of cash, respectively;
each had only 78% of the liquidity it would need under the stress scenario.
The Fed’s internal report on the stress tests criticized Merrill’s “significant amount of
illiquid fixed income assets” and noted that “Merrill’s liquidity pool is low, a fact [the
company] does not acknowledge.” As for Lehman Brothers, the Fed concluded that
“Lehman’s weak liquidity position is driven by its relatively large exposure to overnight
[commercial paper], combined with significant overnight secured [repo] funding of less
liquid assets.” These “less liquid assets” included mortgage-related securities – now
devalued. Meanwhile, Lehman ran stress tests of its own and passed with billions in
“excess cash.”
Systemic Risk Concerns
Although the SEC and the Fed worked together on the liquidity stress tests, with equal
access to the data, each agency has said that for months during the crisis, the other did
not share its analyses and conclusions. For example, following Lehman’s failure in
September, the Fed told the bankruptcy examiner that the SEC had declined to share
two horizontal (cross-firm) reviews of the banks’ liquidity positions and exposures to
commercial real estate. The SEC’s response was that the documents were in “draft”
form and had not been reviewed or finalized. Adding to the tension, the Fed’s on-site
personnel believed that the SEC on-site personnel did not have the background or
expertise to adequately evaluate the data. This lack of communication was remedied
only by a formal memorandum of understanding (MOU) to govern information sharing.
According to former SEC Chairman Christopher Cox, “One reason the MOU was needed
was that the Fed was reluctant to share supervisory information with the SEC, out of
concern that the investment banks would not be forthcoming with information if they
thought they would be referred to the SEC for enforcement.” The MOU was not executed
until July 2008, more than three months after the collapse of Bear Stearns.
IV. Derivatives: “Early Stages of Assessing the Potential Systemic Risk”
The Fed’s Parkinson advised colleagues in an internal August 8 email that the systemic
risks of the repo and derivatives markets demanded attention: “We have given
considerable thought to what might be done to avoid a fire sale of tri-party repo
collateral. (That said, the options under existing authority are not very attractive – lots of
risk to Fed/taxpayer, lots of moral hazard.) We still are at the early stages of assessing
the potential systemic risk from close-out of OTC derivatives transactions by an
investment bank’s counterparties and identifying potential mitigants.”
The repo market was huge, but as discussed in earlier chapters, it was dwarfed by the
global derivatives market. At the end of June 2008, the notional amount of the over-thecounter derivatives market was $673 trillion and the gross market value was $20 trillion.
Adequate information about the risks in this market was not available to market
participants or government regulators like the Federal Reserve. Because the market had
been deregulated by statute in 2000, market participants were not subject to reporting or
disclosure requirements and no government agency had oversight responsibility. While
the Office of the Comptroller of the Currency did report information on derivatives
positions from commercial banks and bank holding companies, it did not collect such
information from the large investment banks and insurance companies like AIG, which
were also major OTC derivatives dealers. During the crisis the lack of such basic
information created heightened uncertainty.
At this point in the crisis, regulators also worried about the interlocking relationships that
derivatives created among the small number of large financial firms that act as dealers in
the OTC derivatives business. A derivatives contract creates a credit relationship
between parties, such that one party may have to make large and unexpected payments
to the other based on sudden price or rate changes or loan defaults. If a party is unable
to make those payments when they become due, that failure may cause significant
financial harm to its counterparty, which may have offsetting obligations to third parties
and depend on prompt payment. Indeed, most OTC derivatives dealers hedge their
contracts with offsetting contracts; thus, if they are owed payments on one contract, they
most likely owe similar amounts on an offsetting contract, creating the potential for a
series of losses or defaults. Since these contracts numbered in the millions and allowed
a party to have virtually unlimited leverage, the possibility of sudden large and
Systemic Risk Concerns
devastating losses in this market could pose a significant danger to market participants
and the financial system as a whole.
The Counterparty Risk Management Policy Group, led by former New York Fed
President E. Gerald Corrigan and consisting of the major securities firms, had warned
that a backlog in paperwork confirming derivatives trades and master agreements
exposed firms to risk should corporate defaults occur. With urging from New York Fed
President Timothy Geithner, by September 2006, 14 major market participants had
significantly reduced the backlog and had ended the practice of assigning trades to third
parties without the prior consent of their counterparties.
Large derivatives positions, and the resulting counterparty credit and operational risks,
were concentrated in a very few firms. Among U.S. bank holding companies, the
following institutions held enormous OTC derivatives positions as of June 30, 2008:
$94.5 trillion in notional amount for JP Morgan, $37.7 trillion for Bank of America, $35.8
trillion for Citigroup, $4.1 trillion for Wachovia, and $3.9 trillion for HSBC. Goldman
Sachs and Morgan Stanley, which began to report their holdings only after they became
bank holding companies in 2008, held $45.9 and $37.0 trillion, respectively, in notional
amount of OTC derivatives in the first quarter of 2009. In 2008, the current and potential
exposure to derivatives at the top five U.S. bank holding companies was on average
three times greater than the capital they had on hand to meet regulatory requirements.
The risk was even higher at the investment banks. Goldman Sachs, just after it changed
its charter, had derivatives exposure more than 10 times capital. These concentrations
of positions in the hands of the largest bank holding companies and investment banks
posed risks for the financial system because of their interconnections with other financial
Broad classes of OTC derivatives markets showed stress in 2008. By the summer of
2008, outstanding amounts of some types of derivatives had begun to decline sharply.
As we will see, over the course of the second half of 2008, the OTC derivatives market
would undergo an unprecedented contraction, creating serious problems for hedging
and price discovery.
The Fed was uneasy in part because derivatives counterparties had played an important
role in the run on Bear Stearns. The novations by derivatives counterparties to assign
their positions away from Bear – and the rumored refusal by Goldman to accept Bear as
a derivatives counterparty – were still a fresh memory across Wall Street. Chris
Mewbourne, a portfolio manager at PIMCO, told the FCIC that the ability to novate
ceased to exist and this was a key event in the demise of Bear Stearns.
Credit derivatives in particular were a serious source of worry. Of greatest interest were
the sellers of credit default swaps: the monoline insurers and AIG, which stopped the
market in CDOs. In addition, the credit rating agencies’ decision to issue a negative
outlook on the monoline insurers had jolted everyone, because they guaranteed
hundreds of billions of dollars in structured products. As we have seen, when their credit
ratings were downgraded, the value of all the assets they guaranteed, including
municipal bonds and other securities, necessarily lost some value in the market, a drop
that affected the conservative institutional investors in those markets. In the vernacular
of Wall Street, this outcome is the knock-on effect; in the vernacular of Main Street, the
domino effect; in the vernacular of the Fed, systemic risk.
Systemic Risk Concerns
V. Banks: “The Markets Were Really, Really Dicey”
By the fall of 2007, signs of strain were beginning to emerge among the commercial
banks. In the fourth quarter of 2007, commercial banks’ earnings declined to a 16-year
low, driven by write-downs on mortgage-backed securities and CDOs and by record
provisions for future loan losses, as borrowers had increasing difficulty meeting their
mortgage payments – and even greater difficulty was anticipated. The net charge-off
rate – the ratio of failed loans to total loans – rose to its highest level since 2002, when
the economy was coming out of the post-9/11 recession. Earnings continued to decline
in 2008 – at first, more for big banks than small banks, in part because of write-downs
related to their investment banking-type activities, including the packaging of mortgagebacked securities, CDOs, and collateralized loan obligations. Declines in market values
required banks to write down the value of their holdings of these securities. As
previously noted, several of the largest banks had also provided support to off-balancesheet activities, such as money market funds and commercial paper programs, bringing
additional assets onto their balance sheets – assets that were losing value fast.
Supervisors had begun to downgrade the ratings of many smaller banks in response to
their high exposures in residential real estate construction, an industry that virtually went
out of business as financing dried up in mid-2007. By the end of 2007, the FDIC had 76
banks, mainly smaller ones, on its “problem list”; their combined assets totaled $22.2
billion. (When large banks started to be downgraded, in early 2008, they stayed off the
FDIC’s problem list, as supervisors rarely give the largest institutions the lowest ratings.)
The market for nonconforming mortgage securitizations (those backed by mortgages
that did not meet Fannie Mae’s or Freddie Mac’s underwriting or mortgage size
guidelines) had also vanished in the fourth quarter of 2007. Not only did these
nonconforming loans prove harder to sell, but they also proved less attractive to keep on
balance sheet, as house price forecasts looked increasingly grim. Already, house prices
had fallen about 7% for the year, depending on the measure. In the first quarter of 2008,
real estate loans in the banking sector showed the smallest quarterly increase since
2003. IndyMac reported a 21% decline in loan production for that quarter from a year
earlier, because it had stopped making nonconforming loans. Washington Mutual, the
largest thrift, discontinued all remaining lending through its subprime mortgage channel
in April 2008.
But those actions could not reduce the subprime and Alt-A exposure that these large
banks and thrifts already had. And on these assets, the markdowns continued in 2008.
Regulators began to focus on solvency, urging the banks to raise new capital. In January
2008, Citigroup secured a total of $14 billion in capital from Kuwait, Singapore, Saudi
Prince Alwaleed bin Talal, and others. In April, Washington Mutual raised $7 billion from
an investor group led by the buyout firm TPG Capital. Wachovia raised $6 billion in
capital at the turn of the year and then an additional $8 billion in April 2008. Despite the
capital raised, though, the downgrades by banking regulators continued.
“The markets were really, really dicey during a significant part of this period, starting with
August 2007,” Roger Cole, then-director of the Division of Banking Supervision and
Regulation at the Federal Reserve Board, told the FCIC. The same was true for the
thrifts. Michael Solomon, a managing director in risk management in the Office of Thrift
Supervision (OTS), told the FCIC, “It was hard for businesses, particularly small,
midsized thrifts – to keep up with [how quickly the ratings downgrades occurred during
the crisis] and change their business models and not get stuck without the chair when
Systemic Risk Concerns
the music stopped . . . They got caught. The rating downgrades started and by the time
the thrift was able to do something about it, it was too late . . . Business models . . . can’t
keep up with what we saw in 2008.”
As the commercial banks’ health worsened in 2008, examiners downgraded even large
institutions that had maintained favorable ratings and required several to fix their risk
management processes. These ratings downgrades and enforcement actions came late
in the day – often just as firms were on the verge of failure. In cases that the FCIC
investigated, regulators either did not identify the problems early enough or did not act
forcefully enough to compel the necessary changes.
For Citigroup, supervisors at the New York Fed, who examined the bank holding
company, and at the Office of the Comptroller of the Currency, who oversaw the national
bank subsidiary, finally downgraded the company and its main bank to “less than
satisfactory” in April 2008 – five months after the firm’s announcement in November
2007 of billions of dollars in write-downs related to its mortgage-related holdings. The
supervisors put the company under new enforcement actions in May and June. Only a
year earlier, both the Fed and the OCC had upgraded the company, after lifting all
remaining restrictions and enforcement actions related to complex transactions that it
had structured for Enron and to the actions of its subprime subsidiary CitiFinancial,
discussed in an earlier chapter. “The risk management assessment for 2006 is reflective
of a control environment where the risks facing Citigroup continue to be managed in a
satisfactory manner,” the New York Fed’s rating upgrade, delivered in its annual
inspection report on April 9, 2007, had noted. “During 2006, all formal restrictions and
enforcement actions between the Federal Reserve and Citigroup were lifted. Board and
senior management remain actively engaged in improving relevant processes.”
But the market disruption had jolted Citigroup’s supervisors. In November 2007, the New
York Fed led a team of international supervisors, the Senior Supervisors Group, in
evaluating 11 of the largest firms to assess lessons learned from the financial crisis up to
that point. Much of the toughest language was reserved for Citigroup. “The firm did not
have an adequate, firm-wide consolidated understanding of its risk factor sensitivities,”
the supervisors wrote in an internal November 19 memo describing meetings with
Citigroup management. “Stress tests were not designed for this type of extreme market
event. . . . Management had believed that CDOs and leveraged loans would be
syndicated, and that the credit risk in super senior AAA CDOs was negligible.”
In retrospect, Citigroup had two key problems: a lack of effective enterprise-wide
management to monitor and control risks and a lack of proper infrastructure and internal
controls with respect to the creation of CDOs. The OCC appears to have identified some
of these issues as early as 2005 but did not effectively act to rectify them. In particular,
the OCC assessed both the liquidity puts and the super-senior tranches as part of its
reviews of the bank’s compliance with the post-Enron enforcement action, but it did not
examine the risks of these exposures. As for the issues it did spot, the OCC failed to
take forceful steps to require mandatory corrective action, and it relied on management’s
assurances in 2006 that the executives would strive to meet the OCC’s goals for
improving risk management.
Systemic Risk Concerns
In contrast, documents obtained by the FCIC from the New York Fed give no indication
that its examination staff had any independent knowledge of those two core problems.
An evaluation of the New York Fed’s supervision of Citigroup, conducted by examiners
from other Reserve Banks (the December 2009 Operations Review of the New York
Fed, which covered the previous four years), concluded:
The supervision program for Citigroup has been less than effective.
Although the dedicated supervisory team is well qualified and generally
has sound knowledge of the organization, there have been significant
weaknesses in the execution of the supervisory program. The team has
not been proactive in making changes to the regulatory ratings of the firm,
as evidenced by the double downgrades in the firm’s financial component
and related subcomponents at year-end 2007. Additionally, the
supervisory program has lacked the appropriate level of focus on the
firm’s risk oversight and internal audit functions. As a result, there is
currently significant work to be done in both of these areas. Moreover, the
team has lacked a disciplined and proactive approach in assessing and
validating actions taken by the firm to address supervisory issues.
Timothy Geithner, secretary of the Treasury and former president of the Federal
Reserve Bank of New York, reflected on the Fed’s oversight of Citigroup, telling the
Commission, “I do not think we did enough as an institution with the authority we had to
help contain the risks that ultimately emerged in that institution.”
In January 2008, an OCC review of the breakdown in the CDO business noted that the
risk in the unit had grown rapidly since 2006, after the OCC’s and Fed’s lifting of
supervisory agreements associated with various control problems at Citigroup. In April
2008, the Fed and OCC downgraded their overall ratings of the company and its largest
bank subsidiary from 2 (satisfactory) to 3 (less than satisfactory), reflecting weaknesses
in risk management that were now apparent to the supervisors.
Both Fed and OCC officials cited the Gramm-Leach-Bliley Act of 1999 as an obstacle
that prevented each from obtaining a complete understanding of the risks assumed by
large financial firms such as Citigroup. The act made it more difficult – though not
impossible – for regulators to look beyond the legal entities under their direct purview
into other areas of a large firm. Citigroup, for example, had many regulators across the
world; even the securitization businesses were dispersed across subsidiaries with
different supervisors – including those from the Fed, OCC, SEC, OTS, and state
In May and June 2008, Citigroup entered into memoranda of understanding with both
the New York Fed and OCC to resolve the risk management weaknesses that the
events of 2007 had laid bare. In the ensuing months, Fed and OCC officials said, they
were satisfied with Citigroup’s compliance with their recommendations. Indeed, in
speaking to the FCIC, Steve Manzari, the senior relationship manager for Citigroup at
the New York Fed from April to September 2008, complimented Citigroup on its
assertiveness in executing its regulators’ requests: aggressively replacing management,
raising capital from investors in late 2007, and putting in place a number of much
needed “internal fixes.” However, Manzari went on, “Citi was trapped in what was a
pretty vicious . . . systemic event,” and for regulators “it was time to come up with a new
Systemic Risk Concerns
At Wachovia, which was supervised by the OCC as well as the OTS and the Federal
Reserve, a 2007 end-of-year report showed that credit losses in its subsidiary Golden
West’s portfolio of “Pick-a-Pay” adjustable-rate mortgages, or option ARMs, were
expected to rise to about 1% of the portfolio for 2008; in 2006, losses in this portfolio had
been less than 0.1%. It would soon become clear that the higher estimate for 2008 was
not high enough. The company would hike its estimate of the eventual losses on the
portfolio to 9% by June and to 22% by September.
Facing these and other growing concerns, Wachovia raised additional capital. Then, in
April, Wachovia announced a loss of $350 million for the first three months of the year.
Depositors withdrew about $15 billion in the following weeks, and lenders reduced their
exposure to the bank, shortening terms, increasing rates, and reducing loan amounts.
By June, according to Angus McBryde, then Wachovia’s senior vice president for
Treasury and Balance Sheet Management, management had launched a liquidity crisis
management plan in anticipation of an even more adverse market reaction to secondquarter losses that would be announced in July.
On June 2, Wachovia’s board ousted CEO Ken Thompson after he had spent 32 years
at the bank, 8 of them at its helm. At the end of the month, the bank announced that it
would stop originating Golden West’s Pick-a-Pay products and would waive all fees and
prepayment penalties associated with them. On July 22, Wachovia reported an $8.9
billion second-quarter loss. The new CEO, Robert Steel, most recently an
undersecretary of the treasury, announced a plan to improve the bank’s financial
condition: raise capital, cut the stock dividend, and lay off 10% to 12% of the staff.
The rating agencies and supervisors ignored those reassurances. On the same day as
the announcement, S&P downgraded the bank, and the Fed, after years of “satisfactory”
ratings, downgraded Wachovia to 3, or “less than satisfactory.” The Fed noted that 2008
projections showed losses that could wipe out the recently raised capital: 2008 losses
alone could exceed $3 billion, an amount that could cause a further ratings downgrade.
The Fed directed Wachovia to reevaluate and update its capital plans and its liquidity
management. Despite having consistently rated Wachovia as “satisfactory” right up to
the summer meltdown, the Fed now declared that many of Wachovia’s problems were
“long-term in nature and result[ed] from delayed investment decisions and a desire to
have business lines operate autonomously.”
The Fed bluntly criticized the board and senior management for “an environment with
inconsistent and inadequate identification, escalation and coverage of all risk taking
activities, including deficiencies in stress testing” and “little accountability for errors.”
Wachovia management had not completely understood the level of risk across the
company, particularly in certain nonbank investments, and management had delayed
fixing these known deficiencies. In addition, the company’s board had not sufficiently
questioned investment decisions. Nonetheless, the Fed concluded that Wachovia’s
liquidity was currently adequate and that throughout the market disruption, management
had minimized exposure to overnight funding markets.
On August 4, the OCC downgraded Wachovia Bank and assessed its overall risk profile
as “high.” The OCC noted many of the same issues as the Fed, and added particularly
strong remarks about the acquisition of Golden West, identifying that mortgage portfolio
Systemic Risk Concerns
and associated real estate foreclosures as the heart of Wachovia’s problem. The OCC
noted that the board had “acknowledged that the Golden West acquisition was a
The OCC wrote that the market was focused on the company’s weakened condition and
that some large fund providers had already limited their exposure to Wachovia. Like the
Fed, however, the OCC concluded that the bank’s liquidity was adequate, unless events
undermined market confidence. And, like the Fed, the OCC approved of the new
management and a new, more hands-on oversight role for the board of directors.
Yet Wachovia’s problems would continue, and in the fall regulators would scramble to
find a buyer for the troubled bank.
Washington Mutual, often called WaMu, was the largest thrift in the country, with over
$300 billion in assets at the end of 2007. At the time, $59 billion of the home loans on its
balance sheet were option ARMs, two times its capital and reserves, with concentrated
exposure in California. The reason WaMu liked option ARMs was simple: in 2005, in
combination with other nontraditional mortgages such as subprime loans, they had
generated returns up to 8 times those on GSE mortgage-backed securities. But that was
then. WaMu was forced to write off $1.9 billion for the fourth quarter of 2007 and another
$1.1 billion in the first quarter of 2008, mostly related to its portfolio of option ARMs.
In response to these losses, the Office of Thrift Supervision, WaMu’s regulator,
requested that the thrift address concerns about asset quality, earnings, and liquidity –
issues that the OTS had raised in the past but that had not been reflected in supervisory
ratings. “It has been hard for us to justify doing much more than constantly nagging
(okay, ‘chastising’) through ROE [Reports of Examination] and meetings, since they
have not really been adversely impacted in terms of losses,” the OTS’s lead examiner at
the company had commented in a 2005 email. Indeed, the nontraditional mortgage
portfolio had been performing very well through 2005 and 2006.
But with WaMu now taking losses, the OTS determined on February 27, 2008, that its
condition required a downgrade in its rating from a 2 to a 3, or “less than satisfactory.” In
March, the OTS advised that WaMu undertake “strategic initiatives” – that is, either find
a buyer or raise new capital. In April, WaMu secured a $7 billion investment from a
consortium led by the Texas Pacific Group, a private equity firm.
But bad news continued for thrifts. On July 14, the OTS closed IndyMac Bank in
Pasadena, California, making that company the largest-ever thrift to fail. On July 22,
2008, WaMu reported a $3.3 billion loss in the second quarter. WaMu’s depositors
withdrew $10 billion over the next two weeks. And the Federal Home Loan Bank of San
Francisco – which, as noted, had historically served with the other 11 Federal Home
Loan Banks as an important source of funds for WaMu and others – began to limit
WaMu’s borrowing capacity. The OTS issued more downgrades in various assessment
categories, while maintaining the overall rating at 3.
Systemic Risk Concerns
As the insurer of many of WaMu’s deposits, the FDIC had a stake in WaMu’s condition,
and it was not as generous as the OTS in its assessment. It had already dropped
WaMu’s rating significantly in March 2008, indicating a “high level of concern.”
The FDIC expressly disagreed with the OTS’s decision to maintain the 3 overall rating,
recommending a 4 instead. Ordinarily, 4 would have triggered a formal enforcement
action, but none was forthcoming. In an August 2008 interview, William Isaac, who was
chairman of the FDIC from 1981 until 1985, noted that the OTS and FDIC had
competing interests. OTS, as primary regulator, “tends to want to see if they can
rehabilitate the bank and doesn’t want to act precipitously as a rule.” On the other hand,
“The FDIC’s job is to handle the failures, and it – generally speaking – would rather be
tougher . . . on the theory that the sooner the problems are resolved, the less expensive
the cleanup will be.”
FDIC Chairman Sheila Bair underscored this tension, telling the FCIC that “our
examiners, much earlier, were very concerned about the underwriting quality of WaMu’s
mortgage portfolio, and we were actively opposed by the OTS in terms of going in and
letting our [FDIC] examiners do loan-level analysis.”
The Treasury’s inspector general would later criticize OTS’s supervision of Washington
Mutual: “We concluded that OTS should have lowered WaMu’s composite rating sooner
and taken stronger enforcement action sooner to force WaMu’s management to correct
the problems identified by OTS. Specifically, given WaMu management’s persistent lack
of progress in correcting OTS-identified weaknesses, we believe OTS should have
followed its own policies and taken formal enforcement action rather than informal
enforcement action.”
In these examples and others that the Commission studied, regulators either failed or
were late to identify the mistakes and problems of commercial banks and thrifts or did
not react strongly enough when they were identified. In part, this failure reflects the
nature of bank examinations conducted during periods of apparent financial calm when
institutions were reporting profits. In addition to their role as enforcers of regulation,
regulators acted something like consultants, working with banks to assess the adequacy
of their systems. This function was, to a degree, a reflection of the supervisors’ “riskfocused” approach. The OCC Large Bank Supervision Handbook published in January
2010 explains, “Under this approach, examiners do not attempt to restrict risk-taking but
rather determine whether banks identify, understand, and control the risks they assume.”
As the crisis developed, bank regulators were slow to shift gears.
Senior supervisors told the FCIC it was difficult to express their concerns forcefully when
financial institutions were generating record-level profits. The Fed’s Roger Cole told the
FCIC that supervisors did discuss issues such as whether banks were growing too fast
and taking too much risk, but ran into pushback. “Frankly a lot of that pushback was
given credence on the part of the firms by the fact that – like a Citigroup was earning $4
to $5 billion a quarter. And that is really hard for a supervisor to successfully challenge.
When that kind of money is flowing out quarter after quarter after quarter, and their
capital ratios are way above the minimums, it’s very hard to challenge.”
Systemic Risk Concerns
Supervisors also told the FCIC that they feared aggravating a bank’s already-existing
problems. For the large banks, the issuance of a formal, public supervisory action taken
under the federal banking statutes marked a severe regulatory assessment of the bank’s
risk practices, and it was rarely employed for banks that were determined to be going
concerns. Richard Spillenkothen, the Fed’s head of supervision until early 2006,
attributed supervisory reluctance to “a belief that the traditional, nonpublic (behind-thescenes) approach to supervision was less confrontational and more likely to induce bank
management to cooperate; a desire not to inject an element of contentiousness into
what was felt to be a constructive or equable relationship with management; and a fear
that financial markets would overreact to public actions, possibly causing a run.”
Spillenkothen argued that these concerns were relevant but that “at times they can
impede effective supervision and delay the implementation of needed corrective action.
One of the lessons of this crisis . . . is that the working presumption should be earlier and
stronger supervisory follow up.”
Douglas Roeder, the OCC’s senior deputy comptroller for Large Bank Supervision from
2001 to 2010, said that the regulators were hampered by inadequate information from
the banks but acknowledged that regulators did not do a good job of intervening at key
points in the run-up to the crisis. He said that regulators, market participants, and others
should have balanced their concerns about safety and soundness with the need to let
markets work, noting, “We underestimated what systemic risk would be in the
Regulators also blame the complexity of the supervisory system in the United States.
The patchwork quilt of regulators created opportunities for banks to shop for the most
lenient regulator, and the presence of more than one supervisor at an organization. For
example, a large firm like Citigroup could have the Fed supervising the bank holding
company, the OCC supervising the national bank subsidiary, the SEC supervising the
securities firm, and the OTS supervising the thrift subsidiary – creating the potential for
both gaps in coverage and problematic overlap. Successive Treasury secretaries and
Congressional leaders have proposed consolidation of the supervisors to simplify this
system over the years. Notably, Secretary Henry Paulson released the “Blueprint for a
Modernized Financial Regulatory Structure” on March 31, 2008, two weeks after the
Bear rescue, in which he proposed getting rid of the thrift charter, creating a federal
charter for insurance companies (now regulated only by the states), and merging the
SEC and CFTC. The proposals did not move forward in 2008.
Systemic Risk Concerns
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. Why was Bear Stearns’ downfall so concerning to those in the financial industry:
repo funding was exempt from runs
Bear Stearns did not invest at all in the repo market
their downfall was long and drawn out and lasted many years
because of how quickly the collapse happened
2. The Primary Dealer Credit Facility (PDCF) was a program that extended next-day
cash loans in return for collateral. This program was highly touted and was used by
a) true
b) false
3. Why were commercial banks beginning to show signs of distress in the latter part of
the net charge-off rate was at its lowest level ever
buyers were having a harder time making their mortgage payments
their earnings dropped to a 16-year low
both b and c above
Systemic Risk Concerns
1. A: Incorrect. To the contrary, great losses occurred with repo funding.
B: Incorrect. Bear Stearns was actually heavily funded in repos before it collapsed.
C: Incorrect. Its demise was very quick and sudden.
D: Correct. Bear Stearns’ downfall happened extremely quickly, and it left many in
(See page 16-1 of the course material.)
2. A: True is incorrect. This is not true because many believed that those who did use
PDCF were in a financial crisis, and it scared investors away.
B: False is correct. This program was only to be used by those in dire need of
assistance and many avoided using it because they did not want to appear to be
financially strapped.
(See pages 16-2 to 16-3 of the course material.)
3. A: Incorrect. The amount of failed loans compared to total loans was at its highest
level since 2002.
B: Incorrect. More and more people were becoming delinquent on making their
mortgage payments. However, this is not the best answer
C: Incorrect. Commercial banks’ earnings were at a 16-year low. However, there is a
better answer.
D: Correct. There were signs of distress among the commercial bank industry
because many mortgages were not being timely paid and earnings were the lowest
they had been in 16 years.
(See page 16-8 of the course material.)
Systemic Risk Concerns
Chapter 17: The Takeover of Fannie Mae and Freddie Mac
From the fall of 2007 until Fannie Mae and Freddie Mac were placed into
conservatorship on September 7, 2008, government officials struggled to strike the right
balance between the safety and soundness of the two government-sponsored
enterprises (GSEs) and their mission to support the mortgage market. The task was
critical because the mortgage market was quickly weakening – home prices were
declining, loan delinquencies were on the rise, and, as a result, the values of mortgage
securities were plummeting. Lenders were more willing to refinance borrowers into
affordable mortgages if these government-sponsored enterprises would purchase the
new loans. If the GSEs bought more loans, that would stabilize the market, but it would
also leave the GSEs with more risk on their already-strained balance sheets.
The GSEs were highly leveraged – owning and guaranteeing $5.3 trillion of mortgages
with capital of less than 2%. When interviewed by the FCIC, former Treasury Secretary
Henry Paulson acknowledged that after he was briefed on the GSEs upon taking office
in June 2006, he believed that they were “a disaster waiting to happen” and that one key
problem was the legal definition of capital, which their regulator lacked discretion to
adjust; indeed, he said that some people referred to it as “bullsh*t capital.” Still, the
GSEs kept buying more of the riskier mortgage loans and securities, which by fall 2007
constituted multiples of their reported capital. The GSEs reported billions of dollars of net
losses on these loans and securities, beginning in the third quarter of 2007.
But many in Treasury believed the country needed the GSEs to provide liquidity to the
mortgage market by purchasing and guaranteeing loans and securities at a time when
no one else would. Paulson told the FCIC that after the housing market dried up in the
summer of 2007, the key to getting through the crisis was to limit the decline in housing,
prevent foreclosures, and ensure continued mortgage funding, all of which required that
the GSEs remain viable. However, there were constraints on how many loans the GSEs
could fund; they and their regulators had agreed to portfolio caps – limits on the loans
and securities they could hold on their books – and a 30% capital surplus requirement.
So, even as each company reported billions of dollars in losses in 2007 and 2008, their
regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), loosened those
constraints. “From the fall of 2007, to the conservatorships, it was a tightrope with no
safety net,” former OFHEO Director James Lockhart testified to the FCIC. Unfortunately,
the balancing act ultimately failed and both companies were placed into conservatorship,
costing the U.S. taxpayers $151 billion – so far.
I. “A Good Time to Buy”
In an August 1, 2007, Fannie Mae CEO Daniel Mudd sought immediate relief from the
portfolio caps required by the consent agreement executed in May 2006 following
Fannie’s accounting scandal. A number of firms told Fannie that they would stop making
loans if Fannie would not buy them. Mudd argued that a relaxed cap would let his
company provide that liquidity. “A moderate, 10 percent increase in the Fannie Mae
portfolio cap would provide us with flexibility . . . and send a strong signal to the market
that the GSEs are able to address liquidity events before they become crises.” He
maintained that the consent agreement allowed OFHEO to lift the cap to address
“market liquidity issues.” Moreover, the company had largely corrected its accounting
The Takeover of Fannie Mae and
Freddie Mac
and internal control deficiencies – the primary condition for removing the cap. Finally, he
stressed that the GSEs’ charter required Fannie to provide liquidity and stability to the
market. “Ultimately,” Mudd concluded, “this request is about restoring market confidence
that the GSEs can fulfill their stabilizing role in housing.”
Fannie Mae executives also saw an opportunity to make money. Because there was
less competition, the GSEs could charge higher fees for guaranteeing securities and pay
less for loans and securities they wanted to own, enabling them (in theory) to increase
II. “The Only Game in Town”
But Fannie and Freddie were “the only game in town” once the housing market dried up
in the summer of 2007, Paulson told the FCIC. And by the spring of 2008, “[the GSEs,]
more than anyone, were the engine we needed to get through the problem.” Few
doubted Fannie and Freddie were needed to support the struggling housing market. The
question was how to do so safely. Purchasing and guaranteeing risky mortgage-backed
securities helped make money available for borrowers, but it could also result in further
losses for the two huge companies later on. “There’s a real tradeoff,” Lockhart said in
late 2007 – a trade-off made all the more difficult by the state of the GSEs’ balance
sheets. The value of risky loans and securities was swamping their reported capital. By
the end of 2007, guaranteed and portfolio mortgages with FICO scores less than 660
exceeded reported capital at Fannie Mae by more than seven to one; Alt-A loans and
securities, by more than six to one. Loans for which borrowers did not provide full
documentation amounted to more than ten times reported capital.
In mid-September, OFHEO relented and marginally loosened the GSEs’ portfolio cap,
from about $728 billion to $735 billion. It allowed Fannie to increase the amount of
mortgage loans and securities it owned by 2% per year – a power that Freddie already
had under its agreement with OFHEO. OFHEO ruled out more dramatic increases
“because the remediation process is not yet finished, many safety and soundness issues
are not yet resolved, and the criteria in the Fannie Mae consent agreement and Freddie
Mac’s voluntary agreement have not been met.”
As the year progressed, Fannie and Freddie became increasingly important to the
mortgage market. By the fourth quarter of 2007, they were purchasing 75% of new
mortgages, nearly twice the 2006 level. With $5 trillion in mortgages resting on razor-thin
capital, the GSEs were doomed if the market did not stabilize. According to Lockhart, “a
withdrawal by Freddie Mac and Fannie Mae or even a drop in confidence in the
Enterprises would have created a self-fulfilling credit crisis.”
In November, Fannie and Freddie reported third-quarter losses of $1.5 billion and $2
billion, respectively. At the end of December 2007, Fannie reported that it had $44 billion
of capital to absorb potential losses on $879 billion of assets and $2.2 trillion of
guarantees on mortgage-backed securities; if losses exceeded 1.45%, it would be
insolvent. Freddie would be insolvent if losses exceeded 1.7%. Moreover, there were
serious questions about the validity of their “reported” capital.
The Takeover of Fannie Mae and
Freddie Mac
III. “It’s a Time Game . . . Be Cool”
In the first quarter, real gross domestic product fell 0.7% at an annual rate, reflecting in
part the first decline in consumer spending since the early 1990s. The unemployment
rate averaged 5% in the first three months of 2008, up from a low of 4.4% in spring of
2007. As the Fed continued to cut interest rates, the economy was sinking further into
recession. In February, Congress passed the Economic Stimulus Act, which raised the
limits on the size of mortgages that Fannie and Freddie could purchase, among other
measures. Later that month, Fannie CEO Mudd reported losses in the fourth quarter of
2007, acknowledging that Fannie was “working through the toughest housing and
mortgage markets in a generation.” The company had issued $7.8 billion of preferred
stock, had completed all 81 requirements of the consent agreement with OFHEO, and
was discussing with OFHEO the possibility of reducing the 30% capital surplus
requirement. The next day, Freddie also reported losses and said the company had
raised $6 billion of preferred stock.
As both companies had filed current financial statements by this time, fulfilling a
condition of lifting the restrictions imposed by the consent agreements, the OFHEO
announced that he would remove the portfolio caps on March 1, 2008. They also said
that OFHEO would consider gradually lowering the 30% capital surplus requirement,
because both companies had made progress in satisfying their consent agreements and
had recently raised capital through preferred stock offerings. Mudd told the FCIC that he
sought relief from the capital surplus requirement because he did not want to face further
regulatory discipline if Fannie fell short of required capital levels.
On February 28, 2008, the day after OFHEO lifted the growth limits, a New York Fed
analyst noted to Treasury that the 30% capital surcharge was a constraint that prevented
the GSEs from providing additional liquidity to the secondary mortgage market.
Calls to ease the surcharge also came from the marketplace. Mike Farrell, the CEO of
Annaly Capital Management, warned Treasury Undersecretary Robert Steel that a crisis
loomed in the credit markets that only the GSEs could solve. “We believe that we are
nearing a tipping point; . . . lack of transparency on pricing for virtually every asset class”
and “a dearth of buyers” foreshadowed worse news, Farrell wrote. Removing the capital
surcharge and passing legislation to overhaul the GSEs would make it possible for them
to provide more stability, he said. Farrell recognized that the GSEs might believe their
return on capital would be insufficient, but contended that “they will have to get past that
and focus on fulfilling their charters,” because “the big picture is that right now whatever
is best for the economy and the financial security of America trumps the ROI [return on
investment] for Fannie and Freddie shareholders.”
Days before Bear Stearns collapsed, Steel reported to Mudd that he had “encouraging”
conversations with Senator Richard Shelby, the ranking member of the Senate
Committee on Banking, Housing, and Urban Affairs, and Representative Barney Frank,
chairman of the House Financial Services Committee, about the possibility of GSE
reform legislation and capital relief for the GSEs. He intended to speak with Senate
Banking Committee Chairman Christopher Dodd. Confident that the government
desperately needed the GSEs to back up the mortgage market, Mudd proposed an
“easier trade.” If regulators would eliminate the surcharge, Fannie Mae would agree to
raise new capital. In a March 7 email to Fannie chief business officer Levin, Mudd
suggested that the 30% capital surplus requirement might be reduced without any trade:
The Takeover of Fannie Mae and
Freddie Mac
“It’s a time game . . . whether they need us more . . . or if we hit the capital wall first. Be
Given the turmoil of the Bear Stearns crisis, Paulson said he wanted to increase
confidence in the mortgage market by having Fannie and Freddie raise capital. Steel told
him that Treasury, OFHEO, and the Fed were preparing plans to relax the GSEs’ capital
surcharges in exchange for assurances that the companies would raise capital.
On March 16, 2008, Steel also reported to his Treasury colleagues that William Dudley,
then executive vice president of the New York Fed, wanted to “harden” the implicit
government guarantee of Freddie and Fannie. Steel wrote that Dudley “leaned on me
hard” to make the guarantee explicit in conjunction with dialing back the surcharge and
attempting to raise new capital, and Steel worried about how this might affect the federal
government’s balance sheet: “I do not like that and it has not been part of my
conversation with anyone else. I view that as a very significant move, way above my pay
grade to double the size of the U.S. debt in one fell swoop.”
IV. “It Will Increase Confidence”
In May, the two companies announced further losses in the first quarter. Even as the
situation deteriorated, on June 9 OFHEO rewarded Fannie Mae for raising $7.4 billion in
new capital by further lowering the capital surcharge, from 20% to 15%. In June,
Fannie’s stock fell 28%; Freddie’s, 34%. The price of protection on $10 million in
Fannie’s debt through credit default swaps jumped to $66,000 in June, up from $47,700
in May; between 2004 and 2006, it had typically been about $13,000. In August, they
both reported more losses for the second quarter.
Even after both Fannie and Freddie became public companies owned by shareholders,
they had continued to possess an asset that is hard to quantify: the implicit full faith and
credit of the U.S. government. The government worried that it could not let the $5.3
trillion GSEs fail, because they were the only source of liquidity in the mortgage market
and because their failure would cause losses to owners of their debt and their
guaranteed mortgage securities. Uncle Sam had rescued GSEs before. It bailed out
Fannie when double-digit inflation wrecked its balance sheet in the early 1980s, and it
came through in the mid-1980s for another GSE in duress, the Farm Credit System. In
the mid-1990s, even a GSE-type organization, the Financing Corporation, was given a
helping hand.
As the market grappled with the fundamental question of whether Fannie and Freddie
would be backed by the government, the yield on the GSEs’ long-term bonds rose. The
difference between the rate that the GSEs paid on their debt and rates on Treasuries – a
premium that reflects investors’ assessment of risk – widened in 2007 to one-half a
percentage point. That was low compared with the same figure for other publicly traded
companies, but high for the ultra-safe GSEs. By June 2008, the spread had risen 65%
over the 2007 level; by September 5, just before regulators parachuted in, the spread
had nearly doubled from its 2007 level to just under 1%, making it more difficult and
costly for the GSEs to fund their operations. On the other hand, the prices of Fannie Mae
mortgage-backed securities actually increased slightly over this time period, while the
prices of private-label mortgage-backed securities dramatically declined. For example,
the price of the FNCI7 index – an index of Fannie mortgage-backed securities with an
average coupon of 7% – increased from 102 in January 2007 to 103 on September 5,
The Takeover of Fannie Mae and
Freddie Mac
2008, two days prior to the conservatorship. As another example, the price of the FNCI5
index – Fannie securities with an average coupon of 5% – increased from 95 to 96
during the same time period.
In July and August 2008, Fannie suffered a liquidity squeeze, because it was unable to
borrow against its own securities to raise sufficient cash in the repo market. Its stock
price dove to less than $7 a share. Fannie asked the Fed for help. A senior adviser in
the Federal Reserve Board’s Division of Banking Supervision and Regulation gave the
FCIC a bleak account of the situation at the two GSEs and noted that “liquidity was just
becoming so essential, so the Federal Reserve agreed to help provide it.”
On July 13, the Federal Reserve Board in Washington authorized the New York Fed to
extend emergency loans to the GSEs “should such lending prove necessary . . . to
promote the availability of home mortgage credit during a period of stress in financial
markets.” Fannie and Freddie would never tap the Fed for that funding.
Also on July 13, Treasury laid out a three-part legislative plan to strengthen the GSEs by
temporarily increasing their lines of credit with the Treasury, authorizing Treasury to
inject capital into the GSEs, and replacing OFHEO with the new Federal Housing
Finance Agency (FHFA), with the power to place the GSEs into receivership. Paulson
told the Senate that regulators needed “a bazooka” at their disposal. “You are not likely
to take it out,” Paulson told legislators. “I just say that by having something that is
unspecified, it will increase confidence. And by increasing confidence it will greatly
reduce the likelihood it will ever be used.” Fannie’s Mudd and Freddie’s Syron praised
the plan.
At the end of July, Congress passed the Housing and Economic Recovery Act (HERA)
of 2008, giving Paulson his bazooka – the ability to extend secured lines of credit to the
GSEs, to purchase their mortgage securities, and to inject capital. The 261-page bill also
strengthened regulation of the GSEs by creating FHFA, an independent federal agency,
as their primary regulator, with expanded authority over Fannie’s and Freddie’s
portfolios, capital levels, and compensation. In addition, the bill raised the federal debt
ceiling by $800 billion to $10.6 trillion, providing funds to operate the GSEs if they were
placed into conservatorship.
After the Federal Reserve Board consented in mid-July to furnish emergency loans, Fed
staff and representatives of the Office of the Comptroller of the Currency (OCC), along
with Morgan Stanley, which acted as an adviser to Treasury, initiated a review of the
GSEs. Timothy Clark, who oversaw the weeklong review for the Fed, told the FCIC that
it was the first time they ever had access to information from the GSEs. He said that
previously, “The GSEs [saw] the Fed as public enemy number one. . . . There was a
battle between us and them.” Clark added, “We would deal with OFHEO, which was also
very guarded. So we did not have access to info until they wanted funding from us.”
Although Fed and OCC personnel were at the GSEs and conferring with executives,
Mudd told the FCIC that he did not know of the agencies’ involvement until their
enterprises were both in conservatorship.
The Takeover of Fannie Mae and
Freddie Mac
The Fed and the OCC discovered that the problems were worse than their suspicions
and reports from FHFA had led them to believe. According to Clark, the Fed found that
the GSEs were significantly “underreserved,” with huge potential losses, and their
operations were “unsafe and unsound.” The OCC rejected the forecasting
methodologies on which Fannie and Freddie relied. Using its own metrics, it found
insufficient reserves for future losses and identified significant problems in credit and risk
management. Kevin Bailey, the OCC deputy comptroller for regulatory policy, told the
FCIC that Fannie’s loan loss forecasting was problematic, and that its loan losses
therefore were understated. He added that Fannie had overvalued its deferred tax
assets – because without future profits, deferred tax assets had no value.
Loss projections calculated by Morgan Stanley substantiated the Fed’s and OCC’s
findings. Morgan Stanley concluded that Fannie’s loss projection methodology was
flawed, and resulted in the company substantially understating losses. Nearly all of the
loss projections calculated by Morgan Stanley showed that Fannie would fall below its
regulatory capital requirement. Fannie’s projections did not.
All told, the litany of understatements and shortfalls led the OCC’s Bailey to a firm
conclusion. If the GSEs were not insolvent at the time, they were “almost there,” he told
the FCIC. Regulators also learned that Fannie was not charging off loans until they were
delinquent for two years, a head-in-the-sand approach. Banks are required to charge off
loans once they are 180 days delinquent. For these and numerous other errors and
flawed methodologies, Fannie and Freddie earned rebukes. “Given the role of the GSEs
and their market dominance,” the OCC report said, “they should be industry leaders with
respect to effective and proactive risk management, productive analysis, and
comprehensive reporting. Instead they appear to significantly lag the industry in all
The Takeover of Fannie Mae and
Freddie Mac
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. At the beginning of the housing crisis, both Fannie Mae and Freddie Mac were not
very leveraged.
a) true
b) false
The Takeover of Fannie Mae and
Freddie Mac
1. A: True is incorrect. To the contrary, both government-sponsored enterprises were
highly leveraged.
B: False is correct. While the two GSEs either owned or guaranteed mortgages of
over $5 trillion, they had capital of less than 2% of those outstanding obligations,
making them highly leveraged.
(See page 17-1 of the course material.)
The Takeover of Fannie Mae and
Freddie Mac
Chapter 18: September 2008 – The Bankruptcy of Lehman
Solvency should be a simple financial concept: if your assets are worth more than your
liabilities, you are solvent; if not, you are in danger of bankruptcy. But on the afternoon of
Friday, September 12, 2008, experts from the country’s biggest commercial and
investment banks met at the Wall Street offices of the Federal Reserve to ponder the
fate of Lehman Brothers, and could not agree whether or not the 157-year-old firm was
Only two days earlier, Lehman had reported shareholder equity – the measure of
solvency – of $28 billion at the end of August. Over the previous nine months, the bank
had lost $6 billion but raised more than $10 billion in new capital, leaving it with more
reported equity than it had a year earlier.
But this arithmetic reassured hardly anyone outside the investment bank. Fed officials
had been discussing Lehman’s solvency for months, and the stakes were very high. To
resolve the question, the Fed would not rely on Lehman’s $28 billion figure, given
questions about whether Lehman was reporting assets at market value. As one New
York Fed official wrote to colleagues in July, “Balance-sheet capital isn’t too relevant if
you’re suffering a massive run.” If there is a run, and a firm can only get fire-sale prices
for assets, even large amounts of capital can disappear almost overnight.
The bankers thought Lehman’s real estate assets were overvalued. In light of Lehman’s
unreliable valuation methods, the bankers had good reason for their doubts. None of the
bankers at the New York Fed that weekend believed the $54 billion in real estate assets
(excluding real estate held for sale) on Lehman’s books was an accurate figure. If the
assets were worth only half that amount (a likely scenario, given market conditions), then
Lehman’s $28 billion in equity would be gone. In a fire sale, some might sell for even
less than half their stated value.
Testifying before the FCIC, former Lehman Brothers CEO Richard Fuld insisted his firm
had been solvent: “There was no capital hole at Lehman Brothers. At the end of
Lehman’s third quarter, we had $28.4 billion of equity capital.” Fed Chairman Ben
Bernanke disagreed: “I believe it had a capital hole.” He emphasized that New York
Federal Reserve Bank President Timothy Geithner, Treasury Secretary Henry Paulson,
and SEC Chairman Christopher Cox agreed it was “just way too big a hole. And my own
view is it’s very likely that the company was insolvent, even, not just illiquid.”
It had been quite a week; it would be quite a weekend. The debate will continue over the
largest bankruptcy in American history, but nothing will change the basic facts: a
consortium of banks would fail to agree on a rescue, two last-minute deals would fall
through, and the government would decide not to rescue this investment bank – for
financial reasons, for political reasons, for practical reasons, for philosophical reasons,
and because, as Bernanke told the FCIC, if the government had lent money, “the firm
would fail, and not only would we be unsuccessful but we would have saddled the
taxpayer with tens of billions of dollars of losses.”
The Bankruptcy of Lehman
I. “Get More Conservatively Funded”
After the demise of Bear Stearns in March 2008, most observers – including Bernanke,
Paulson, Geithner, and Cox – viewed Lehman Brothers as the next big worry among the
four remaining large investment banks. Geithner said he was “consumed” with finding a
way that Lehman might “get more conservatively funded.” Fed Vice Chairman Donald
Kohn told Bernanke that in the wake of Bear’s collapse, some institutional investors
believed it was a matter not of whether Lehman would fail, but when. One set of
numbers in particular reinforced their doubts: on March 18, the day after JP Morgan
announced its acquisition of Bear Stearns, the market (through credit default swaps on
Lehman’s debt) put the cost of insuring $10 million of Lehman’s five-year senior debt at
$310,000 annually; for Merrill Lynch, the cost was $241,000; and for Goldman Sachs,
The chief concerns were Lehman’s real estate-related investments and its reliance on
short-term funding sources, including $7.8 billion of commercial paper and $197 billion of
repos at the end of the first quarter of 2008. There were also concerns about the firm’s
more than 900,000 derivative contracts with a myriad of counterparties.
As they did for all investment banks, the Fed and SEC asked: Did Lehman have enough
capital – real capital, after possible asset write-downs? And did it have sufficient liquidity
– cash – to withstand the kind of run that had taken down Bear Stearns? Solvency and
liquidity were essential and related. If money market funds, hedge funds, and investment
banks believed Lehman’s assets were worth less than Lehman’s valuations, they would
withdraw funds, demand more collateral, and curtail lending. That could force Lehman to
sell its assets at fire sale prices, wiping out capital and liquidity virtually overnight. Bear
proved it could happen.
“The SEC traditionally took the view that liquidity was paramount in large securities
firms, but the Fed, as a consequence of its banking mandate, had more of an emphasis
on capital raising,” Erik Sirri, head of the SEC’s Division of Trading and Markets, told the
FCIC. “Because the Fed had become the de facto primary regulator because of its
balance sheet, its view prevailed. The SEC wanted to be collaborative, and so came to
accept the Fed’s focus on capital. However, as time progressed, both saw the
importance of liquidity with respect to the problems at the large investment banks.”
In fact, both problems had to be resolved. Bear’s demise had precipitated Lehman’s “first
real financing difficulties” since the liquidity crisis began in 2007, Lehman Treasurer
Paolo Tonucci told the FCIC. Over the two weeks following Bear’s collapse, Lehman
borrowed from the Fed’s new lending facility, the Primary Dealer Credit Facility (PDCF),
but had to be careful to avoid seeming over reliant on the PDCF for cash, which would
signal funding problems.
Lehman built up its liquidity to $45 billion at the end of May, but it and Merrill performed
the worst among the four investment banks in the regulators’ liquidity stress tests in the
spring and summer of 2008.
Meanwhile, the company was also working to improve its capital position. First, it
reduced real estate exposures (again, excluding real estate held for sale) from $90
billion to $71 billion at the end of May and to $54 billion at the end of the summer.
Second, it raised new capital and longer-term debt – a total of $15.5 billion of preferred
stock and senior and subordinated debt from April through June 2008.
The Bankruptcy of Lehman
Treasury Undersecretary Robert Steel praised Lehman’s efforts, publicly stating that it
was “addressing the issues.” But other difficulties loomed. Fuld would later describe
Lehman’s main problem as one of market confidence, and he suggested that the
company’s image was damaged by investors taking “naked short” positions (short selling
Lehman’s securities without first borrowing them), hoping Lehman would fail, and
potentially even helping it fail by eroding confidence. “Bear went down on rumors and a
liquidity crisis of confidence,” Fuld told the FCIC. “Immediately thereafter, the rumors and
the naked short sellers came after us.” The company pressed the SEC to clamp down
on the naked short selling. The SEC’s Division of Risk, Strategy and Financial Innovation
shared with the FCIC a study it did concerning short selling. As Chairman Mary Schapiro
explained to the Commission, “We do not have information at this time that manipulative
short selling was the cause of the collapse of Bear and Lehman or of the difficulties
faced by other investment banks during the fall of 2008.” The SEC to date has not
brought short selling charges related to the failure of these investment banks.
On March 18, Lehman reported better-than-expected earnings of $489 million for the
first quarter of 2008. Its stock jumped nearly 50%, to $46.49. But investors and analysts
quickly raised questions, especially concerning the reported value of Lehman’s real
estate assets. called Lehman’s write-downs “suspiciously minuscule.” In a
speech in May, David Einhorn of Greenlight Capital, which was then shorting Lehman’s
stock, noted the bank’s large portfolio of commercial real estate loans and said, “There is
good reason to question Lehman’s fair value calculations. . . . I suspect that greater
transparency on these valuations would not inspire market confidence.”
Nell Minow, editor and co-founder of the Corporate Library, which researches and rates
firms on corporate governance, raised other reasons that observers might have been
skeptical of management at Lehman. “On Lehman Brothers’ [board], . . . they had an
actress, a theatrical producer, and an admiral, and not one person who understood
financial derivatives.” The Corporate Library gave Lehman a D rating in June 2004, a
grade it downgraded to F in September 2008. On June 9, Lehman announced a
preliminary $2.8 billion loss for its second quarter – the first loss since it became a public
company in 1994. The share price fell to $30. Three days later Lehman announced it
was replacing Chief Operating Officer Joseph Gregory and Chief Financial Officer Erin
Callan. The stock slumped again, to $22.70.
II. “This Is Not Sounding Good at All”
After Lehman reported its final second-quarter results on June 12, the New York Fed’s
on-site monitor at Lehman, Kirsten Harlow, reported that there had been “no adverse
information on liquidity, novations, terminations or ability to fund either secured or
unsecured [funds].” The announced liquidity numbers were better that quarter, as were
the capital numbers.
Nevertheless, Lehman’s lenders and supervisors were worried. The next morning,
William Dudley, then head of the New York Fed’s Markets Group (and its current
president), emailed Bernanke, Geithner, Kohn, and others that the PDCF should be
extended because it “remains critical to the stability” of some of the investment banks –
particularly Lehman. “I think without the PDCF, Lehman might have experienced a full
blown liquidity crisis,” he wrote.
The Bankruptcy of Lehman
Just one week after the earnings release, Harlow reported that Lehman was indeed
having funding difficulties. Four financial institutions had “trading issues” with Lehman
and had reduced their exposure to the firm, including Natixis, a French investment bank
that had already eliminated all activity with Lehman. JP Morgan reported that large
pension funds and some smaller Asian central banks were reducing their exposures to
Lehman, as well as to Merrill Lynch. And Citigroup requested a $3 to $5 billion “comfort
deposit” to cover its exposure to Lehman, settling later for $2 billion. In an internal
memo, Thomas Fontana, the head of risk management in Citigroup’s global financial
institutions group, wrote that “loss of confidence [in Lehman] is huge at the moment.”
Timothy Clark, senior adviser in the Federal Reserve’s banking supervision and
regulation division, was short and direct: “This is not sounding good at all.”
On June 25, results from the regulators’ most recent stress test showed that Lehman
would need $15 billion more than the $54 billion in its liquidity pool to survive a loss of all
unsecured borrowings and varying amounts of secured borrowings. Lehman’s
borrowings in the overnight commercial paper market were increasing, however, from $3
billion at the end of November 2007 to $8 billion at the end of May 2008. And it was
reliant on repo funding, particularly the portions that matured overnight and were
collateralized by illiquid assets. As of mid-June, 62% of Lehman’s liquidity was
dependent on borrowing against nontraditional securities, such as illiquid mortgagerelated securities – which could not be financed with the PDCF and of which investors
were becoming increasingly wary.
On July 10, Federated Investors – a large money market fund and one of Lehman’s
largest tri-party repo lenders – notified JP Morgan, Lehman’s clearing bank, that
Federated would “no longer pursue additional business with Lehman,” because JP
Morgan was “unwilling to negotiate in good faith” and had “become increasingly
uncooperative” on repo terms. Dreyfus, another large money market fund and a Lehman
tri-party repo lender, also pulled its repo line from the firm.
III. “Spook the Market”
As the Fed considered the risks of the tri-party repo market, it also mulled over more
specific measures to help Lehman. The New York Fed and FDIC both rejected the
company’s proposal to convert to a bank holding company, a proposal which Geithner
told Fuld was “gimmicky” and “[could not] solve a liquidity/capital problem.” A proposal
by the Fed’s Dudley followed the Bear Stearns model: $60 billion of Lehman’s assets
would be held by a new special-purpose vehicle, financed by $5 billion of Lehman’s
equity and a $55 billion loan from the Fed. This proposal would remove the illiquid
assets from the market and potentially avert a fire sale that could render Lehman
insolvent. It didn’t go anywhere.
But when that idea was floated in July, the need for such action was still somewhat
speculative. Not so by August. In an August 8 email to colleagues at the Federal
Reserve and Treasury, Patrick Parkinson, then the deputy director of the Federal
Reserve Board’s Division of Research and Statistics, described a “game plan” that
would: (1) identify activities of Lehman that could significantly harm financial markets
and the economy if it filed for chapter 11 bankruptcy protection, (2) gather information to
more accurately assess the potential effects of its failure, and (3) identify risk mitigation
actions for areas of serious potential harm.
The Bankruptcy of Lehman
As they now realized, regulators did not know nearly enough about over-the-counter
derivatives activities at Lehman and other investment banks, which were major OTC
derivatives dealers. Investment banks disclosed the total number of OTC derivative
contracts they had, the total exposures of the contracts, and their estimated market
value, but they did not publicly report the terms of the contracts or the counterparties.
Thus, there was no way to know who would be owed how much and when payments
would have to be made – information that would be critically important to analyze the
possible impact of a Lehman bankruptcy on derivatives counterparties and the financial
Parkinson reviewed a standing recommendation to form a “default management group”
of senior executives of major market participants to work with regulators to anticipate
issues if a major counterparty should default. The recommendation was from the privatesector Counterparty Risk Management Policy Group, the same group that had alerted
the Fed to the backlog problem in the OTC derivatives market earlier in the decade.
Parkinson suggested accelerating the formation of this group while being careful not to
signal concerns about any one market participant. On August 15, Parkinson emailed
New York Fed officials that he was worried that no sensible game plan could be
formulated without more information. He was informed that New York Fed officials had
just met with Lehman two days earlier to obtain derivative-related information, that they
still needed more information, and that the meeting had “caused a stir,” which in turn
required assurances that requests for information would not be limited to Lehman.
New York Fed officials were also “very reluctant” to request copies of the master
agreements that would shed light on the Lehman’s derivatives counterparties, because
such a request would send a “huge negative signal.” The formation of the industry group
seemed “less provocative,” wrote a New York Fed official, but could still “spook the
market.” Parkinson believed that the information was important, but attempting to collect
it was “not without risks.” He also recognized the difficulties in unraveling the complex
dependencies among the many Lehman subsidiaries and their counterparties, which
would keep lawyers and accountants busy for a long time.
On August 28, Treasury’s Steve Shafran informed Parkinson that Secretary Paulson
agreed on the need to collect information on OTC derivatives. It just had to be done in a
way that minimized disruptions. On September 5, Parkinson circulated a draft letter
requesting the information from Lehman CEO Fuld. Geithner would ask E. Gerald
Corrigan, the Goldman Sachs executive and former New York Fed president who had
co-chaired the Counterparty Risk Management Policy Group report, to form an industry
group to advise on information needed from a troubled investment bank. Parkinson,
Shafran, and others would also create a “playbook” for an investment bank failure at
Secretary Paulson’s request. Events over the following week would render these efforts
On September 4, executives from Lehman Brothers apprised executives at JP Morgan,
Lehman’s tri-party repo clearing bank, of the third-quarter results that it would announce
two weeks later. A $3.9 billion loss would reflect “significant asset write-downs.” The firm
was also considering several steps to bolster capital, including an investment by Korea
Development Bank or others, the sale of Lehman’s investment management division
(Neuberger Berman), the sale of real estate assets, and the division of the company into
a “good bank” and “bad bank” with private equity sponsors. The executives also
discussed JP Morgan’s concerns about Lehman’s repo collateral.
The Bankruptcy of Lehman
On Monday, September 8, more than 20 New York Fed officials were notified of a
meeting the next morning “to continue the discussion of near-term options for dealing
with a failing nonbank.” They received a list documenting Lehman’s tri-party repo
exposure at roughly $200 billion. Before its collapse, Bear Stearns’s exposure had been
only $50 to $80 billion. The documentation further noted that 10 counterparties provided
80% of Lehman’s repo financing, and that intraday liquidity provided by Lehman’s
clearing banks could become a problem. Indeed, JP Morgan, Citigroup, and Bank of
America had all demanded more collateral from Lehman, with the threat they might “cut
off Lehman if they don’t receive it.”
On Tuesday morning, September 9, news there would be no investment from Korea
Development Bank shook the market. Lehman’s stock plunged 55% from the day before,
closing at $7.79. To prepare for an afternoon call with Bernanke, Geithner directed his
staff to “put together a quick ‘what’s different? what’s the same?’ list about [Lehman] vs.
[Bear Stearns], as well as about mid-March (then) vs. early Sept (now).” The Fed’s
Parkinson emailed Treasury’s Shafran about his concerns that Lehman would announce
further losses the next week, that it might not be able to raise equity, and that even
though its liquidity position was better than Bear Stearns’s had been, Lehman remained
vulnerable to a loss of confidence.
At 5:00 P.M., Paulson convened a call with Cox, Geithner, Bernanke, and Treasury staff
“to deal with a possible Lehman bankruptcy.” At 5:20 P.M., Treasury Chief of Staff Jim
Wilkinson emailed Michelle Davis, the assistant secretary for public affairs at Treasury,
to express his distaste for government assistance: “We need to talk. . . . I just can’t
stomach us bailing out Lehman. . . . Will be horrible in the press don’t u think.” That
same day, Fuld agreed to post an additional $3.6 billion of collateral to JP Morgan.
Lehman’s bankruptcy estate would later claim that Lehman did so because of JP
Morgan’s improper threat to withhold repo funding. Zubrow said JP Morgan requested
the collateral because of its growing exposure as a derivatives trading counterparty to
Lehman. Steven Black, JP Morgan’s president, said he requested $5 billion from
Lehman, which agreed to post $3.6 billion. He did not believe the request put undue
pressure on Lehman. On Tuesday night, executives of Lehman and JP Morgan met
again at Lehman’s request to discuss options for raising capital. The JP Morgan group
was not impressed. “[Lehman] sent the Junior Varsity,” JP Morgan executives reported
to Black. “They have no proposal and are looking to us for ideas/credit line to bridge
them to the first quarter when they intend to split into good bank/bad bank.” Black
responded, “Let’s give them an order for the same drugs they have apparently been
taking to think we would do something like that.” The Lehman bankruptcy estate has a
different view. It alleges Black agreed to send a due diligence team, following Dimon’s
suggestion that his firm might be willing to purchase Lehman preferred stock, but instead
sent over senior risk managers to probe Lehman’s confidential records and plans.
The bankruptcy estate alleges that later that night, JP Morgan demanded that Lehman
execute amended agreements to its tri-party repo services before pre-announcing its
third-quarter earnings at 7:30 the next morning. The amendments required Lehman to
provide additional guarantees, increased Lehman’s potential liability, and gave JP
Morgan additional control over Lehman bank accounts. Again, the Lehman bankruptcy
estate argues that Lehman executed the agreements because JP Morgan executives led
Lehman to believe its bank would refuse to extend intraday credit if Lehman did not do
so. JP Morgan denies this. Black told the FCIC, “JPMC never told Lehman that it would
The Bankruptcy of Lehman
stop extending credit and clearing if the September Agreements were not executed
before the markets opened on [Wednesday,] September 10, 2008.”
Before the market opened on Wednesday, Lehman announced its $3.9 billion thirdquarter loss, including a $5.6 billion write-down. Four hours later, Matthew Rutherford,
an adviser to Treasury, emailed colleagues that several large money funds had reduced
their exposure to Lehman, although there was not yet “a wholesale pull back of [repo]
“Importantly, Fidelity, the largest fund complex, stressed that while they hadn’t made any
significant shifts yet today, they were still in the process of making decisions and wanted
to update me later in the day,” Rutherford wrote. By Friday, Fidelity would have reduced
its tri-party repo lending to Lehman to less than $2 billion from over $12 billion the
previous Friday; according to Fidelity’s response to an FCIC survey of market
participants, in the week prior to Bear’s demise in March, Fidelity had pulled its entire
$9.6 billion repo line to that company.
IV. “Imagination Hat”
At the Federal Reserve, working groups were directed to “spend the next few hours
fleshing out how a Fed-assisted BofA acquisition transaction might look, how a private
consortium of preferred equity investors transaction might look, and how a Fed takeout
of tri-party repo lenders would look.” That day, New York Fed Senior Vice President
Patricia Mosser circulated her opinion on Dudley’s request for “thoughts on how to
resolve Lehman.” She laid out three options: (1) find a buyer at any price, (2) wind down
Lehman’s affairs, or (3) force it into bankruptcy. Regarding option 1, Mosser said it
“should be done in a way that requires minimal temporary support. . . . No more Maiden
Lane LLCs and no equity position by [the] Fed. Moral hazard and reputation cost is too
high. If the Fed agrees to another equity investment, it signals that everything [the Fed]
did in March in terms of temporary liquidity backstops is useless. Horrible precedent; in
the long run MUCH worse than option 3.” Option 3, bankruptcy, would be “[a] mess on
every level, but fixes the moral hazard problem.”
On Wednesday night, a New York Fed official circulated a “Liquidation Consortium”
game plan to colleagues. The plan was to convene in one room senior-level
representatives of Lehman’s counterparties in the tri-party repo, credit default swap, and
over-the-counter derivatives markets – everyone who would suffer most if Lehman failed
– and have them explore joint funding mechanisms to avert a failure. According to the
proposed game plan, Secretary Paulson would tell the participants they had until the
opening of business in Asia the following Monday morning (Sunday night, New York
time) to devise a credible plan.
Former Bank of America CEO Ken Lewis told the FCIC that Treasury Secretary Paulson
had called him on Wednesday, September 10, and asked him to take another look at
acquiring Lehman. Paulson and Geithner had arranged for Fuld and Lewis to discuss an
acquisition in July, but Fuld had not been interested in selling the entire firm at that time.
Because of this history, Lewis expressed his concerns to Paulson that Fuld would not
want to sell the entire company or would not be willing to sell at a realistic price. Still, a
team of Bank of America executives began reviewing Lehman’s books, and on the next
day, Fuld sounded optimistic about a deal. But Bank of America determined that
Lehman’s assets were overvalued, and Lewis told Paulson there would be no deal
The Bankruptcy of Lehman
without government assistance. Undeterred, Paulson told Lewis – as Lewis informed the
FCIC – to put on his “imagination hat” and figure out a deal. His insistence kept the Bank
of America executives working, but on Friday, September 12, Lewis called Paulson to
repeat his assessment – no government support, no deal.
Some believed government action was required. At 10:46 A.M., Hayley Boesky, a senior
New York Fed official, forwarded to her colleagues an email from the hedge fund
manager Louis Bacon suggesting the New York Fed could “attempt to stabilize or
support the LEH situation” but noting that “none of the above will fix the fundamental
problem, which is too many bad assets that need to get off too many balance sheets.”
At 1:40 P.M., Fed officials circulated the outline of a plan to create a “Lehman Default
Management Group,” a group of Lehman counterparties and creditors who would make
plans to cope with a Lehman bankruptcy. They would agree to hold off on fully
exercising their rights to close out their trades with Lehman; instead, they would
establish a process to “net down” – that is, reduce – all exposures using a common
valuation method. A little before midnight on Thursday, Boesky notified colleagues that
panicked hedge funds had called to say they were “expecting [a] full blown recession”
and that there was a “full expectation that Leh goes, wamu and then ML [Merrill Lynch].”
They were “ALL begging, pleading for a large scale solution which spans beyond just
LEH.” Boesky compared the level of panic to the failure of Bear Stearns – “On a scale of
1 to 10, where 10 is Bear-Stearns-week-panic, I would put sentiment today at a 12.”
At almost the same time, JP Morgan demanded that Lehman post another $5 billion in
cash “by the opening of business tomorrow in New York”; if it didn’t, JP Morgan would
“exercise our right to decline to extend credit to you.” JP Morgan CEO Dimon, President
Black, and CRO Zubrow had first made the demand in a phone call earlier that evening
to Lehman CEO Fuld, CFO Ian Lowitt, and Treasurer Paolo Tonucci. Tonucci told the JP
Morgan executives on the call that Lehman could not meet the demand. Dimon said
Lehman’s difficulties in coming up with the money were not JP Morgan’s problem,
Tonucci told the FCIC. “They just wanted the cash. We made the point that it’s too much
cash to mobilize. There was no give on that. Again, they said ‘that’s not our problem, we
just want the cash.’” When Tonucci asked what would keep JP Morgan from asking for
$10 billion tomorrow, Dimon replied, “Nothing, maybe we will.”
Under normal circumstances, Tonucci would not have tolerated this treatment, but
circumstances were far from normal. “JPM as ‘clearing bank’ continues to ask for more
cash collateral. If we don’t provide the cash, they refuse to clear, we fail,” was the
message circulated in an email to Lehman executives on Friday, September 12. So
Lehman “delivered the $5 billion in cash only by pulling virtually every unencumbered
asset it could deliver.”
JP Morgan’s Zubrow saw it differently. He told the FCIC that the previously posted $3.6
billion of collateral by Lehman was “inappropriate” because it was “illiquid” and “could not
be reasonably valued.” Moreover, Zubrow said the potential collateral shortfall was
greater than $5 billion. Lehman’s former CEO, Fuld, told the FCIC that he agreed to post
the $5 billion because JP Morgan said it would be returned to Lehman at the close of
business the following day. The Lehman bankruptcy estate made the same allegation.
This dispute is now the subject of litigation; the Lehman bankruptcy estate is suing JP
Morgan to retrieve the $5 billion – and the original $3.6 billion.
The Bankruptcy of Lehman
V. “Heads of Family”
Should Lehman be allowed to go bankrupt? Within the government, sentiments varied.
On Friday morning, as Secretary Paulson headed to New York to “sort through this
Lehman mess,” Wilkinson wrote that he still “[couldn’t] imagine a scenario where we put
in [government] money . . . we shall see.” That afternoon, Fed Governor Warsh wrote, in
response to a colleague’s hope the Fed would not have to protect some of Lehman’s
debt holders, “I hope we don[’]t protect anything!” But on Friday, Fed Chairman
Bernanke was taking no chances. He stayed behind in Washington, in case he had to
convene the Fed’s board to exercise its emergency lending powers.
Early Friday evening, Treasury Secretary Paulson summoned the “heads of family” – the
phrase used by Harvey Miller, Lehman’s bankruptcy counsel, to describe the CEOs of
the big Wall Street firms – to the New York Fed’s headquarters. Paulson told them that a
private-sector solution was the only option to prevent a Lehman bankruptcy. The people
in the room needed to come up with a realistic set of options to help limit damage to the
system. A sudden and disorderly wind-down could harm the capital markets and pose
the significant risk of a precipitous drop in asset prices, resulting in collateral calls and
reduced liquidity: that is, systemic risk. He could not offer the prospect of containing the
damage if the executives were unable to fashion an orderly resolution of the situation, as
had been done in 1998 for Long-Term Capital Management. Paulson did offer the Fed’s
help through regulatory approvals and access to lending facilities, but emphasized that
the Fed would not provide “any form of extraordinary credit support.” As New York Fed
General Counsel Tom Baxter told the FCIC, Paulson made it clear there would be no
government assistance, “not a penny.”
H. Rodgin Cohen, a veteran Wall Street lawyer who has represented most of the major
banks, including Lehman, told the FCIC that the government’s “not a penny” posture was
a calculated strategy: “I don’t know exactly what the government was thinking, but my
impression was they were playing a game of chicken or poker or whatever. It was said
on more than one occasion that it would be very politically difficult to rescue Lehman.
There had been a lot of blowback after Bear Stearns. I believe the government thought
that it could, with respect to a game of chicken, persuade the private sector to take a big
chunk” of Lehman’s liabilities.
The Fed’s internal liquidation consortium game plan would seem to confirm Cohen’s
view, given that it contemplated a financial commitment, even though that was not to be
divulged. Moreover, notwithstanding Paulson’s “not a penny” statement, the United
Kingdom’s chancellor of the exchequer, Alistair Darling, said that Paulson told him that
“the FRBNY might be prepared to provide Barclays with regulatory assistance to support
a transaction if it was required.”
At that consortium meeting on Friday night, Citigroup CEO Vikram Pandit asked if the
group was also going to talk about AIG. Timothy Geithner said simply: “Let’s focus on
VI. “Tell Those Sons of Bitches to Unwind”
What would happen if JP Morgan refused to provide intraday credit for Lehman in the triparty repo market on Monday, September 15? The Fed had been considering this
possibility since the summer. As Parkinson noted, the fundamental problem was that
even if Lehman filed for bankruptcy, the SEC would want Lehman’s broker-dealer to live
The Bankruptcy of Lehman
on and would not want the Fed in its position as lender to grab tri-party collateral.
Parkinson told the FCIC staff that Zubrow informed him over the weekend that JP
Morgan would not unwind Lehman’s repos on Monday if the Fed did not expand the
types of collateral that could be financed through the PDCF lending facility. Earlier in the
year, Parkinson had said that JP Morgan’s refusal to unwind would be unforgiveable.
Now he told Geithner to “tell those sons of bitches . . . to unwind.”
Merrill CEO John Thain told the FCIC that by Saturday morning, the group of executives
reviewing Lehman’s assets had estimated that they were overvalued by anywhere from
$15 to $25 billion. Thain thought that was more than the assembled executives would be
willing to finance and, therefore, Thain believed Lehman would fail. If Lehman failed,
Thain believed, Merrill would be next. So he had called Ken Lewis, the CEO of Bank of
America, and they met later that day at Bank of America’s New York corporate
apartment. By Sunday, the two agreed that Bank of America would acquire Merrill for
$29 per share, payable in Bank of America stock.
On Saturday afternoon, Lehman’s counsel provided the Fed with a document describing
how Lehman’s default on its obligations would “trigger a cascade of defaults through to
the [subsidiaries] which have large OTC [derivatives] books.” Bernanke, Fed Governor
Kohn, Geithner, and other senior Fed officials subsequently participated in a conference
call to discuss the possibility of going “to Congress to ask for other authorities,”
something Geithner planned to “pitch.” However, Fed General Counsel Scott Alvarez
cautioned others not to mention the plan to JP Morgan, because he did not want to
“suggest Fed willingness to give JPMC cover to screw [Lehman] or anyone else.”
By Saturday night, however, it appeared that the parade of horrors that would result from
a Lehman bankruptcy had been avoided. An agreement apparently had been reached.
Barclays would purchase Lehman, excluding $40 to $50 billion of assets financed by the
private consortium (even though the bankers in the consortium had estimated those
assets to be significantly overvalued). Michael Klein, an adviser to Barclays, had told
Lehman President Bart McDade that Barclays was willing to purchase Lehman, given
the private consortium agreement to assist the deal. It seemed a deal would be
VII. “This Doesn’t Seem Like It Is Going to End Pretty”
But on Sunday, things went terribly wrong. At 8:00 A.M., Barclays CEO John Varley and
President Robert Diamond told Paulson, Geithner, and Cox that the Financial Services
Authority (FSA) had declined to approve the deal. The issue boiled down to a guarantee
– the New York Fed required Barclays to guarantee Lehman’s obligations from the sale
until the transaction closed, much as JP Morgan had done for Bear Stearns in March.
Under U.K. law, the guarantee required a Barclays shareholder vote, which could take
30 to 60 days. Though it could waive that requirement, the FSA asserted that such a
waiver would be unprecedented, that it had not heard about this guarantee until
Saturday night, and that Barclays did not really want to take on that obligation anyway.
Geithner pleaded with FSA Chairman Callum McCarthy to waive the shareholder vote,
but McCarthy wanted the New York Fed to provide the guarantee instead of Barclays.
Otherwise, according to the FSA, “Barclays would have had to provide a (possibly
unlimited) guarantee, for an undefined period of time, covering prior and future
exposures and liabilities of Lehman that would continue to apply including in respect of
all transactions entered into prior to the purchase, even in the event the transaction
ultimately failed.”
The Bankruptcy of Lehman
For Paulson, such a guarantee by the Fed was unequivocally out of the question. The
guarantee could have put the Fed on the hook for tens of billions of dollars. If the run on
Lehman had continued despite the guarantee, Barclays’ shareholders could reject the
acquisition, and the Fed would be in possession of an insolvent bank.
Baxter told the FCIC that Barclays had known all along that the guarantee was required,
because JP Morgan had to provide the same type of guarantee when it acquired Bear
Stearns. Indeed, Baxter said he was “stunned” at this development. He believed that the
real reason Barclays said it could not guarantee Lehman’s obligations was the U.K.
government’s discomfort with the transaction.
On Sunday morning, Treasury’s Wilkinson emailed JP Morgan Investment Bank CEO
Jes Staley that he was in a meeting with Paulson and Geithner and that things did not
look good. He concluded, “This doesn’t seem like it is going to end pretty.” In another
note a little more than an hour later, he added that there would be no government
assistance: “No way [government] money is coming in. . . . I’m here writing the usg coms
[United States government communications] plan for orderly unwind . . . also just did a
call with the WH [White House] and usg is united behind no money. No way in hell
Paulson could blink now . . . we will know more after this [CEO meeting] this morning but
I think we are headed for wind down unless Barclays deal gets untangled.”
It did not. Paulson made a last-ditch pitch to his U.K. counterpart, Darling, without
success. Two years later, Darling admitted that he had vetoed the transaction: “Yeah I
did. Imagine if I had said yes to a British bank buying a very large American bank
which…collapsed the following week.” He would have found himself telling a British
audience, “Everybody sitting in this room and your children and your grandchildren and
their grandchildren would be paying for years to come.” That Bank of America had taken
itself out of the picture may have played a role in Darling’s decision: “My first reaction
was ‘If this is such a good deal how come no American bank is going to go near it?’” So
Darling concluded that for Barclays to accept the guarantee, which could have a grave
impact on the British economy, was simply out of the question: “I spoke to Hank Paulson
and said ‘Look, there’s no way we could allow a British bank to take over the liability of
an American bank,’ which in effect meant the British taxpayer was underwriting an
American bank.”
Following that decision in London, Lehman Brothers was, for all practical purposes,
dead. Cohen, Lehman’s counsel at the time, told the FCIC, “When Secretary Paulson
came out of the meeting with Geithner and Cox, they called Lehman’s president and me
over and said, ‘We have the consortium, but the British government won’t do it. Darling
said he did not want the U.S. cancer to spread to the U.K.’”
At around 1:00 P.M., Lehman’s team – President Bart McDade, CFO Ian Lowitt, Head of
Principal Investing Alex Kirk, and others – reconvened at Lehman’s offices to “digest
what obviously was stark news.” Upon arriving, they heard that the New York Fed would
provide more flexible terms for the PDCF lending facility, which would include expanding
the types of collateral borrowers could use. McDade, Kirk, Lowitt, and Miller returned to
the New York Fed building and met with the Fed’s Baxter and Dudley, the SEC’s Sirri,
and others to discuss the expanded PDCF program. According to McDade and Kirk, the
government officials – led by Baxter – made it plain they would not permit Lehman to
borrow against the expanded types of collateral, as other firms could. The sentiment was
clear but the reasons were vague, McDade told the FCIC. He said the refusal to allow
The Bankruptcy of Lehman
Lehman to provide the expanded types of collateral made the difference in Lehman’s
being able to obtain the funding needed to open for business on Monday.
Baxter explained to the FCIC, however, that Lehman’s broker-dealer affiliate – not the
holding company – could borrow against the expanded types of collateral. A New York
Fed email written at 2:15 P.M. on that Sunday, September 14, stated that Lehman’s
counsel was informed of the expansion of PDCF-eligible collateral but that such
collateral would not be available to the broker-dealer if it filed for bankruptcy. The
minutes of Lehman’s September 14 board meeting show that the Fed rejected Lehman’s
request for an even broader range of collateral to be eligible for PDCF financing and
preferred that Lehman’s holding company – but not the broker-dealer – file for
bankruptcy and that the broker-dealer “be wound down in an orderly fashion.” In a letter
dated September 14, the New York Fed informed Lehman Senior Vice President Robert
Guglielmo that the broker-dealer could finance expanded types of collateral with the
PDCF, but that letter was not sent until 2:24 A.M. on September 15 – after Lehman had
filed for bankruptcy. The Lehman broker-dealer borrowed $20 to $28 billion from the
PDCF each day over the next three days.
As Kirk recounted to the FCIC, during that Sunday meeting at the New York Fed,
government officials stepped out for an hour and came back to ask: “Are you planning
on filing bankruptcy tonight?” A surprised Miller replied that “no one in the room was
authorized to file the company, only the Board could . . . and the Board had to be called
to a meeting and have a vote. . . . There would be some lag in terms of having to put all
the papers together to actually file it. There was a practical issue that you couldn’t . . .
get it done quickly.” Unmoved, government officials explained that directors of Lehman’s
U.K. subsidiary – LBIE – would be personally liable if they did not file for bankruptcy by
the opening of business Monday. As Kirk recalled, “They then told us ‘we would like you
to file tonight. . . . It’s the right thing to do, because there’s something else which we
can’t tell you that will happen this evening. We would like both events to happen tonight
before the opening of trading Monday morning.’” The second event would turn out to be
the announcement of Bank of America’s acquisition of Merrill Lynch.
VIII. “The Only Alternative Was That Lehman Had to Fail”
Miller insisted that there had to be an alternative, because filing for bankruptcy would be
“Armageddon.” Lehman had prepared a presentation arguing that a Lehman bankruptcy
would be catastrophic. It would take at least five years to resolve, cost $8 to $10 billion,
and cause major disruptions in the United States and abroad.
Baxter told the FCIC, “I knew that the consequences were going to be bad; that wasn’t
an issue. Lehman was in denial at that point in time. There was no way they believed
that this story ends with a Lehman bankruptcy . . . they kept thinking that they were
going to be bailed out by the taxpayer of the United States. And I’m not trying to
convince you that that belief was a crazy belief because they had seen that happen in
the Bear case.” Baxter’s mission, however, was to “try to get them to understand that
they weren’t going to be rescued, and then focus on what their real options were, which
were drift into Monday morning with nothing done and then have chaos break out, or
alternatively file.” He concluded, “From my point of view, first thing was to convince
Harvey that it was far better to file than to go into Monday and have complete
pandemonium break out. And then he had to have discussions with the Lehman Board
The Bankruptcy of Lehman
because they had a fiduciary duty to resolve what was in the best interests of the
company and its shareholders and other stakeholders.”
“The only alternative was that Lehman had to fail,” Miller testified to the FCIC. He stated
that Baxter provided no further details on the government’s plan for the fallout from
bankruptcy, but assured him that the situation was under control. Then, Miller told the
FCIC, Baxter told the Lehman delegation to leave the Fed offices. “They basically threw
us out,” Miller said. Miller remembered telling his colleagues as they left the building, “‘I
don’t think they like us.’”
Miller continued:
We went back to the headquarters, and it was pandemonium up there –
no it was like a scene from [the 1946 film] It’s a Wonderful Life with the
run on the savings and loan crisis. . . . [A]ll of paparazzi running around.
There was a guy there . . . in a sort of a Norse god uniform with a helmet
and a picket sign saying “Down with Wall Street.” . . . There were
hundreds of employees going in and out. . . . Bart McDade was reporting
to the board what had happened. Most of the board members were
stunned. Henry Kaufman, in particular, was asking “How could this
happen in America?”
The group informed the board that the Barclays deal had fallen apart. The government
had instructed the board to file for bankruptcy. SEC’s Cox called. With Tom Baxter also
on the line, Cox told the board that the situation was serious and required action. The
board asked Cox if he was directing them to file for bankruptcy. Cox and Baxter
conferred for a few minutes, and then answered that the decision was the board’s to
make. The board again asked if Cox and Baxter were telling them to file for bankruptcy.
Cox and Baxter conferred again, then replied that they believed the government’s
position had been made perfectly clear at the meeting at the Fed earlier in the day.
Following that call, McDade advised the board that Lehman would be unable to obtain
funding without government assistance. The board voted to file for bankruptcy. The
company filed at 1:45 A.M. on Monday morning.
IX. “A Calamity”
Fed Chairman Bernanke told the FCIC that government officials understood a Lehman
bankruptcy would be catastrophic:
We never had any doubt about that. It was going to have huge impacts on
funding markets. It would create a huge loss of confidence in other
financial firms. It would create pressure on Merrill and Morgan Stanley, if
not Goldman, which it eventually did. It would probably bring the shortterm money markets into crisis, which we didn’t fully anticipate; but, of
course, in the end it did bring the commercial paper market and the
money market mutual funds under pressure. So there was never any
doubt in our minds that it would be a calamity, catastrophe, and that, you
know, we should do everything we could to save it.
The Bankruptcy of Lehman
“What’s the connection between Lehman Brothers and General Motors?” he asked
rhetorically. “Lehman Brothers’ failure meant that commercial paper that they used to
finance went bad.” Bernanke noted that money market funds, in particular one named
the Reserve Primary Fund, held Lehman’s paper and suffered losses. He explained that
this “meant there was a run in the money market mutual funds, which meant the
commercial paper market spiked, which [created] problems for General Motors.”
“As the financial industry came under stress,” Paulson told the FCIC, “investors pulled
back from the market, and when Lehman collapsed, even major industrial corporations
found it difficult to sell their paper. The resulting liquidity crunch showed that firms had
overly relied on this short term funding and had failed to anticipate how restricted the
commercial paper market could become in times of stress.”
Harvey Miller testified to the FCIC that “the bankruptcy of Lehman was a catalyst for
systemic consequences throughout the world. It fostered a negative reaction that
endangered the viability of the financial system. As a result of failed expectations of the
financial markets and others, a major loss of confidence in the financial system
On the day that Lehman filed for bankruptcy, the Dow plummeted more than 500 points;
$700 billion in value from retirement plans, government pension funds, and other
investment portfolios disappeared.
As for Lehman itself, the bankruptcy affected about 8,000 subsidiaries and affiliates with
$600 billion in assets and liabilities, the firm’s more than 100,000 creditors, and about
26,000 employees. Its failure triggered default clauses in derivatives contracts, allowing
its counterparties to have the option of seizing its collateral and terminating the
contracts. After the parent company filed, about 80 insolvency proceedings of its
subsidiaries in 18 foreign countries followed. In the main bankruptcy proceeding, about
66,000 claims – exceeding $873 billion – have been filed against Lehman as of
September 2010. Miller told the FCIC that Lehman’s bankruptcy “represents the largest,
most complex, multi-faceted and far-reaching bankruptcy case ever filed in the United
States.” The costs of the bankruptcy administration are approaching $1 billion; as of this
writing, the proceeding is expected to last at least another two years.
In his testimony before the FCIC, Bernanke admitted that the considerations behind the
government’s decision to allow Lehman to fail were both legal and practical. From a
legal standpoint, Bernanke explained, “We are not allowed to lend without a reasonable
expectation of repayment. The loan has to be secured to the satisfaction of the Reserve
Bank. Remember, this was before TARP. We had no ability to inject capital or to make
guarantees.” A Sunday afternoon email from Bernanke to Fed Governor Warsh indicated
that more than $12 billion in capital assistance would have been needed to prevent
Lehman’s failure. “In case I am asked: How much capital injection would have been
needed to keep LEH alive as a going concern? I gather $12B or so from the private guys
together with Fed liquidity support was not enough.”
In March, the Fed had provided a loan to facilitate JP Morgan’s purchase of Bear
Stearns, invoking its authority under section 13(3) of the Federal Reserve Act. But, even
with this authority, practical considerations were in play. Bernanke explained that
Lehman had insufficient collateral and the Fed, had it acted, would have lent into a run:
“On Sunday night of that weekend, what was told to me was that – and I have every
The Bankruptcy of Lehman
reason to believe – was that there was a run proceeding on Lehman, that is people were
essentially demanding liquidity from Lehman; that Lehman did not have enough
collateral to allow the Fed to lend it enough to meet that run.” Thus, “If we lent the money
to Lehman, all that would happen would be that the run [on Lehman] would succeed,
because it wouldn’t be able to meet the demands, the firm would fail, and not only would
we be unsuccessful but we would [have] saddled the [t]axpayer with tens of billions of
dollars of losses.” The Fed had no choice but to stand by as Lehman went under,
Bernanke insisted.
As Bernanke acknowledged to the FCIC, however, his explanation for not providing
assistance to Lehman was not the explanation he offered days after the bankruptcy – at
that time, he said that he believed the market was prepared for the event. On September
23, 2008, he testified: “The failure of Lehman posed risks. But the troubles at Lehman
had been well known for some time, and investors clearly recognized – as evidenced, for
example, by the high cost of insuring Lehman’s debt in the market for credit default
swaps – that the failure of the firm was a significant possibility. Thus, we judged that
investors and counterparties had had time to take precautionary measures.” In addition,
though the Federal Reserve subsequently asserted that it did not have the legal ability to
save Lehman because the firm did not have sufficient collateral to secure a loan from the
Fed under section 13(3), the authority to lend under that provision is very broad. It
requires not that loans be fully secured but rather that they be “secured to the
satisfaction of the Federal Reserve bank.” Indeed, in March 2009, Federal Reserve
General Counsel Scott Alvarez concluded that requiring loans under 13(3) to be fully
secured would “undermine the very purpose of section 13(3), which was to make credit
available in unusual and exigent circumstances to help restore economic activity.”
To CEO Fuld and others, the Fed’s emergency lending powers under section 13(3)
provided a permissible vehicle to obtain government support. Although Fed officials
discussed and dismissed many ideas in the chaotic days leading up to the bankruptcy,
the Fed did not furnish to the FCIC any written analysis to illustrate that Lehman lacked
sufficient collateral to secure a loan under 13(3). Fuld asserted to the FCIC that in fact,
“Lehman had adequate financeable collateral. . . . [O]n September 12, the Friday night
preceding Lehman’s bankruptcy filing, Lehman financed itself and did not need access
to the Fed’s discount window. . . . What Lehman needed on that Sunday night was a
liquidity bridge. We had the capital. Along with its excess available collateral, Lehman
also could have used whole businesses as collateral—such as its Neuberger Berman
subsidiary—as did AIG some two days later.” Fuld also rejected assertions about
Lehman’s capital hole. He told the FCIC, “As of August 31, 2008, two weeks prior to the
bankruptcy filing, Lehman had . . . $26.7 billion in equity capital. Positive equity of $26.7
billion is very different from the negative $30 or $60 billion ‘holes’ claimed by some.”
Moreover, Fuld maintained that Lehman would have been saved if it had been granted
bank holding company status – as were Goldman Sachs and Morgan Stanley the week
after Lehman’s bankruptcy.
The Fed chairman denied any bias against Lehman Brothers. In his view, the only real
resolution short of bankruptcy had been to find a buyer. Bernanke said: “When the
potential buyers were unable to carry through – in the case of Bank of America, because
they changed their minds and decided they wanted to buy Merrill instead; in the case of
Barclays, [because they withdrew] . . . we essentially had no choice and had to let it fail.”
The Bankruptcy of Lehman
During the September 16, 2008, meeting of the Fed’s Federal Open Market Committee,
some members stated that the government should not have prevented Lehman’s failure
because doing so would only strengthen the perception that some firms were “too big to
fail” and erode market discipline. They noted that letting Lehman fail was the only way to
provide credibility to the assertion that no firm was “too big to fail” and one member
stated that the market was beginning to “play” the Treasury and Federal Reserve. Other
meeting participants believed that the disorderly failure of a key firm could have a broad
and disruptive effect on financial markets and the economy, but that the appropriate
solution was capital injections, a power the Federal Reserve did not have. Bernanke’s
view was that only a fiscal and perhaps regulatory response could address the potential
for wide-scale failure of financial institutions.
Merrill’s Thain made it through the Lehman weekend by negotiating a lifesaving
acquisition by Bank of America, formerly Lehman’s potential suitor. Thain blamed the
failure to bail out Lehman on politicians and regulators who feared the political
consequences of rescuing the firm. “There was a tremendous amount of criticism of
what was done with Bear Stearns so that JP Morgan would buy them,” Thain told the
FCIC. “There was a criticism of bailing out Wall Street. It was a combination of political
unwillingness to bail out Wall Street and a belief that there needed to be a reinforcement
of moral hazard. There was never a discussion about the legal ability of the Fed to do
this.” He noted, “There was never discussion to the best of my recollection that they
couldn’t [bail out Lehman]. It was only that they wouldn’t.”
Thain also told the FCIC that in his opinion, “allowing Lehman to go bankrupt was the
single biggest mistake of the whole financial crisis.” He wished that he and the other
Wall Street executives had tried harder to convince Paulson and Geithner to prevent
Lehman’s failure: “As I think about what I would do differently after that weekend . . . is
try to grab them and shake them that they can’t let this happen. . . . They were not very
much in the mood to listen. They were not willing to listen to the idea that there had to be
government support. . . . The group of us should have just grabbed them and shaken
them and said, ‘Look, you guys could not do this.’ But we didn’t, and they were not
willing to entertain that discussion.”
FCIC staff asked Thain if he and the other executives explicitly said to Paulson,
Geithner, or anyone else, “You can’t let this happen.” Thain replied, “We didn’t do it
strongly enough. We said to them, ‘Look, this is going to be bad.’ But it wasn’t like, ‘No...
you have to help.’”
Another prominent member of that select group, JP Morgan’s Dimon, had a different
view. He told the FCIC, “I didn’t think it was so bad. I hate to say that. . . . But I [thought]
it was almost the same if on Monday morning the government had saved Lehman. . . .
You still would have terrible things happen. . . . AIG was going to have their problems
that had nothing to do with Lehman. You were still going to have the runs on the other
banks and you were going to have absolute fear and panic in the global markets.
Whether Lehman itself got saved or not . . . the crisis would have unfolded along a
different path, but it probably would have unfolded.”
Fed General Counsel Alvarez and New York Fed General Counsel Baxter told the FCIC
that there would have been questions either way. As Baxter put it, “I think that if the
Federal Reserve had lent to Lehman that Monday in a way that some people think –
without adequate collateral and without other security to ensure repayment – this
hearing and other hearings would have only been about how we wasted the taxpayers’
The Bankruptcy of Lehman
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. Lehman Brother’s bankruptcy was the third largest in American history.
a) true
b) false
2. What aspects of Lehman Brothers most worried regulators prior to its bankruptcy:
its heavy reliance on short-term funding
a large amount of derivative contracts
its heavy payroll
both a and b
3. The Federal Reserve embraced Lehman Brothers plan to convert their business to a
bank holding company.
a) true
b) false
The Bankruptcy of Lehman
1. A: True is incorrect. The firm’s demise was actually the largest in American history.
B: False is correct. The firm was over 150 years old at the time it declared
bankruptcy, the largest in American history.
(See page 18-1 of the course material.)
2. A: Incorrect. The firm did have a heavy reliance on short-term financing mechanisms
leading up to its bankruptcy. However, this is not the best answer.
B: Incorrect. These were with a variety of counterparties as well. However, this is not
the best answer.
C: Incorrect. This was not a factor in the demise of the company.
D: Correct. Both the heavy reliance on short-term funding and the large amount of
derivative contracts were problems confronting the company.
(See page 18-2 of the course material.)
3. A: True is incorrect. This plan was rejected by both the New York Fed and the FDIC.
They did not believe the plan would change in any meaningful way the liquidity
problems facing the company.
B: False is correct. Regulators rejected the proposal as “gimmicky” and would not
be a solution to the liquidity crisis facing the firm.
(See page 18-4 of the course material.)
The Bankruptcy of Lehman
Chapter 19: The Bailout of AIG
Nine billion dollars is a lot of money, but as AIG executives and the board examined their
balance sheet and pondered the markets in the second week of September 2008, they
were almost certain $9 billion in cash could not keep the company alive through the next
week. The AIG corporate empire held more than $1 trillion in assets, but most of the
liquid assets, including cash, were held by regulated insurance subsidiaries whose
regulators did not allow the cash to flow freely up to the holding company, much less out
to troubled subsidiaries such as AIG Financial Products. The company’s liabilities,
especially those due in the near future, were much larger than the $9 billion on hand.
On Friday, September 12, 2008, AIG was facing challenges on a number of fronts. It had
to fund $1.4 billion of its own commercial paper on that day because traditional investors
– for example, money market funds – no longer wanted even short-term unsecured
exposure to AIG; and the company had another $3.2 billion coming due the following
week. On another front, the repo lenders – who had the comfort of holding collateral for
their loans to AIG ($9.7 billion in mostly overnight funding) – were nonetheless becoming
skittish about the perceived weakness of the company and the low quality of most of its
collateral: mortgage-related securities.
On a third front, AIG had already put up billions of dollars in collateral to its credit default
swap counterparties. By June of 2008, counterparties were demanding $15.7 billion, and
AIG had posted $13.2 billion. By September 12, the calls had soared to $23.4 billion,
and AIG had paid $18.9 billion – $7.6 billion to Goldman alone – and it looked very likely
that AIG would need to post billions more in the near future. That day, S&P and Moody’s
both warned of potential coming downgrades to AIG’s credit rating, which, if they
happened, would lead to an estimated $10 billion in new collateral calls. A downgrade
would also trigger liquidity puts that AIG had written on commercial paper, requiring AIG
to come up with another $4 to $5 billion.
Finally, AIG was increasingly strained by its securities lending business. As a lender of
securities, AIG received cash from borrowers, typically equal to between 100% and
102% of the market value of the securities they lent. As borrowers began questioning
AIG’s stability, the company had to accept below-market terms – sometimes accepting
cash equal to only 90% of the value of the securities. Furthermore, AIG had invested this
cash in mortgage-related assets, whose value had fallen. Since September 2007, state
regulators had worked with AIG to reduce exposures of the securities lending program to
mortgage-related assets, according to testimony by Eric Dinallo, the former
superintendent of the New York State Insurance Department (NYSID). Still, by the end
of June 2008, AIG had invested $75 billion in cash in mortgage-related securities, which
had declined in value to $59.5 billion. By late August 2008, the parent company had to
provide $3.3 billion to its struggling securities lending subsidiary, and counterparties
were demanding $24 billion to offset the shortfall between the cash collateral provided
and the diminished value of the securities.
That Friday, AIG’s board dispatched a team led by Vice Chairman Jacob Frenkel to
meet with top officials at the Federal Reserve Bank of New York. Elsewhere in the
building, Treasury Secretary Henry Paulson and New York Fed President Timothy
Geithner were telling Wall Street bankers that they had the weekend to devise a solution
to prevent Lehman’s bankruptcy without government assistance. Now came this
The Bailout of AIG
emergency meeting regarding another beleaguered American institution. “Bottom line,”
the New York Fed later reported of that meeting, “[AIG’s] Treasurer estimates that parent
and [Financial Products] have 5-10 days before they are out of liquidity.”
AIG posed a simple question: how could it obtain an emergency loan under the Federal
Reserve’s 13(3) authority? Without a solution, there was no way this conglomerate,
despite more than $1 trillion in assets, would survive another week.
I. “Current Liquidity Position Is Precarious”
AIG’s visit to the New York Fed may have been an emergency, but it should not have
been a surprise. With the Primary Dealer Credit Facility (PDCF), the Fed had effectively
opened its discount window – traditionally available only to depository institutions – to
investment banks that qualified as primary dealers; AIG did not qualify. But over the
summer, New York Fed officials had begun to consider providing emergency
collateralized funding to even more large institutions that were systemically important.
That led the regulators to look closely at two trillion-dollar holding companies, AIG and
GE Capital. Both were large participants in the commercial paper market: AIG with $20
billion in outstanding paper, GE Capital with $90 billion. In August, the New York Fed set
up a team to study the two companies’ funding and liquidity risk.
On August 11, New York Fed officials met with Office of Thrift Supervision (OTS)
regulators to discuss AIG. The OTS said that it was “generally comfortable with [the]
firm’s current liquidity . . . [and] confident that the firm could access the capital markets
with no problem if it had to.” The New York Fed did not agree. On August 14, 2008,
Kevin Coffey, an analyst from the Financial Sector Policy and Analysis unit, wrote that
despite raising $20 billion earlier in the year, “AIG is under increasing capital and liquidity
pressure” and “appears to need to raise substantial longer term funds to address the
impact of deteriorating asset values on its capital and available liquidity as well as to
address certain asset/liability funding mismatches.”
Coffey listed six concerns: (1) AIG’s significant losses on investments, primarily because
of securities lending activities; (2) $26.5 billion in mark-to-market losses on AIG Financial
Products’ credit default swap book and related margin calls, for which AIG had posted
$16.5 billion in collateral by mid-August; (3) significant near-term liabilities; (4)
commitments to purchase collateralized debt obligations due to outstanding liquidity
puts; (5) ratings-based triggers in derivative contracts that could cause significant
additional collateral calls if AIG were downgraded; and (6) limited standby credit facilities
to manage sudden cash needs. He noted Moody’s and S&P had highlighted worries
about earnings, capital, and liquidity following AIG’s 2008 second-quarter earnings. The
agencies warned they would downgrade AIG if it did not address these issues.
Four days later, Goldman Sachs issued a report to clients that echoed much of Coffey’s
internal analysis. The report, “Don’t Buy AIG: Potential Downgrades, Capital Raise on
the Horizon,” warned that “we foresee $9-$20 billion in economic losses from [AIG’s
credit default swap] book, which could result in larger cash outlays . . . resulting in a
significant shift in the risk quality of AIG’s assets. . . . Put simply, we have seen this
credit overhang story before with another stock in our coverage universe, and foresee
outcomes similar in nature but on a much larger scale.” Goldman appeared to be
referring to Bear Stearns
The Bailout of AIG
On September 2, the New York Fed’s Danielle Vicente noted the situation had
worsened: “AIG’s current liquidity position is precarious and asset liability management
appears inadequate given the substantial off balance sheet liquidity needs.” Liquidating
an $835 billion securities portfolio to cover liabilities would mean substantial losses and
“potentially” affect prices, she wrote. Borrowing against AIG’s securities through the
Fed’s PDCF might allow AIG to unwind its positions calmly while satisfying immediate
cash needs, but Vicente questioned whether the PDCF was “necessary for the survival
of the firm.” Arguably, however, AIG’s volatile funding sources made the firm vulnerable
to runs. Off-balance-sheet commitments – including collateral calls, contract
terminations, and liquidity puts – could be as high as $33 billion if AIG was downgraded.
Yet AIG had only $4 billion of revolving credit facilities in addition to the $12 to $13 billion
of cash it had on hand at the time.
The rating agencies waited to see how AIG would address its liquidity and capital needs.
Analysts worried about the losses in AIG’s credit default swaps and investment
portfolios, about rating agency actions, and about subsequent impacts on capital.
Indeed, Goldman’s August 18 report on AIG concluded that the firm itself and the rating
agencies were in denial about impending losses.
By early September, management was no longer in denial. At the Friday, September 12,
meeting at the New York Fed, AIG executives reported that the company was “facing
serious liquidity issues that threaten[ed] its survival viability” and that a downgrade,
possibly after a rating agency meeting September 15, would trigger billions of dollars in
collateral calls, liquidity puts, and other liquidity needs. AIG’s stock had fallen
significantly (shares hit an intraday low of $11.49 Friday, down from a $17.55 close the
day before) and credit default swap spreads had reached 14% during the day, indicating
that protection on $10 million of AIG debt would cost approximately $1.4 million per year.
AIG reported it was having problems with its commercial paper, able to roll only $1.1
billion of the $2.5 billion that matured on September 12. In addition, some banks were
pulling away and even refusing to provide repo funding. Assets were illiquid, their values
had declined, borrowing was restricted, and raising capital was not viable.
II. “Spillover Effect”
The New York Fed knew that a failure of AIG would have dramatic, far-reaching
consequences. By the evening of September 12, after the meeting with AIG executives,
that possibility looked increasingly realistic. Hayley Boesky of the New York Fed emailed
William Dudley and others. “More panic from [hedge funds]. Now focus is on AIG,” she
wrote. “I am hearing worse than LEH. Every bank and dealer has exposure to them.”
Shortly before midnight, New York Fed Assistant Vice President Alejandro La-Torre
emailed Geithner, Dudley, and other senior officials about AIG: “The key takeaway is
that they are potentially facing a severe run on their liquidity over the course of the next
several (approx. 10) days if they are downgraded. . . . Their risk exposures are
concentrated among the 12 largest international banks (both U.S. and European) across
a wide array of product types (bank lines, derivatives, securities lending, etc.) meaning
[there] could be significant counterparty losses to those firms in the event of AIG’s
The Bailout of AIG
New York Fed officials met on Saturday morning, and gathered additional information
about AIG’s financial condition, but according to New York Fed General Counsel Tom
Baxter, it “seemed clear that the private sector solution would materialize for AIG.” And
by the end of the day on Saturday, AIG appeared to the Fed to be pursuing privatesector leads.
On Sunday morning, September 14, Adam Ashcraft of the New York Fed circulated a
memo, “Comment on Possible 13-3 Lending to AIG,” discussing the effect of a fire sale
by AIG on asset markets. In an accompanying email, Ashcraft wrote that the “threat” by
AIG to sell assets was “a clear attempt to scare policymakers into giving [AIG] access to
the discount window, and avoid making otherwise hard but viable options: sell or hedge
the CDO risk (little to no impact on capital), sell subsidiaries, or raise capital.”
Before a 2:30 P.M. meeting, LaTorre sent an analysis, “Pros and cons of lending to
AIG,” to colleagues. The pros included avoiding a messy collapse and dislocations in
markets such as commercial paper. If AIG collapsed, it could have a “spillover effect on
other firms involved in similar activities (e.g., GE Finance)” and would “lead to $18B
increase in European bank capital requirements.” In other words, European banks that
had lowered credit risk – and, as a result, lowered capital requirements – by buying
credit default swaps from AIG would lose that protection if AIG failed. AIG’s bankruptcy
would also affect other companies because of its “non-trivial exotic derivatives book,” a
$2.7 trillion over-the-counter derivatives portfolio of which $1 trillion was concentrated in
12 large counterparties. The memo also noted that an AIG failure “could cause
dislocations in CDS market [that] . . . could leave dealer books significantly unbalanced.”
The cons of a bailout included a “chilling effect” on private-sector solutions thought to be
under way; the possibility that a Fed loan would be insufficient to keep AIG afloat,
“undermining efficacy of 13-3 lending as a policy tool”; an increase in moral hazard; the
perception that it would be “incoherent” to lend to AIG and not Lehman; the possibility of
assets being insufficient to cover the potential liquidity hole. LaTorre concluded, “Without
punitive terms, lending [to AIG] could reward poor risk management,” which included
AIG’s unwillingness to sell or hedge some of its CDO risk.
The private-sector solutions had hit a wall, however. On Monday morning – after
Lehman had declared bankruptcy, and with no private-sector solution on the horizon –
the Fed initiated an effort to have JP Morgan and Goldman Sachs assemble a syndicate
of banks to lend about $75 billion to keep AIG afloat. In the afternoon, the rating
agencies announced their assessments, which were even worse than expected. All
three rating agencies announced downgrades of AIG: S&P by three notches to A-, and
Moody’s and Fitch by two notches to A2 and A, respectively. The downgrades triggered
an additional $13 billion in cash collateral calls on AIG Financial Products’ credit default
swaps. Goldman Sachs alone requested $2.1 billion. Demands hit $32 billion, and AIG’s
payouts increased to $19.5 billion. The company’s stock plummeted 61% to $4.76 from
the closing price of $12.14 the previous Friday – a fraction of its all-time high of $145.84.
The syndicate of banks did not agree on a deal, despite the expectations of Fed officials.
“Once Lehman filed [for bankruptcy] on the morning of the 15th, everyone decided that,
‘we’ve got to protect our own balance sheet,’ and the banks that were going to provide
the $75 billion decided that they were not going to,” Baxter told the FCIC. Sarah
Dahlgren, a senior New York Fed official, agreed with Baxter. Lehman’s bankruptcy “was
the end of the private-sector solution,” she told the Commission.
The Bailout of AIG
After the markets closed, AIG informed the New York Fed it was unable to access the
short-term commercial paper market. Regulators spent the next several hours preparing
for a late-night teleconference with Geithner. The “Lead point,” according to an email
circulated to the Fed’s AIG monitoring group, was that “the size, name, franchise and
market presence (wholesale and retail) [of AIG] raise questions about potential
worldwide contagion, should this franchise become impaired.” Late that night, for the
second time since the beginning of the crisis, the Federal Reserve Board invoked
section 13(3) of the Federal Reserve Act to bail out a company. As it had done for Bear
Stearns, the New York Fed, with the support of the Treasury, would rescue a brandname financial institution.
The Federal Open Market Committee was briefed about AIG. Members were told that
AIG faced a liquidity crisis but that it was unclear if there were also solvency issues. In
addition, the staff noted that money market funds had even broader exposure to AIG
than to Lehman and that the parent company could run out of money quite soon, even
within days.
On Tuesday morning, the Fed put a number on the table: it would loan $85 billion so that
AIG could meet its immediate obligations. The collateral would be the assets of the
parent company and its primary non-regulated subsidiaries, plus the stock of almost all
the regulated insurance subsidiaries. The Fed stated that “a disorderly failure of AIG
could add to already significant levels of financial market fragility and lead to
substantially higher borrowing costs, reduced household wealth, and materially weaker
economic performance.” By Wednesday, a share of AIG sold for as little as $1.99. The
previous eight years’ profits of $66 billion would be dwarfed by the $99.3 billion loss for
this one year, 2008.
But $85 billion would soon prove insufficient. Treasury added $49.1 billion under its
Troubled Asset Relief Program (TARP). Ultimately, according to the Congressional
Oversight Panel, taxpayer funds committed to AIG reached $182 billion. The panel
faulted the government for deciding to bail out AIG too hastily: “With AIG, the Federal
Reserve and Treasury broke new ground. They put the U.S. taxpayer on the line for the
full cost and full risk of rescuing a failing company.” The Treasury Department defended
its decision, saying that the panel report “overlooks the basic fact that the global
economy was on the brink of collapse and there were only hours in which to make
critical decisions.”
III. “Like a Gnat on an Elephant”
The Office of Thrift Supervision has acknowledged failures in its oversight of AIG. In a
March 18, 2009, congressional hearing, Acting Director Scott Polakoff testified that
supervisors failed to recognize the extent of liquidity risk of the Financial Products
subsidiary’s credit default swap portfolio. John Reich, a former OTS director, told the
FCIC that as late as September 2008, he had “no clue – no idea – what [AIG’s] CDS
liability was.”
According to Mike Finn, the director for the OTS’s northeast region, the OTS’s authority
to regulate holding companies was intended to ensure the safety and soundness of the
FDIC-insured subsidiary of AIG and not to focus on the potential impact on AIG of an
uninsured subsidiary like AIG Financial Products. Finn ignored the OTS’s responsibilities
under the European Union’s Financial Conglomerates Directive (FCD) – responsibilities
The Bailout of AIG
the OTS had actively sought. The directive required foreign companies doing business in
Europe to have the equivalent of a “consolidated supervisor” in their home country.
Starting in 2004, the OTS worked to persuade the European Union that it was capable of
serving as AIG’s “home country consolidated supervisor.” In 2005 the agency wrote:
“AIG and its subsidiaries are subject to consolidated supervision by OTS. . . . As part of
its supervision, OTS will conduct continuous on-site reviews of AIG and its subsidiaries.”
Yet even Reich told FCIC staff that he did not understand his agency’s responsibilities
under the FCD. The former director said he was never sure what authority the OTS had
over AIG Financial Products, which he said had slipped through a regulatory gap.
Further undermining the OTS’s claim that it lacked authority over AIG Financial Products
are its own actions: the OTS did in fact examine the subsidiary, albeit much too late to
matter. OTS examiners argued they got little cooperation from Joseph Cassano, the
head of the subsidiary. Joseph Gonzales, the examiner in charge from April 2004 to
November 2006, told FCIC staff, “I overheard one employee saying that Joe Cassano
felt that [the OTS was] overreaching our scope by going into FP.”
The OTS did not look carefully at the credit default swap portfolio guaranteed by the
parent company – even though AIG did describe the nature of its super-senior portfolio
in its annual reports at that time, including the dollar amount of total credit default swaps
that it had written. Gonzales said that the OTS did not know about the CDS during the
2004-05 period. After a limited review in July 2007 – conducted a week before Goldman
sent AIG Financial Products its first demand for collateral – the OTS concluded that the
risk in the CDS book was too small to be measured and decided to put off a more
detailed review until 2008. The agency’s stated reason was its limited time and staff
In February 2008, AIG reported billions of dollars in losses and material weaknesses in
the way it valued credit default swap positions. Yet the OTS did not initiate an in-depth
review of the credit default swaps until September 2008 – ten days before AIG went to
the Fed seeking a rescue – completing the review on October 17, more than a month
after AIG failed. It was, former OTS director of Conglomerate Operations Brad Waring
admitted, “in hindsight, a bad choice.”
The Bailout of AIG
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. Which of the following was the main reason the government was forced to bail out
AIG in 2008:
low interest rates
high interest rates
a lack of liquidity
an unprecedented number of insurance claims
2. The Federal Reserve felt that if it failed to bail out AIG it would not have a dramatic
negative effect on the market place.
a) true
b) false
The Bailout of AIG
1. A: Incorrect. Interest rates had no real factor in the firm’s demise.
B: Incorrect. Interest rates were actually low, but that did not materially affect the
C: Correct. While the firm’s assets were in the trillions of dollars, demand from
investors and creditors put an unmanageable strain on their liquidity.
D: Incorrect. It was the firm’s poor investments, resulting in a lack of liquidity, that
was their downfall rather than insurance claims.
(See page 19-1 of the course material.)
2. A: True is incorrect. To the contrary, the bailout was based on concerns about the
impact of AIG’s failure on the market place as a whole.
B: False is correct. It was thought that the failure of AIG would have significant
impacts on the financial markets.
(See page 19-3 of the course material.)
The Bailout of AIG
Chapter 20: Crisis and Panic
September 15, 2008 – the date of the bankruptcy of Lehman Brothers and the takeover
of Merrill Lynch, followed within 24 hours by the rescue of AIG – marked the beginning of
the worst market disruption in postwar American history and an extraordinary rush to the
safest possible investments. Creditors and investors suspected that many other large
financial institutions were on the edge of failure, and the Lehman bankruptcy seemed to
prove that at least some of them would not have access to the federal government’s
safety net.
John Mack, CEO of Morgan Stanley during the crisis, told the FCIC, “In the immediate
wake of Lehman’s failure, Morgan Stanley and similar institutions experienced a classic
‘run on the bank,’ as investors lost confidence in financial institutions and the entire
investment banking business model came under siege.” Fed Chairman Ben Bernanke
told the FCIC, “As a scholar of the Great Depression, I honestly believe that September
and October of 2008 was the worst financial crisis in global history, including the Great
As it had on the weekend of Bear’s demise, the Federal Reserve announced new
measures on Sunday, September 14, to make more cash available to investment banks
and other firms. Yet again, it lowered its standards regarding the quality of the collateral
that investment banks and other primary dealers could use while borrowing under the
two programs to support repo lending, the Primary Dealer Credit Facility (PDCF) and the
Term Securities Lending Facility (TSLF). And, providing a temporary exception to its
rules, it allowed the investment banks and other financial companies to borrow cash
from their insured depository affiliates. The investment banks drew liberally on the Fed’s
lending programs.
But the new measures did not quell the market panic. Among the first to be directly
affected were the money market funds and other institutions that held Lehman’s $4
billion in unsecured commercial paper and made loans to the company through the triparty repo market. Investors pulled out of funds with known exposure to that jeopardy,
including the Reserve Management Company’s Reserve Primary Fund and Wachovia’s
Evergreen Investments. Other parties with direct connections to Lehman included the
hedge funds, investment banks, and investors who were on the other side of Lehman’s
more than 900,000 over-the-counter derivatives contracts.
Investors also pulled out of funds that did not have direct Lehman exposure. The
managers of these funds, in turn, pulled $165 billion out of the commercial paper market
in September and shifted billions of dollars of repo loans to safer collateral, putting
further pressure on investment banks and other finance companies that depended on
those markets.
Investors and uninsured depositors yanked tens of billions of dollars out of banks whose
real estate exposures might be debilitating (Washington Mutual, Wachovia) in favor of
those whose real estate exposures appeared manageable (Wells Fargo, JP Morgan).
Hedge funds withdrew tens of billions of dollars of assets held in custody at the
remaining investment banks (Goldman Sachs, Morgan Stanley, and even Merrill Lynch,
as the just-announced Bank of America acquisition wouldn’t close for another three and
a half months) in favor of large commercial banks with prime brokerage businesses (JP
Crisis and Panic
Morgan, Credit Suisse, Deutsche Bank), because the commercial banks had more
diverse sources of liquidity than the investment banks as well as large bases of insured
deposits. JP Morgan and BNY Mellon, the tri-party repo clearing banks, clamped down
on their intraday exposures, demanding more collateral than ever from the remaining
investment banks and other primary dealers. Many banks refused to lend to one
another; the cost of interbank lending rose to unprecedented levels.
On Monday, September 15, the Dow Jones Industrial Average fell more than 500 points,
or 4%, the largest single-day point drop since the 9/11 terrorist attacks. These drops
would be exceeded on September 29 – the day that the House of Representatives
initially voted against the $700 billion Troubled Asset Relief Program (TARP) proposal to
provide extraordinary support to financial markets and firms – when the Dow Jones fell
7% and financial stocks fell 16%. For the month, the S&P 500 would lose $889 billion of
its value, a decline of 9% – the worst month since September 2002. And specific
institutions would take direct hits.
I. Money Market Funds: “Dealers Weren’t Even Picking Up Their Phones”
When Lehman declared bankruptcy, the Reserve Primary Fund had $785 million
invested in Lehman’s commercial paper. The Primary Fund was the world’s first money
market mutual fund, established in 1971 by Reserve Management Company. The fund
had traditionally invested in conservative assets such as government securities and
bank certificates of deposit and had for years enjoyed Moody’s and S&P’s highest
ratings for safety and liquidity.
In March 2006, the fund had advised investors that it had “slightly underperformed” its
rivals, owing to a “more conservative and risk averse manner” of investing – “for
example, the Reserve Funds do not invest in commercial paper.” But immediately after
publishing this statement, it quietly but dramatically changed that strategy. Within 18
months, commercial paper grew from zero to one-half of Reserve Primary’s assets. The
higher yields attracted new investors and the Reserve Primary Fund was the fastestgrowing money market fund complex in the United States in 2006, 2007, and 2008 –
doubling in the first eight months of 2008 alone.
Earlier in 2008, Primary Fund’s managers had loaned Bear Stearns money in the repo
market up to two days before Bear’s near-collapse, pulling its money only after Bear
CEO Alan Schwartz appeared on CNBC in the company’s final day. But after the
government assisted rescue of Bear, Luciano, like many other professional investors,
said he assumed that the federal government would similarly save the day if Lehman or
one of the other investment banks, which were much larger and posed greater apparent
systemic risks, ran into trouble. These firms, Luciano said, were too big to fail.
On September 15, when Lehman declared bankruptcy, the Primary Fund’s Lehman
holdings amounted to 1.2% of the fund’s total assets of $62.4 billion. That morning, the
fund was flooded with redemption requests totaling $10.8 billion. State Street, the fund’s
custodian bank, initially helped the fund meet those requests, largely through an existing
overdraft facility, but stopped doing so at 10:10 A.M. With no means to borrow, Primary
Fund representatives reportedly described State Street’s action as “the kiss of death” for
the Primary Fund. Despite public assurances from the fund’s investment advisors, Bruce
Bent Sr. and Bruce Bent II, that the fund was committed to maintaining a $1.00 net asset
value, investors requested an additional $29 billion later on Monday and Tuesday,
September 16.
Crisis and Panic
Meanwhile, on Monday, the fund’s board had determined that the Lehman paper was
worth 80 cents on the dollar. That appraisal had quickly proved optimistic. After the
market closed Tuesday, Reserve Management publicly announced that the value of its
Lehman paper was zero, “effective 4:00PM New York time today.” As a result, the fund
broke the buck. Four days later, the fund sought SEC permission to officially suspend
After the Primary Fund broke the buck, the run took an ominous turn: it even slammed
money market funds with no direct Lehman exposure. This lack of exposure was
generally known, since the SEC requires these funds to report details on their
investments at least quarterly. Investors pulled out simply because they feared that their
fellow investors would run first. “It was overwhelmingly clear that we were staring into the
abyss – that there wasn’t a bottom to this – as the outflows picked up steam on
Wednesday and Thursday,” Fed economist Patrick McCabe told the FCIC. “The
overwhelming sense was that this was a catastrophe that we were watching unfold.”
Within a week, investors in prime money market funds – funds that invested in highly
rated securities – withdrew $349 billion; within three weeks, they withdrew another $85
billion. That money was mostly headed for other funds that bought only Treasuries and
agency securities; indeed, it was more money than those funds could invest, and they
had to turn people away. As a result of the unprecedented demand for Treasuries, the
yield on four-week Treasuries fell close to 0%, levels not seen since World War II.
Money market mutual funds needing cash to honor redemptions sold their now illiquid
investments. Unfortunately, there was little market to speak of. And holding unsecured
commercial paper from any large financial institution was now simply out of the question:
fund managers wanted no part of the next Lehman. An FCIC survey of the largest
money market funds found that many were unwilling to purchase commercial paper from
financial firms during the week after Lehman. Of the respondents, the five with the most
drastic reduction in financial commercial paper cut their holdings by half, from $58 billion
to $29 billion. This led to unprecedented increases in the rates on commercial paper,
creating problems for borrowers, particularly for financial companies, such as GE
Capital, CIT, and American Express, as well as for nonfinancial corporations that used
commercial paper to pay their immediate expenses such as payroll and inventories. The
cost of commercial paper borrowing spiked in mid-September, dramatically surpassing
the previous highs in 2007.
The government responded with two new lending programs on Friday, September 19.
Treasury would guarantee the $1 net asset value of eligible money market funds, for a
fee paid by the funds. And the Fed would provide loans to banks to purchase highquality-asset-backed commercial paper from money market funds. In its first two weeks,
this program loaned banks $150 billion, although usage declined over the ensuing
months. The two programs immediately slowed the run on money market funds.
With the financial sector in disarray, the SEC imposed a temporary ban on short-selling
on the stocks of about 800 banks, insurance companies, and securities firms. This
action, taken on September 18, followed an earlier temporary ban put in place over the
summer on naked short-selling – that is, shorting a stock without arranging to deliver it to
the buyer – of 19 financial stocks in order to protect them from “unlawful manipulation.”
Meanwhile, Treasury Secretary Henry Paulson and other senior officials had decided
they needed a more systematic approach to dealing with troubled firms and troubled
markets. Paulson started seeking authority from Congress for TARP.
Crisis and Panic
II. Morgan Stanley: “Now We’re the Next in Line”
Investors scrutinized the two remaining large, independent investment banks after the
failure of Lehman and the announced acquisition of Merrill. Especially Morgan Stanley.
On Monday, September 15, the annual cost of protecting $10 million in Morgan Stanley
debt through credit default swaps jumped to $682,000 – from $363,000 on Friday –
about double the cost for Goldman. “As soon as we come in on Monday, we’re in the
eye of the storm with Merrill gone and Lehman gone,” John Mack, then Morgan
Stanley’s CEO, said to the FCIC. He later added, “Now we’re the next in line.”
Morgan Stanley officials had some reason for confidence. On the previous Friday, the
company’s liquidity pool was more than $130 billion – Goldman’s was $120 billion – and,
like Goldman, it had passed the regulators’ liquidity stress tests months earlier. But the
early market indicators were mixed. David Wong, Morgan Stanley’s treasurer, heard
early from his London office that several European banks were not accepting Morgan
Stanley as a counterparty on derivatives trades. He called those banks and they agreed
to keep their trades with Morgan Stanley, at least for the time being.
But the relative stability was fleeting. Morgan Stanley immediately became the target of
a hedge fund run. To protect themselves, hedge funds pulled billions of dollars in cash
and other assets out of Morgan Stanley, Merrill, and Goldman in favor of prime brokers
in bank holding companies, such as JP Morgan; big foreign banks, such as Deutsche
Bank and Credit Suisse; and custodian banks, such as BNY Mellon and Northern Trust,
which they believed were safer and more transparent. Fund managers told the FCIC that
some prime brokers took aggressive measures to prevent hedge fund customers from
demanding their assets.
Soon, hedge funds would suffer unprecedented runs by their own investors. According
to an FCIC survey of hedge funds that survived, investor redemption requests averaged
20% of client funds in the fourth quarter of 2008. This pummeled the markets. Money
invested in hedge funds totaled $2.2 trillion, globally, at the end of 2007, but because of
leverage, their market impact was several times larger. Widespread redemptions forced
hedge funds to sell extraordinary amounts of assets, further depressing market prices.
Many hedge funds would halt redemptions or collapse.
On Monday, hedge funds requested about $10 billion from Morgan Stanley. Then, on
Tuesday morning, Morgan Stanley announced a profit of $1.4 billion for the three months
ended August 31, 2008, about the same as that period a year earlier. Mack had decided
to release the good news a day early, but this move had backfired. “One hedge fund
manager said to me after the fact . . . that he thought pre-announcing earnings a day
early was a sign of weakness. So I guess it was, because people certainly continued to
short our stock or sell our stock – I don’t know if they were shorting it but they were
certainly selling it,” Mack told the FCIC.
The hedge fund run became a $32 billion torrent on Wednesday, the day after AIG was
bailed out and the day that “many of our sophisticated clients started to liquefy,” as
Wong put it. Many of the hedge funds now sought to exercise their contractual capability
to borrow more from Morgan Stanley’s prime brokerage without needing to post
collateral. Morgan Stanley borrowed $13 billion from the Fed’s PDCF on Tuesday, $27
billion on Wednesday, and $35.3 billion on Friday.
Crisis and Panic
These developments triggered the event that Fed policymakers had worried about over
the summer: an increase in collateral calls by the two tri-party repo clearing banks, JP
Morgan and BNY Mellon. As had happened during the Bear episode, the two clearing
banks became concerned about their intraday exposures to Morgan Stanley, Merrill, and
Goldman. They would not make those loans to the three investment banks without
requiring bigger haircuts, which translated into requests for more collateral.
Commercial paper markets also seized up for Morgan Stanley. From Friday, September
12, to the end of September, the amount of the firm’s outstanding commercial paper had
fallen nearly 40%, and it had rolled over only $20 million. By comparison, on average
Morgan Stanley rolled over about $240 million every day in the last two weeks of August.
On Saturday, Morgan Stanley executives briefed the New York Fed on the situation. By
this time, the firm had a total of $35.3 billion in PDCF funding and $32.5 billion in TSLF
funding from the Fed. Morgan Stanley’s liquidity pool had dropped from $130 billion to
$55 billion in one week. Repo lenders had pulled out $31 billion and hedge funds had
taken $86 billion out of Morgan Stanley’s prime brokerage. That run had vastly exceeded
the company’s most severe scenario in stress tests administered only one month earlier.
During the week, Goldman Sachs had encountered a similar run. Its liquidity pool had
fallen from about $120 billion on the previous Friday to $57 billion on Thursday. At the
end of the week, its Fed borrowing totaled $5 billion from the PDCF and $13.5 billion
from the TSLF.
Bernanke told the FCIC that the Fed believed the run on Goldman that week could lead
to its failure: “[Like JP Morgan,] Goldman Sachs I would say also protected themselves
quite well on the whole. They had a lot of capital, a lot of liquidity. But being in the
investment banking category rather than the commercial banking category, when that
huge funding crisis hit all the investment banks, even Goldman Sachs, we thought there
was a real chance that they would go under.” Although it did not keep pace with Morgan
Stanley’s use of the Fed’s facilities, Goldman Sachs would continue to access the Fed’s
facilities, increasing its PDCF borrowing to a high of $24 billion in October and its TSLF
borrowing to a high of $43.5 billion in December.
On Sunday, September 21, both Morgan Stanley and Goldman Sachs applied to the Fed
to become bank holding companies. The Fed, in tandem with the Department of Justice,
approved the two applications with extraordinary speed, waiving the standard five-day
antitrust waiting period. Morgan Stanley instantly converted its $39 billion industrial loan
company into a national bank, subject to supervision by the Office of the Comptroller of
the Currency (OCC), and Goldman converted its $26 billion industrial loan company into
a state-chartered bank that was a member of the Federal Reserve System, subject to
supervision by the Fed and New York State. The Fed would begin to supervise the two
new bank holding companies.
The two companies gained the immediate benefit of emergency access to the discount
window for terms of up to 90 days. But, more important, “I think the biggest benefit is it
would show you that you’re important to the system and the Fed would not make you a
holding company if they thought in a very short period of time you’d be out of business,”
Mack told the FCIC. “It sends a signal that these two firms are going to survive.”
Crisis and Panic
In a show of confidence, Warren Buffett invested $5 billion in Goldman Sachs, and
Mitsubishi UFJ invested $9 billion in Morgan Stanley. Mack said he had been waiting all
weekend for confirmation of Mitsubishi’s investment when, late Sunday afternoon, he
received a call from Bernanke, Geithner, and Paulson. “Basically they said they wanted
me to sell the firm,” Mack told the FCIC. Less than an hour later, Mitsubishi called to
confirm its investment and the regulators backed off.
Despite the weekend announcements, however, the run on Morgan Stanley continued.
“Over the course of a week, a decreasing number of people [were] willing to do new
repos,” Wong said. “They just couldn’t lend anymore.”
III. Over-the-Counter Derivatives: “A Grinding Halt”
Trading in the over-the-counter derivatives markets had been declining as investors
grew more concerned about counterparty risk and as hedge funds and other market
participants reduced their positions or exited. Activity in many of these markets slowed to
a crawl; in some cases, there was no market at all – no trades whatsoever. A sharp and
unprecedented contraction of the market occurred. This market was unregulated and
largely opaque, with no public reporting requirements and little or no price discovery.
With the Lehman bankruptcy, participants in the market became concerned about the
exposures and creditworthiness of their counterparties and the value of their contracts.
That uncertainly caused an abrupt retreat from the market.
Badly hit was the market for derivatives based on nonprime mortgages. The contraction
of the OTC derivatives market had implications beyond the valuation of mortgage
securities. Derivatives had been used to manage all manner of risk – the risk that
currency exchange rates would fluctuate, the risk that interest rates would change, the
risk that asset prices would move. Efficiently managing these risks in derivatives markets
required liquidity so that positions could be adjusted daily and at little cost. But in the fall
of 2008, everyone wanted to reduce exposure to everyone else. There was a rush for
the exits as participants worked to get out of existing trades. And because everyone was
worried about the risk inherent in the next trade, there often was no next trade – and
volume fell further. The result was a vicious circle of justifiable caution and inaction.
Meanwhile, in the absence of a liquid derivatives market and efficient price discovery,
every firm’s risk management became more expensive and difficult. The usual hedging
mechanisms were impaired. An investor that wanted to trade at a loss to get out of a
losing position might not find a buyer, and those that needed hedges would find them
more expensive or unavailable.
Several measures revealed the lack of liquidity in derivatives markets. First, the number
of outstanding contracts in a broad range of OTC derivatives sharply declined. Since its
deregulation by federal statute in December 2000, this market had increased more than
sevenfold. From June 30, 2008 to the end of the year, however, outstanding notional
amounts of OTC derivatives fell by more than 10%. This decline defied historical
precedent. It was the first significant contraction in the market over a six-month period
since the Bank for International Settlements began keeping statistics in 1998. Moreover,
it occurred during a period of great volatility in the financial markets. At such a time, firms
usually turn to the derivatives market to hedge their increased risks – but now they fled
the market.
Crisis and Panic
The lack of liquidity in derivatives markets was also signaled by the higher prices
charged by OTC derivatives dealers to enter into contracts. Dealers bear additional risks
when markets are illiquid, and they pass the cost of those risks on to market participants.
The cost is evident in the increased “bid-ask spread” – the difference between the price
at which dealers were willing to buy contracts (the bid price) and the price at which they
were willing to sell them (the ask price). As markets became less liquid during the crisis,
dealers worried that they might be saddled with unwanted exposure. As a result, they
began charging more to sell contracts (raising their ask price), and the spread rose. In
addition, they offered less to buy contracts (lowered their bid price), because they feared
involvement with un-creditworthy counterparties. The increase in the spread in these
contracts meant that the cost to a firm of hedging its exposure to the potential default of
a loan or of another firm also increased. The cost of risk management rose just when the
risks themselves had risen.
In sum, the sharp contraction in the OTC derivatives market in the fall of 2008 greatly
diminished the ability of institutions to enter or unwind their contracts or to effectively
hedge their business risks at a time when uncertainty in the financial system made risk
management a top priority.
IV. Washington Mutual: “It’s Yours”
In the eight days after Lehman’s bankruptcy, depositors pulled $16.7 billion out of
Washington Mutual, which now faced imminent collapse. WaMu had been the subject of
concern for some time because of its poor mortgage-underwriting standards and its
exposures to payment-option adjustable-rate mortgages (ARMs). Moody’s had
downgraded WaMu’s senior unsecured debt to Baa3, the lowest-tier investment-grade
rating, in July, and then to junk status on September 11, citing “WAMU’s reduced
financial flexibility, deteriorating asset quality, and expected franchise erosion.”
The Office of Thrift Supervision (OTS) determined that the thrift likely could not “pay its
obligations and meet its operating liquidity needs.” The government seized the bank on
Thursday, September 25, 2008, appointing the Federal Deposit Insurance Corporation
as receiver; many unsecured creditors suffered losses. With assets of $307 billion as of
June 30, 2008, WaMu thus became the largest insured depository institution in U.S.
history to fail – bigger than IndyMac, bigger than any bank or thrift failure in the 1980s
and 1990s. JP Morgan paid $1.9 billion to acquire WaMu’s banking operations from the
FDIC on the same day; on the next day, WaMu’s parent company (now minus the thrift)
filed for Chapter 11 bankruptcy protection.
V. Wachovia: “At the Front End of the Dominoes as Other Dominoes Fell”
Wachovia, having bought Golden West, was the largest holder of payment-option ARMs,
the same product that had helped bring down WaMu and Countrywide. Concerns about
Wachovia – then the fourth-largest bank holding company – had also been escalating for
some time. On September 9, the Merrill analyst Ed Najarian downgraded the company’s
stock to “underperform,” pointing to weakness in its option ARM and commercial loan
portfolios. On September 11, Wachovia executives met Fed officials to ask for an
exemption from rules that limited holding companies’ use of insured deposits to meet
their liquidity needs. The Fed did not accede; staff believed that Wachovia’s cash
position was strong and that the requested relief was a “want” rather than a “need.”
Crisis and Panic
But they changed their minds after the Lehman bankruptcy, immediately launching daily
conference calls to discuss liquidity with Wachovia management. Depositor outflows
increased. On September 19, the Fed supported the company’s request to use insured
deposits to provide liquidity to the holding company. On September 20, a Saturday,
Wells Fargo Chairman Richard M. Kovacevich told Robert Steel, Wachovia’s CEO and
recently a Treasury undersecretary, that Wells might be interested in acquiring the
besieged bank, and the two agreed to speak later in the week.
Throughout the following week, it became increasingly clear that Wachovia needed to
merge with a stronger financial institution. Then, WaMu’s failure on September 25
“raised creditor concern about the health of Wachovia,” the Fed’s Alvarez told the FCIC.
“The day after the failure of WaMu, Wachovia Bank depositors accelerated the
withdrawal of significant amounts from their accounts,” Alvarez said.
David Wilson, the Office of the Comptroller of the Currency’s lead examiner at
Wachovia, agreed. “The whole world changed” for Wachovia after WaMu’s failure, he
said. The FDIC’s Bair had a slightly different view. WaMu’s failure “was practically a
nonevent,” she told the FCIC. “It was below the fold if it was even on the front page . . .
barely a blip given everything else that was going on.”
The run on Wachovia Bank, the country’s fourth-largest commercial bank, was a “silent
run” by uninsured depositors and unsecured creditors sitting in front of their computers,
rather than by depositors standing in lines outside bank doors. By noon on Friday,
September 26, creditors were refusing to roll over the bank’s short-term funding,
including commercial paper and brokered certificates of deposit. The FDIC’s John
Corston testified that Wachovia lost $5.7 billion of deposits and $1.1 billion of
commercial paper and repos that day.
By the end of the day on Friday, Wachovia told the Fed that worried creditors had asked
it to repay roughly half of its long-term debt – $50 billion to $60 billion. Wachovia “did not
have to pay all these funds from a contractual basis (they had not matured), but would
have difficulty [borrowing from these lenders] going forward given the reluctance to
repay early,” Richard Westerkamp, the Richmond Fed’s lead examiner at Wachovia, told
the FCIC.
In one day, the value of Wachovia’s 10-year bonds fell from 73 cents to 29 cents on the
dollar, and the cost of buying protection on $10 million of Wachovia debt jumped from
$571,000 to almost $1,400,000 annually. Wachovia’s stock fell 27%, wiping out $8 billion
in market value. Comptroller of the Currency John Dugan, whose agency regulated
Wachovia’s commercial bank subsidiary, sent FDIC Chairman Bair a short and alarming
email stating that Wachovia’s liquidity was unstable. “Wachovia was at the front end of
the dominoes as other dominoes fell,” Steel told the FCIC.
Government officials were not prepared to let Wachovia open for business on Monday,
September 29, without a deal in place. Wells Fargo had already expressed interest in
buying Wachovia; by Friday, Citigroup had as well. Wachovia entered into confidentiality
agreements with both companies on Friday and the two suitors immediately began their
due diligence investigations.
Crisis and Panic
The key question was whether the FDIC would provide assistance in an acquisition.
Though Citigroup never considered making a bid that did not presuppose such
assistance, Wells Fargo was initially interested in purchasing all of Wachovia without it.
FDIC assistance would require the first-ever application of the systemic risk exception
under FDICIA. Over the weekend, federal officials hurriedly considered the systemic
risks if the FDIC did not intervene and if creditors and uninsured depositors suffered
The signs for the bank were discouraging. Given the recent withdrawals, the FDIC and
OCC predicted in an internal analysis that Wachovia could face up to $115 billion of
additional cash outflows the following week – including, most prominently, $42 billion of
further deposit outflows, as well as $12 billion from corporate deposit accounts and $30
billion from retail brokerage customers. Yet Wachovia had only $17 billion in cash and
cash equivalents. While the FDIC and OCC estimated that the company could use its
collateral to raise another $86 billion through the Fed’s discount window, the repo
market, and the Federal Home Loan Banks, even those efforts would bring the amount
on hand to only $103 billion to cover the potential $115 billion outflow.
During the weekend, the Fed argued that Wachovia should be saved, with FDIC
assistance if necessary. Its analysis focused on the firm’s counterparties and other
“interdependencies” with large market participants, and stated that asset sales by mutual
funds could cause short-term funding markets to “virtually shut down.” According to
supporting analysis by the Richmond Fed, mutual funds held $66 billion of Wachovia
debt, which Richmond Fed staff concluded represented “significant systemic
consequences”; and investment banks, “already weak and exposed to low levels of
confidence,” owned $39 billion of Wachovia’s $191 billion debt and deposits. These firms
were in danger of becoming “even more reliant on Federal Reserve support programs,
such as PDCF, to support operations in the event of a Wachovia[-led] disruption.”
In addition, Fed staff argued that a Wachovia failure would cause banks to “become
even less willing to lend to businesses and households. . . . [T]hese effects would
contribute to weaker economic performance, higher unemployment, and reduced
wealth.” Both Wells Fargo and Citigroup made offers to acquire the failing bank. Each
was conditioned on some government assistance.
FDIC staff expected Wachovia’s losses to be between $35 billion and $52 billion. On the
basis of that analysis and the particulars of the offers, they estimated that the Wells
proposal would cost the FDIC between $5.6 billion and $7.2 billion, whereas the
Citigroup proposal would cost the FDIC nothing. Late Sunday, Wachovia submitted its
own proposal, under which the FDIC would provide assistance directly to the bank so
that it could survive as a stand-alone entity.
But the FDIC still hadn’t decided to support the systemic risk exception. Its board –
which included the heads of the OCC and OTS – met at 6:00 A.M. on Monday,
September 29, to decide Wachovia’s fate before the markets opened. FDIC Associate
Director Miguel Browne hewed closely to the analysis prepared by the Richmond Fed:
Wachovia’s failure carried the risk of knocking down too many dominoes in lines
stretching in too many directions whose fall would hurt too many people, including
American taxpayers. He also raised concerns about potential global implications and
reduced confidence in the dollar. Bair remained reluctant to intervene in private financial
markets but ultimately agreed. “Well, I think this is, you know . . . one option of a lot of
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not-very-good options,” she said at the meeting. “I have acquiesced in that decision
based on the input of my colleagues, and the fact the statute gives multiple decision
makers a say in this process. I’m not completely comfortable with it but we need to move
forward with something, clearly, because this institution is in a tenuous situation.”
To win the approval of Bair and John Reich (the OTS director who served on the FDIC
board), Treasury ultimately agreed to take the unusual step of funding all government
losses from the proposed transaction. Without this express commitment from Treasury,
the FDIC would have been the first to bear losses out of its Deposit Insurance Fund,
which then held about $34.6 billion; normally, help would have come from Treasury only
after that fund was depleted. According to the minutes of the meeting, Bair thought it
was “especially important” that Treasury agree to fund losses, given that “it has
vigorously advocated the transaction.”
After just 30 minutes, the FDIC board voted to support government assistance. The
resolution also identified the winning bidder: Citigroup. “It was the fog of war,” Bair told
the FCIC. “The system was highly unstable. Who was going to take the chance that
Wachovia would have a depository run on Monday?”
Wachovia’s board quickly voted to accept Citigroup’s bid. Wachovia, Citigroup, and the
FDIC signed an agreement in principle and Wachovia and Citigroup executed an
exclusivity agreement that prohibited Wachovia from, among other things, negotiating
with other potential acquirers.
In the midst of the market turmoil, the Federal Open Market Committee met at the end of
September 2008, at about the time of the announced Citigroup acquisition of Wachovia
and the invocation of the systemic risk exception. “The planned merger of two very large
institutions led to some concern among FOMC participants that bigger and bigger firms
were being created that would be ‘too big to fail,’” according to a letter from Chairman
Bernanke to the FCIC. He added that he “shared this concern, and voiced my hope that
TARP would create options other than mergers for managing problems at large
institutions and that subsequently, through the process of regulatory reform, we might
develop good resolution mechanisms and decisively address the issues of financial
concentration and too big to fail.”
Citigroup and Wachovia immediately began working on the deal – even as Wachovia’s
stock fell 81.6% to $1.84 on September 29, the day that TARP was initially rejected by
lawmakers. They faced tremendous pressure from the regulators and the markets to
conclude the transaction before the following Monday, but the deal was complicated:
Citigroup was not acquiring the holding company, just the bank, and Citigroup wanted to
change some of the original terms. Then came a surprise: on Thursday morning,
October 2, Wells Fargo returned to the table and made a competing bid to buy all of
Wachovia for $7 a share – seven times Citigroup’s bid, with no government assistance.
There was a great deal of speculation over the timing of Wells Fargo’s new proposal,
particularly given IRS Notice 2008-83. This administrative ruling, issued just two days
earlier, allowed an acquiring company to write off the losses of an acquired company
immediately, rather than spreading them over time. Wells told the SEC that the IRS
ruling permitted the bank to reduce taxable income by $3 billion in the first year following
the acquisition rather than by $1 billion per year for three years. However, Wells said this
“was itself not a major factor” in its decision to bid for Wachovia without direct
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government assistance. Former Wells chairman Kovacevich told the FCIC that Wells’s
revised bid reflected additional due diligence, the point he had made to Wachovia CEO
Steel at the time. But the FDIC’s Bair said Kovacevich told her at the time that the tax
change had been a factor leading to Wells’s revised bid.
On Thursday, October 2, three days after accepting Citigroup’s federally assisted offer,
Wachovia’s board convened an emergency 11:00 P.M. session to discuss Wells’s
revised bid. The Wachovia board voted unanimously in favor.
At about 3:00 A.M. Friday, Wachovia’s Steel, its General Counsel Jane Sherburne, and
FDIC Chairman Bair called Citigroup CEO Vikram Pandit to inform him that Wachovia
had signed a definitive merger agreement with Wells. Steel read from prepared notes.
Pandit was stunned. “He was disappointed. That’s an understatement,” Steel told the
FCIC. Pandit thought Citigroup and Wachovia already had a deal. After Steel and
Sherburne dropped off the phone call, Pandit asked Bair if Citigroup could keep its
original loss-sharing agreement to purchase Wachovia if it matched Wells’s offer of $7 a
share. Bair said no, reasoning that the FDIC was not going to stand in the way of a
private deal. Nor was it the role of the agency to help Citigroup in a bidding war. She
also told the FCIC that she had concerns about Citigroup’s own viability if it acquired
Wachovia for that price. “In reality, we didn’t know how unstable Citigroup was at that
point,” Chairman Bair said. “Here we were selling a troubled institution . . . with a
troubled mortgage portfolio to another troubled institution. . . . I think if that deal had
gone through, Citigroup would have had to have been bailed out again.”
Later Friday morning, Wachovia announced the deal with Wells with the blessing of the
FDIC. “This agreement won’t require even a penny from the FDIC,” Kovacevich said in
the press release. Steel added that the “deal enables us to keep Wachovia intact and
preserve the value of an integrated company, without government support.”
On Monday, October 6, Citigroup filed suit to enjoin Wells Fargo’s acquisition of
Wachovia, but without success. The Wells Fargo deal would close at midnight on
December 31, for $7 per share.
IRS Notice 2008-83 was repealed in 2009. The Treasury’s inspector general, who later
conducted an investigation of the circumstances of its issuance, reported that the
purpose of the notice was to encourage strong banks to acquire weak banks by
removing limitations on the use of tax losses. The inspector general concluded that there
was a legitimate argument that the notice may have been an improper change of the tax
code by Treasury; the Constitution allows Congress alone to change the tax code. A
congressional report estimated that repealing the notice saved about $7 billion of tax
revenues over 10 years. However, the Wells controller, Richard Levy, told the FCIC that
to date Wells has not recognized any benefits from the notice, because it has not yet
had taxable income to offset.
VI. TARP: “Comprehensive Approach”
Ten days after the Lehman bankruptcy, the Fed had provided nearly $300 billion to
investment banks and commercial banks through the PDCF and TSLF lending facilities,
in an attempt to quell the storms in the repo markets, and the Fed and Treasury had
announced unprecedented programs to support money market funds. By the end of
September, the Fed’s balance sheet had grown 67% to $1.5 trillion.
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But the Fed was running out of options. In the end, it could only make collateralized
loans to provide liquidity support. It could not replenish financial institutions’ capital,
which was quickly dissolving. Uncertainty about future losses on bad assets made it
difficult for investors to determine which institutions could survive, even with all the Fed’s
new backstops. In short, the financial system was slipping away from its lender of last
On Thursday, September 18, the Fed and Treasury proposed what Secretary Paulson
called a “comprehensive approach” to stem the mounting crisis in the financial system by
purchasing the toxic mortgage-related assets that were weighing down many banks’
balance sheets. In the early hours of Saturday, September 20, as Goldman Sachs and
Morgan Stanley were preparing to become bank holding companies, Treasury sent
Congress a draft proposal of the legislation for TARP. The modest length of that
document – just three pages – belied its historical significance. It would give Treasury
the authority to spend as much as $700 billion to purchase toxic assets from financial
The initial reaction was not promising. For example, Senate Banking Committee
Chairman Christopher Dodd said on Tuesday, “This proposal is stunning and
unprecedented in its scope – and lack of detail, I might add.” “There are very few details
in this legislation,” Ranking Member Richard Shelby said. “Rather than establishing a
comprehensive, workable plan for resolving this crisis, I believe this legislation merely
codifies Treasury’s ad hoc approach.”
Paulson told a Senate committee on Tuesday, “Of course, we all believe that the very
best thing we can do is make sure that the capital markets are open and that lenders are
continuing to lend. And so that is what this overall program does, it deals with that.”
Bernanke told the Joint Economic Committee Wednesday: “I think that this is the most
significant financial crisis in the post-War period for the United States, and it has in fact a
global reach. . . . I think it is extraordinarily important to understand that, as we have
seen in many previous examples of different countries and different times, choking up of
credit is like taking the lifeblood away from the economy.” He told the House Financial
Services Committee on the same day, “People are saying, ‘Wall Street, what does it
have to do with me?’ That is the way they are thinking about it. Unfortunately, it has a lot
to do with them. It will affect their company, it will affect their job, it will affect their
economy. That affects their own lives, affects their ability to borrow and to save and to
save for retirement and so on.” By the evening of Sunday, September 28, as bankers
and regulators hammered out Wachovia’s rescue, congressional negotiators had agreed
on the outlines of a deal.
Nevertheless, on Monday, September 29, just hours after Citigroup had announced its
proposed government-assisted acquisition of Wachovia, the House rejected TARP by a
vote of 228 to 205. The markets’ response was immediate: the Dow Jones Industrial
Average quickly plunged 778 points, or almost 7%.
To broaden the bill’s appeal, TARP’s supporters made changes, including a temporary
increase in the cap on FDIC’s deposit insurance coverage from $100,000 to $250,000
per customer account. On Wednesday evening, the Senate voted in favor by a margin of
74 to 25. On Friday, October 3, the House agreed, 263 to 171, and President George W.
Bush signed the law, which had grown to 169 pages. TARP’s stated goal was to restore
liquidity and confidence in financial markets by providing “authority for the Federal
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Government to purchase and insure certain types of troubled assets for the purposes of
providing stability to and preventing disruption in the economy and financial system and
protecting taxpayers.” To provide oversight for the $700 billion program, the legislation
established the Congressional Oversight Panel and the Office of the Special Inspector
General for the Troubled Asset Relief Program (SIGTARP).
But the markets continued to deteriorate. On Monday, October 6, the Dow closed below
10,000 for the first time in four years; by the end of the week it was down almost 1,900
points, or 18%, below its peak in October 2007. The spread between the interest rate at
which banks lend to one another and interest rates on Treasuries – a closely watched
indicator of market confidence – hit an all-time high. And the dollar value of outstanding
commercial paper issued by both financial and nonfinancial companies had fallen by
$264 billion in the month between Lehman’s failure and TARP’s enactment. Even firms
that had survived the previous disruptions in the commercial paper markets were now
feeling the strain. In response, on October 7, the Fed created yet another emergency
program, the Commercial Paper Funding Facility, to purchase secured and unsecured
commercial paper directly from eligible issuers. This program, which allowed firms to roll
over their debt, would be widely used by financial and nonfinancial firms. The three
financial firms that made the greatest use of the program were foreign institutions: UBS
(which borrowed a cumulative $72 billion over time), Dexia ($53 billion), and Barclays
($38 billion). Other financial firms included GE Capital ($16 billion), Prudential Funding
($2.4 billion), and Toyota Motor Credit Corporation ($3.6 billion). Nonfinancial firms that
participated included Verizon ($1.5 billion), Harley-Davidson ($2.3 billion), McDonald’s,
($203 million) and Georgia Transmission ($109 million).
Treasury was already rethinking TARP. The best way to structure the program was not
obvious. Which toxic assets would qualify? How would the government determine fair
prices in an illiquid market? Would firms holding these assets agree to sell them at a fair
price if doing so would require them to realize losses? How could the government avoid
overpaying? Such problems would take time to solve, and Treasury wanted to bring
stability to the deteriorating markets as quickly as possible.
The key concern for markets and regulators was that they weren’t sure they understood
the extent of toxic assets on the balance sheets of financial institutions – so they couldn’t
be sure which banks were really solvent. The quickest reassurance, then, would be to
simply recapitalize the financial sector. The change was allowed under the TARP
legislation, which stated that Treasury, in consultation with the Fed, could purchase
financial instruments, including stock, if they deemed such purchases necessary to
promote financial market stability. However, the new proposal would pose a host of new
problems. By injecting capital in these firms, the government would become a major
shareholder in the private financial sector.
On Sunday, October 12, after agreeing to the terms of the capital injections, Paulson,
Bernanke, Bair, Dugan, and Geithner selected a small group of major financial
institutions to which they would immediately offer capital: the four largest commercial
bank holding companies (Bank of America, Citigroup, JP Morgan, and Wells), the three
remaining large investment banks (Goldman and Morgan Stanley, which were now bank
holding companies, and Merrill, which Bank of America had agreed to acquire), and two
important clearing and settlement banks (BNY Mellon and State Street). Together, these
nine institutions held more than $11 trillion in assets, or about 75% of all assets in U.S.
Crisis and Panic
Paulson summoned the firms’ chief executives to Washington on Columbus Day,
October 13. Along with Bernanke, Bair, Dugan, and Geithner, Paulson explained that
Treasury had set aside $250 billion from TARP to purchase equity in financial institutions
under the newly formed Capital Purchase Program (CPP). Specifically, Treasury would
purchase senior preferred stock that would pay a 5% dividend for the first five years; the
rate would rise to 9% thereafter to encourage the companies to pay the government
back. Firms would also have to issue stock warrants to Treasury and agree to abide by
certain standards for executive compensation and corporate governance.
The regulators had already decided to allocate half of these funds to the nine firms
assembled that day: $25 billion each to Citigroup, JP Morgan, and Wells; $15 billion to
Bank of America; $10 billion each to Merrill, Morgan Stanley, and Goldman; $3 billion to
BNY Mellon; and $2 billion to State Street.
“We didn’t want it to look or be like a nationalization” of the banking sector, Paulson told
the FCIC. For that reason, the capital injections took the form of nonvoting stock, and the
terms were intended to be attractive. Paulson emphasized the importance of the banks’
participation to provide confidence to the system. He told the CEOs: “If you don’t take
[the capital] and sometime later your regulator tells you that you are undercapitalized . . .
you may not like the terms if you have to come back to me.” All nine firms took the deal.
“They made a coherent, I thought, a cogent argument about responding to this crisis,
which, remember, was getting dramatically worse. It wasn’t leading to a run on some of
the banks but it was getting worse in the marketplace,” JP Morgan’s Dimon told the
To further reassure markets that it would not allow the largest financial institutions to fail,
the government also announced two new FDIC programs the next day. The first
temporarily guaranteed certain senior debt for all FDIC-insured institutions and some
holding companies. This program was used broadly. For example, Goldman Sachs had
$26 billion in debt backed by the FDIC outstanding in January 2009, and $21 billion at
the end of 2009, according to public filings; Morgan Stanley had $16 billion at the end of
2008 and $24 billion at the end of 2009. GE Capital, one of the heaviest users of the
program, had $35 billion of FDIC-backed debt outstanding at the end of 2008 and $60
billion at the end of 2009. Citigroup had $32 billion of FDIC guaranteed debt outstanding
at the end of 2008 and $65 billion at the end of 2009; JPMorgan Chase had $21 billion
outstanding at the end of 2008 and $41 billion at the end of 2009.
The second provided deposit insurance to certain non-interest-bearing deposits, like
checking accounts, at all insured depository institution. Because of the risk to taxpayers,
the measures required the Fed, the FDIC, and Treasury to declare a systemic risk
exception under FDICIA, as they had done two weeks earlier to facilitate Citigroup’s bid
for Wachovia.
Later in the week, Treasury opened TARP to qualifying “healthy” and “viable” banks,
thrifts, and holding companies, under the same terms that the first nine firms had
received. The appropriate federal regulator – the Fed, FDIC, OCC, or OTS – would
review applications and pass them to Treasury for final approval. The program was
intended not only to restore confidence in the banking system but also to provide banks
with sufficient capital to fulfill their “responsibilities in the areas of lending, dividend and
compensation policies, and foreclosure mitigation.”
Crisis and Panic
“The whole reason for designing the program was so many banks would take it, would
have the capital, and that would lead to lending. That was the whole purpose,” Paulson
told the FCIC. However, there were no specific requirements for those banks to make
loans to businesses and households. “Right after we announced it we had critics start
saying, ‘You’ve got to force them to lend,’” Paulson said. Although he said he couldn’t
see how to do this, he did concede that the program could have been more effective in
this regard. The enabling legislation did have provisions affecting the compensation of
senior executives and participating firms’ ability to pay dividends to shareholders. Over
time, these provisions would become more stringent, and the following year, in
compliance with another measure in the act that created TARP, Treasury would create
the Office of the Special Master for TARP Executive Compensation to review the
appropriateness of compensation packages among TARP recipients.
Treasury invested about $188 billion in financial institutions under TARP’s Capital
Purchase Program by the end of 2008; ultimately, it would invest $205 billion in 707
financial institutions.
In the ensuing months, Treasury would provide much of TARP’s remaining $450 billion
to specific financial institutions, including AIG ($40 billion plus a $30 billion lending
facility), Citigroup ($20 billion plus loss guarantees), and Bank of America ($20 billion).
On December 19, it established the Automotive Industry Financing Program, under
which it ultimately invested $81 billion of TARP funds to make investments in and loans
to automobile manufacturers and auto finance companies, specifically General Motors,
GMAC, Chrysler, and Chrysler Financial. On January 12, 2009, President Bush notified
Congress that he intended not to access the second half of the $700 billion in TARP
funds, so that he might “‘ensure that such funds are available early’ for the new
As of September 2010 – two years after TARP’s creation – Treasury had allocated $395
billion of the $700 billion authorized. Of that amount, $204 billion had been repaid, $185
billion remained outstanding, and $3.9 billion in losses had been incurred. About $55
billion of the outstanding funds were in the Capital Purchase Program. Treasury still held
large stakes in GM (61% of common stock), Ally Financial (formerly known as GMAC;
56%), and Chrysler (9%). Moreover, $47.5 billion of TARP funds remained invested in
AIG in addition to $49.7 billion of loans from the New York Fed and a $26 billion nonTARP equity investment by the New York Fed in two of AIG’s foreign insurance
companies. By December 2010, all nine companies invited to the initial Columbus Day
meeting had fully repaid the government.
Of course, TARP was only one of more than two dozen emergency programs totaling
trillions of dollars put in place during the crisis to stabilize the financial system and to
rescue specific firms. Indeed, TARP was not even the largest. Many of these programs
are discussed in this and previous chapters. For just some examples: The Fed’s TSLF
and PDCF programs peaked at $483 billion and $156 billion, respectively. Its money
market funding peaked at $350 billion in January 2009, and its Commercial Paper
Funding Facility peaked at $365 billion, also in January 2009. When it was introduced,
the FDIC’s program to guarantee senior debt for all FDIC-insured institutions stood
ready to backstop as much as $939 billion in bank debt. The Fed’s largest program,
announced in November 2008, purchased $1.25 trillion in agency mortgage-backed
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AIG would be the first TARP recipient that was not part of the Capital Purchase
Program. It still had two big holes to fill, despite the $85 billion loan from the New York
Fed. Its securities-lending business was underwater despite payments in September and
October of $24 billion that the Fed loan had enabled; and it still needed $27 billion to pay
credit default swap (CDS) counterparties, despite earlier payments of $35 billion.
On November 10, the government announced that it was restructuring the New York Fed
loan and, in the process, Treasury would purchase $40 billion in AIG preferred stock. As
was done in the Capital Purchase Program, in return for the equity provided, Treasury
received stock warrants from AIG and imposed restrictions on dividends and executive
Crisis and Panic
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. In the aftermath of bankruptcy of Lehman Brothers and the takeover of Merrill Lynch,
what was the effect on other banks:
there was little or no impact
there was concern that led to many people to take their money out
there was only minor demand for investments
the federal government froze all accounts in all banks for 30 days to prevent a
run on the banks
2. What advantage did Morgan Stanley and Goldman Sachs achieve by becoming bank
holding companies in the midst of the financial crisis:
there was no real benefit
a lower level of government scrutiny
greater public confidence in their ability to ride out the storm
access to the Fed’s discount window to borrow money needed to maintain
adequate liquidity
3. As a show of confidence and support, Warren Buffet invested $5 billion in what
financial institution:
Lehman Brothers
Goldman Sachs
Bank of America
4. Congress responded to the economic crisis in part by raising the level of FDIC
deposit insurance from ______ to ______.
$50,000; $100,000
$50,000; $250,000
$100,000; $250,000
$100,000; $200,000
Crisis and Panic
1. A: Incorrect. There was tremendous concern that translated into an increased
demand for funds.
B: Correct. As investor confidence disappeared, the demand for money from those
investors required financial institutions to seek short term support from the federal
C: Incorrect. The demand was so high the financial institutions required more capital.
D: Incorrect. There was no such action taken.
(See page 20-1 of the course material.)
2. A: Incorrect. The two converted in order to increase their liquidity, which was
necessary in light of increased redemption demands.
B: Incorrect. Those companies actually became subject to more government
C: Incorrect. Public sentiment was not relevant to the mechanics of this decision.
D: Correct. The decision was made to bolster the liquidity of the companies which
were both under increased pressure.
(See page 20-5 of the course material.)
3. A: Incorrect. Lehman Brothers was forced to declare bankruptcy.
B: Correct. Warren Buffet made this large investment in Goldman Sachs as a sign
of support for the institution which was under severe pressure due to the failure of
some of its counterparts.
C: Incorrect. Countrywide was purchased for pennies on the dollar by Bank of
D: Incorrect. Bank of America certainly suffered during the financial crisis, but was
less harmed than some of its rivals.
(See page 20-6 of the course material.)
Crisis and Panic
4. A: Incorrect. FDIC coverage at the time of the crisis was $100,000, and the increase
was even more.
B: Incorrect. The level of coverage at the start of the crisis was $100,000.
C: Correct. This move was made in an attempt to raise confidence levels in financial
D: Incorrect. Congress raised the level of coverage to $250,000.
(See page 20-12 of the course material.)
Crisis and Panic
Chapter 21: The Economic Fallout
Panic and uncertainty in the financial system plunged the nation into the longest and
deepest recession in generations. The credit squeeze in financial markets cascaded
throughout the economy. In testifying to the Commission, Bank of America CEO Brian
Moynihan described the impact of the financial crisis on the economy: “Over the course
of the crisis, we, as an industry, caused a lot of damage. Never has it been clearer how
poor business judgments we have made have affected Main Street.” Indeed, Main Street
felt the tremors as the upheaval in the financial system rumbled through the U.S.
economy. Seventeen trillion dollars in household wealth evaporated within 21 months,
and reported unemployment hit 10.1% at its peak in October 2009.
As the housing bubble deflated, families that had counted on rising housing values for
cash and retirement security became anchored to mortgages that exceeded the
declining value of their homes. They ratcheted back on spending, cumulatively putting
the brakes on economic growth – the classic “paradox of thrift,” described almost a
century ago by John Maynard Keynes.
In the aftermath of the panic, when credit was severely tightened, if not frozen, for
financial institutions, companies found that cheap and easy credit was gone for them,
too. It was tougher to borrow to meet payrolls and to expand inventories; businesses that
had neither credit nor customers trimmed costs and laid off employees. Still today, credit
availability is tighter than it was before the crisis.
Without jobs, people could no longer afford their house payments. Yet even if moving
could improve their job prospects, they were stuck with houses they could not sell.
Millions of families entered foreclosure and millions more fell behind on their mortgage
payments. Others simply walked away from their devalued properties, returning the keys
to the banks – an action that would destroy families’ credit for years. The surge in
foreclosed and abandoned properties dragged home prices down still more, depressing
the value of surrounding real estate in neighborhoods across the country. Even those
who stayed current on their mortgages found themselves whirled into the storm.
Towns that over several years had come to expect and rely on the housing boom now
saw jobs and tax revenue vanish. As their resources dwindled, these communities found
themselves saddled with the municipal costs they had taken on in part to expand
services for a growing population. Sinking housing prices upended local budgets that
relied on property taxes. Problems associated with abandoned homes required more
police and fire protection.
At FCIC hearings around the country, regional experts testified that the local impact of
the crisis has been severe. From 2007 to 2009, for example, banks in Sacramento had
stopped lending and potential borrowers retreated, said Clarence Williams, president of
the California Capital Financial Development Corporation. Bankers still complain to him
not only that demand from borrowers has fallen off but also that they may be subject to
increased regulatory scrutiny if they do make new loans. In September 2010, when the
FCIC held its Sacramento hearing, that region’s once-robust construction industry was
still languishing.
The Economic Fallout
The effects of the financial crisis have been felt in individual U.S. households and
businesses, big and small, and around the world. Policy makers on the state, national,
and global levels are still grappling with the aftermath, as are the homeowners and
lenders now dealing with the complications that entangle the foreclosure process.
I. Households: “I’m Not Eating. I’m Not Sleeping”
The recession officially began in December 2007. By many measures, its effects on the
job market were the worst on record, as reflected in the speed and breadth of the falloff
in jobs, the rise of the ranks of underemployed workers, and the long stretches of time
that millions of Americans were and still are surviving without work. The economy shed
3.6 million jobs in 2008 – the largest annual plunge since record keeping began in 1940.
By December 2009, the United States had lost another 4.7 million jobs. Through
November 2010, the economy had regained nearly 1 million jobs, putting only a small
dent in the declines.
The underemployment rate – the total of unemployed workers who are actively looking
for jobs, those with part-time work who would prefer full-time jobs, and those who need
jobs but say they are too discouraged to search – increased from 8.8% in December
2007 to 13.7% in December 2008, reaching 17.4% in October 2009. This was the
highest level since calculations for that labor category were first made in 1994. As of
November 2010, the underemployment rate stood at 17%. The average length of time
individuals spent unemployed spiked from 9.4 weeks in June 2008 to 18.2 weeks in
June 2009, and 25.2 weeks in June 2010. Fifty-nine percent of all job seekers, according
to the most recent government statistics, searched for work for at least 15 weeks.
The labor market is daunting across the board, but it is especially grim among African
American workers, whose jobless rate is 16.0%, about 6 percentage points above the
national average; workers between the ages of 16 and 19 years old, at 24.6%; and
Hispanics, at 13.2%. And the impact has been especially severe in certain professions:
unemployment in construction, for instance, climbed to an average of 19.1% in 2009,
and averaged 20.6% during the first 11 months of 2010.
Real gross domestic product, the nation’s measure of economic output adjusted for
inflation, fell at an annual rate of 4% in the third quarter of 2008 and 6.8% in the fourth
quarter. After falling again in the first half of 2009 and then modestly growing in the
second half, average GDP for the year was 2.6% lower than in 2008, the biggest drop
since 1946.
Looking at the labor market, Edward Lazear, chairman of President George W. Bush’s
Council of Economic Advisers during the crisis, told the Commission that the financial
crisis was linked with today’s economic problems: “I think most of it had to do with
investment. . . . Panic in financial markets and tightness in financial markets that
persisted through 2009 prevented firms from investing in the way that they otherwise
would, and I think that slows the rehiring of workers and still continues to be a problem in
labor markets.”
In June 2009, the nation officially emerged out of the recession that had begun 18
months earlier. The good news still had not reached many of the 26.2 million Americans
who were out of work, who could not find full-time work, or who had stopped looking for
work as of November 2010. Jeannie McDermott of Bakersfield told the FCIC she started
a business refilling printer ink cartridges, but in a tight economy, she didn’t earn enough
to make a living. She said she had been searching for a fulltime job since 2008.
The Economic Fallout
Households suffered the impact of the financial crisis not only in the job market but also
in their net worth and their access to credit. Of the $1 trillion lost from 2007 to the first
quarter of 2009 in household net wealth – the difference between what households own
and what they owe – about $5.6 trillion was due to declining house prices, with much of
the remainder due to the declining value of financial assets. As a point of reference,
GDP in 2008 was $14.4 trillion. And, as a separate point, the amount of wealth lost in the
dot-com crash early in the decade was $6.5 trillion, with far fewer repercussions for the
economy as a whole. The painful drop in real estate and financial asset values followed
a $6.8 trillion run-up in household debt from 2000 to 2007. Aided by the gains in home
prices and, to a lesser degree, stock prices, households’ net wealth had reached a peak
of $66 trillion in the second quarter of 2007. The collapse of the housing and stock
markets erased much of the gains from the run-up – while household debt remained
near historic highs, exceeding even the levels of 2006. As of the third quarter of 2010,
despite firmer stock and housing prices and a decline in household borrowing,
household net worth totaled $54.9 trillion, a 16.5% drop-off from its pinnacle just three
years earlier. Nationwide, home prices dropped 32% from their peak in 2006 to their low
point early in 2009. The homeownership rate declined from its peak of 69.2% in 2004 to
66.9% in the fall of 2010. Because so many American households own homes, and
because for most homeowners their housing represents their single most important
asset, these declines have been especially debilitating. Borrowing via home equity loans
or cash-out refinancing has fallen sharply.
At an FCIC hearing in Bakersfield, California, Marie Vasile explained how her family had
relocated 40 miles into the mountains to a rental house to help her husband’s fragile
health. Their old home was put up for sale and languished on the market, losing value.
Eventually, she and her husband found buyers willing to take their house in a “short
sale” – that is, a sale at a price less than the balance of the mortgage. But because the
lender was acting slowly to approve that deal, they risked losing the sale and then going
into foreclosure. “To top this all off,” Vasile told commissioners, “my husband is in the
position of possibly losing his job. . . . So not only do I have a house that I don’t know
what’s happening to, I don’t know if he’s going to have a job come December. This is
more than I can handle. I’m not eating. I’m not sleeping.”
Serious mortgage delinquencies – payments that are late 90 days or more or homes in
the foreclosure process – have spread since the crisis. Among regions, the eastern
states in the Midwest (Ohio, Indiana, Illinois, Wisconsin, and Michigan) had the highest
delinquency rate, topping 5% in 2007. By fall 2010, this rate had risen to 9.2%. Other
regions also endured high rates – especially the so-called sand states, where the
housing crisis was the worst. The third quarter 2010 serious delinquency rate for Florida
was 19.5%; Nevada, 17.8%; Arizona, 10.8%; and California, 10.3%. The data company
CoreLogic identified the 25 housing markets with the worst records of “distressed” sales,
which include short sales and sales of foreclosed properties. Las Vegas led the list in
mid-2010, with distressed sales accounting for more than 60% of all home sales. “The
state was overbuilt and some 100,000 jobs were predicated on a level of growth and
consumer spending that seemed to evaporate almost overnight,” Jeremy Aguero, an
economic and marketing analyst who follows the Nevada economy, testified to the
The performance of the stock market in the wake of the crisis also reduced wealth. The
Standard and Poor’s 500 Index fell by a third in 2008 – the largest single year decline
since 1974 – as big institutional investors moved to Treasury securities and other
The Economic Fallout
investments that they perceived as safe. Individuals felt these effects not only in their
current budgets but also in their prospects for retirement. By one calculation, assets in
retirement accounts such as 401(k)s lost $2.8 trillion, or about a third of their value,
between September 2007 and December 2008. While the stock market has recovered
somewhat, the S&P 500 as of December 31, 2010, was still about 13% below where it
was at the start of 2008. Similarly, stock prices worldwide plummeted more than 40% in
2008 but rebounded by 24% in 2009, according to the MSCI World Index stock fund
(which represents a collection of 1,500 global stocks).
The financial market fallout jeopardized some public pension plans – many of which
were already troubled before the crisis. In Colorado, state budget officials warned that
losses of $11 billion, unaddressed, could cause the Public Employees Retirement
Association plan – which covers 450,000 public workers and teachers – to go bust in two
decades. The state cut retiree benefits to adjust for the losses. Montana’s public pension
funds lost $2 billion, or a fourth of their value, in the six months following the 2008
downturn, in part because of investments in complex Wall Street securities.
Even before the fall of 2008, consumer confidence had been on a downward slope for
months. The Conference Board reported in May 2008 that its measure of consumer
confidence fell to the lowest point since late 1992. By early 2009, confidence had
plummeted to a new low; it has recovered somewhat since then but has remained
stubbornly bleak.
“[We find] nobody willing to make a decision. . . . nobody willing to take a chance,
because of the uncertainty in the economic environment, and that goes for both the state
and the federal level,” the commercial real estate developer and appraiser Gregory
Bynum testified at the FCIC’s Bakersfield hearing.
Influenced by the dramatic loss in wealth and by job insecurity, households have cut
back on debt. Total credit card debt expanded every year for two decades until it peaked
at $989 billion at the end of 2008. Almost two years later, that total had fallen 19%, to
$802 billion. The actions of banks have also played an important role: since 2008, they
have tightened lending standards, reduced lines of credit on credit cards, and increased
fees and interest rates. In the third quarter of 2008, 67% of banks imposed standards on
credit cards that were tighter than those in place in the previous quarter. In the fourth
quarter, 59% did so, meaning that many banks tightened again. In fact, a significant
number of banks tightened credit card standards quarter after quarter until the summer
of 2009. Only in the latest surveys have even a small numbers of banks begun to loosen
them. Faced with financial difficulties, over 1.4 million households declared bankruptcy in
2009, up from approximately 1.1 million in 2008.
Together, the decline in households’ financial resources, banks’ tightening of lending
standards, and consumers’ lack of confidence have led to large cuts in spending.
Consumer spending, which in the United States makes up more than two-thirds of GDP,
fell at an annual rate of roughly 3.5% in the second half of 2008 and then fell again in the
first half of 2009. Gains since then have been modest. Spending on cars and trucks fell
by an extraordinary 40% between the end of 2007 and the spring of 2009, in part
because consumer financing was less available as well as because of job and wage
The Economic Fallout
II. Businesses: “Squirrels Storing Nuts”
When the financial panic hit in September 2008, business financing dried up. Firms that
could roll over their commercial paper faced higher interest rates and shorter terms.
Those that could not roll over their paper relied on old-fashioned financing – bank loans
– or used their own cash reserves. Large firms, one analyst said at the time, turned to
their cash balances like “squirrels storing nuts.” Jeff Agosta, an executive at Devon
Energy Corporation, told the FCIC that had the government not supported the
commercial paper market, “We would have been eating grasshoppers and living in tents.
Things could have been that bad.” While his expression was hyperbolic, the fear was
very real. The lack of credit and the sharp drop in demand took its toll on businesses. In
2006, just under 20,000 U.S. companies filed for bankruptcy protection. That figure more
than tripled to nearly 61,000 in 2009. Firms’ long-term plans suddenly had to be
reevaluated – the effects of those decisions persist, even though credit markets have
recovered somewhat.
As for the banks, by mid-2007 they had begun to restrict access to credit even for large
and medium-size businesses. The Federal Open Market Committee noted this tightening
when it announced on September 18, 2007, that it was cutting the federal funds rate.
After the Lehman bankruptcy, companies such as Gannett Corporation, FairPoint
Communications, and Duke Energy drew down their existing lines of credit because they
were worried about getting shut out of credit markets.
Without access to credit, with cash reserves dwindling, and with uncertainty about the
economy high, corporations laid off workers or cut their investments, inhibiting growth
and reducing their potential for improving productivity. A survey of chief financial officers
found that 57% of U.S. companies were somewhat or very affected by credit constraints,
leading to decisions to make cuts in capital investment, technology, and elsewhere.
News headlines chronicled the problems: scarce capital forced midsize firms to pare
back investments and shutter offices, while industrial companies including Caterpillar,
Corning, and John Deere; pharmaceutical companies such as Merck and Wyeth; and
tech companies alike laid off employees as the recession took hold. Some businesses
struggled to cover payrolls and the financing of inventory.
The introduction in October 2008 of the Commercial Paper Funding Facility, under which
the Federal Reserve loaned money to nonfinancial entities, enabled the commercial
paper market to resume functioning at more normal rates and terms. But even with the
central bank’s help, nearly 70% of banks tightened credit standards and lending in the
fourth quarter of 2008. And small businesses particularly felt the squeeze. Because they
employ nearly 40% of the country’s private-sector workforce, “loans to small businesses
are especially vital to our economy,” Federal Reserve Board Governor Elizabeth Duke
told Congress early in 2010. Unlike the larger firms, which had come to rely on capital
markets for borrowing, these companies had generally obtained their credit from
traditional banks, other financial institutions, nonfinancial companies, or personal
borrowing by owners. The financial crisis disrupted all these sources, making credit more
scarce and more expensive.
In a survey of small businesses by the National Federation of Independent Business in
2009, 14% of respondents called credit “harder to get.” That figure compares with 9% in
2008 and a previous peak, at around 11%, during the credit crunch of 1991. Fed
Chairman Ben Bernanke said in a July 2010 speech that getting a small business loan
The Economic Fallout
was still “very difficult.” He also noted that banks’ loans to small businesses had dropped
from more than $710 billion in the second quarter of 2008 to less than $670 billion in the
first quarter of 2010.
Another factor – hesitancy to take on more debt in an anemic economy – is certainly
behind some of the statistics tracking lending to small businesses. Speaking on behalf of
the Independent Community Bankers of America, C. R. Cloutier, president and CEO of
Midsouth Bank in Lafayette, Louisiana, told the FCIC, “Community banks are willing to
lend. That’s how banks generate a return and survive. However, quality loan demand is
down. . . . I can tell you from my own bank’s experience, customers are scared about the
economic climate and are not borrowing. . . . Credit is available, but businesses are not
demanding it.”
Still, creditworthy borrowers seeking loans face tighter credit from banks than they did
before the crisis, surveys and anecdotal evidence suggest. Historically, banks charged a
2 percentage point premium over their funding costs on business loans, but that
premium had hit 3 points by year-end 2008 and had continued to rise in 2009, raising the
costs of borrowing.
Small businesses’ access to credit also declined when the housing market collapsed.
During the boom, many business owners had tapped the rising equity in their homes,
taking out low-interest home equity loans. Seventeen percent of small employers with a
mortgage refinanced it specifically to capitalize their businesses. As housing prices
declined, their ability to use this option was reduced or blocked altogether by the
lenders. Jerry Jost told the FCIC he borrowed against his home to help his daughter
start a bridal dress business in Bakersfield several years ago. When the economy
collapsed, Jost lost his once-profitable construction business, and his daughter’s
business languished. The Jost family has exhausted its life savings while struggling to
find steady work and reliable incomes.
The standards for credit card loans, another source of financing for small businesses,
also became more stringent. In the Fed’s April 2010 Senior Loan Officer Survey, a
majority of banks indicated that their standards for approving credit card accounts for
small businesses were tighter than “the longer-run average level that prevailed before
the crisis.” Banks had continued to tighten their terms on business credit card loans to
small businesses, for both new and existing accounts, since the end of 2009. But the
July 2010 update of the Fed survey showed the first positive signs since the end of 2006
that banks were easing up on underwriting standards for small businesses.
In an effort to assist small business lenders, the Federal Reserve in March 2009 created
the Term Asset-Backed Securities Loan Facility (TALF), a program to aid securitization
of loans, including auto loans, student loans, and small business loans. Another federal
effort aimed at improving small businesses’ access to credit was guidance in February
2010 from the Federal Reserve and other regulators, advising banks to try to meet the
credit needs of “creditworthy small business borrowers” with the assurances that
government supervisors would not hinder those efforts. Yet the prevailing headwinds
have been difficult to overcome. Without access to credit, many small businesses that
had depleted their cash reserves had trouble paying bills, and bankruptcies and loan
defaults rose. Defaults on small business loans increased to 12% in 2008, from 8% in
2007. Overall, the current state of the small business sector is a critical factor in the
struggling labor market: ailing small businesses have laid people off in large numbers,
and stronger small businesses are not hiring additional workers.
The Economic Fallout
Independent finance companies, which had often funded themselves by issuing
commercial paper, were constrained as well. The business finance company CIT Group
Inc. was one such firm. Even $2.3 billion in additional capital support from the federal
Troubled Asset Relief Program (TARP) program did not save CIT from filing for
bankruptcy protection in November 2009. Still, some active lenders to smaller
businesses, such as GE Capital, a commercial lender with a focus on middle-market
customers, were able to continue to offer financing. GE Capital’s commercial paper
borrowing fared better than others.
Nonetheless, the terms of the company’s borrowing did worsen. In 2008, it registered to
borrow up to $98 billion in commercial paper through one government program and
issued $13.4 billion in long-term debt and $21.8 billion in commercial paper under
another program. That GE Capital had trimmed commercial paper before the crisis to
less than 10% of its total debt, or about $46 billion, also softened the effects of the crisis
on the company. “A decision was made that it would be prudent for us to reduce our
reliance on the commercial paper market, and we did,” Mark Barber, the deputy
treasurer of GE Company and GE Capital, told the Commission. The firm put more than
$60 billion in cash on its balance sheet, with $52 billion in back-up bank lines of credit, if
The decline in global trade also hurt the U.S. economy as well as economies across the
world. As the financial crisis peaked in Europe and the United States, exports collapsed
in nearly every major trading country. The decline in exports shaved more than 3
percentage points off GDP growth in the third and fourth quarters of 2008. Recently,
exports have begun to recover, and as of the fall of 2010 they are back near precrisis
III. Commercial Real Estate: “Nothing’s Moving”
Commercial real estate – offices, stores, warehouses – also took a pounding, an
indicator both of the sector’s reliance on the lending markets, which were impaired by
the crisis, and of its role as a barometer of business activity. Companies do not need
more space if they go out of business, lay off workers, or decide not to expand. Weak
demand, in turn, lowers rents and forces landlords to give their big tenants incentives to
stay put. One example: two huge real estate brokerages with headquarters in New York
City received nine months’ free rent for signing leases in 2008 and 2009.
In fall 2010, commercial vacancy rates were still sky-high, with 20% of all office space
unoccupied. And the actual rate is probably much higher because layoffs create
“shadow vacancies” – a couple of desks here, part of a floor there – that tenants must fill
before demand picks back up. In the absence of demand, banks remain unwilling to lend
to all but the safest projects involving the most creditworthy developers that have precommitted tenants. “Banks are neither financing, nor are they dumping their bad
properties, creating a log jam,” one developer told a National Association of Realtors
survey. “Nothing’s moving.”
In Nevada, where tourism and construction once fed the labor force, commercial
property took a huge hit. Office vacancies in Las Vegas are now hovering around 24%,
compared with their low of 8% midway through 2005. Vacancies in retail commercial
space in Las Vegas top 10%, compared with historical vacancy rates of 3% to 4%. The
economic downturn tugged national-brand retailers into bankruptcy, emptying out the
The Economic Fallout
anchor retail space in Nevada’s malls and shopping centers. As demand for vacant
property fell, land values in and around Las Vegas plummeted.
Because lenders were still reluctant, few developers nationally could afford to build or
buy, right into the fall of 2010. Lehman’s bankruptcy meant that Monday Properties
came up short in its efforts to build a $300 million, 35-story glass office tower in
Arlington, Virginia, across the river from Washington, D.C. Potential tenants wanted to
know if the developer had financing; potential lenders wanted to know if it had tenants.
“It’s a bit of a cart-and-horse situation,” said CEO Anthony Westreich, who in October
2010 took the big risk of starting construction on the building without signed tenants or
permanent financing. The collapse of teetering financial institutions put commercial real
estate developers and commercial landlords in binds when overextended banks
suddenly pulled out of commercial construction loans. And when banks failed and were
taken over by the Federal Deposit Insurance Commission, the commercial landlords
overnight lost major bank tenants and the long-term leases that went with them. In
California, at least 35 banks have failed since 2003.
Almost half of commercial real estate loans were underwater as of February 2010,
meaning the loans were larger than the market value of the property. Commercial real
estate loans are especially concentrated among the holdings of community and regional
banks. Some commercial mortgages were also securitized, and by August 2010, the
delinquency rate on these packaged mortgages neared 9% – the highest in the history of
the industry and an ominous sign for real estate a full two years after the height of the
financial storm. At the end of 2008, the default rate had been 1.6%.
Near the end of 2010, it was not at all clear when or even if the commercial real estate
market had hit bottom. Green Street Advisors of Newport Beach, California, which tracks
real estate investment trusts, believed that it reached its nadir in mid-2009. About half of
the decline between 2007 and 2009 has been recovered, according to Mike Kirby, Green
Street’s director of research. “Nevertheless,” Kirby added, “values remain roughly 20%
shy of their peak.” That’s one perspective. On the other side, Moody’s Investors Service,
whose REAL Commercial Property Price Index tracks sales of commercial buildings,
says it is too early to make a call. Moody’s detected some signs of a pickup in the spring
and fall of 2010, and Managing Director Nick Levidy said, “We expect commercial real
estate prices to remain choppy until transaction volumes pick up.” The largest
commercial real estate loan losses are projected for 2011 and beyond, according to a
report issued by the Congressional Oversight Panel. And, looking forward, nearly $700
billion in commercial real estate debt will come due from 2011 through 2013.
IV. Government: “States Struggled to Close Shortfalls”
The recession devastated not only many companies and their workers but also state and
local governments that saw their tax revenue fall – just when people who had lost their
jobs, or were in bankruptcy or foreclosure proceedings, were demanding more services.
Those services included Medicaid, unemployment compensation, and welfare, in
addition to local assistance for mental health care, for children, and for the homeless. “At
least 46 states struggled to close shortfalls when adopting budgets for the current fiscal
year,” recently reported the Center on Budget and Policy Priorities, a Washington think
The Economic Fallout
“A critical aspect of our situation in Sacramento and . . . throughout the state is that
these increased demands for services are occurring at a time that resources . . . are
being dramatically reduced,” Bruce Wagstaff, the agency administrator with
Sacramento’s Countywide Services Agency, explained to the Commission.
Unlike the federal government, almost every state is constitutionally required to produce
a balanced budget, so running a deficit is not an option. Sujit CanagaRetna, a senior
fiscal analyst with the Council of State Governments, told the FCIC that the budget
shortfalls facing the states “are staggering numbers. It’s not just the big states; it’s
almost all states.” He said the “great transformation” occurring in state finances means
states are forced to “reorient their whole stance vis a vis the kind of programs and
services they offer their citizens.” In the 2011 fiscal year alone, which started July 2010,
states must come up with $130 billion in savings or new revenue to balance their
budgets, one study estimated. By the fall of 2010, there was some good news: revenue
from some taxes and fees in some states had started to pick up, or at least slowed their
rate of decline.
In a September 2010 report, the National Conference of State Legislatures declared that
the states “are waiting to see if the economy will sustain this nascent revenue growth . . .
And despite recent revenue improvements, more gaps loom as states confront the
phase out of federal stimulus funds, expiring tax increases and growing spending
Some states were hit harder than others, either because they were particularly affected
by the crisis or because they came into the crisis with structural budget problems. In
2010, New Jersey Governor Chris Christie proposed chopping $11 billion – or a quarter
– of the state budget to eliminate a deficit. California officials struggled through the
summer and fall to close a $19 billion shortfall, an amount larger than the entire budgets
of some states. Nonetheless, the state’s independent budget analysis office said in
November that the deficit had instead grown to $25 billion – $6 billion in the $87 billion
budget for this year and $19 billion in the fiscal year commencing in June 2011. As
people lost jobs, many also lost their health insurance, helping to drive 3.8 million
Americans into the Medicaid program in 2009 alone, an 8% increase – the largest in a
single year since the early days of this government health insurance plan, according to
the Kaiser Family Foundation, a nonprofit organization focusing on health care research.
Every state showed an enrollment increase: in nine states it was greater than 15%; in
Nevada and Wisconsin, greater than 20%.
States share the cost of Medicaid with the federal government. Congress included $87
billion in the stimulus package to help them with this expense, and it has extended the
assistance through June 2011 at a reduced level. If the economy has not improved by
then, Kaiser predicts, paying for this program will be another huge potential source of
trouble for the states.
The National League of Cities recently said that U.S. cities are in their worst fiscal shape
in at least a quarter of a century and probably have not yet hit bottom – even after four
straight years of falling revenue. Because property taxes are one of the main source of
revenue for most local governments, and because some local assessors are only now
recording lower property values, their revenue is likely to continue to decline for at least
several more years.
The Economic Fallout
“The effects of a depressed real estate market, low levels of consumer confidence, and
high levels of unemployment will likely play out in cities through 2010, 2011 and
beyond,” the survey of 338 cities reported. The authors of the survey projected that
revenue would fall 3% in 2010, and cities’ budgets would shrink another 2%, the largest
cutbacks in the 25 years for which the group has published the report.
Investors now look askance at once-solid state and local bonds, raising borrowing costs
for many states and making their task of balancing the budget even harder.
Municipalities in Florida, the state with the third-highest rate of home foreclosures, saw
borrowing costs rise when they sold $442 million in bonds in September 2010.
The federal government’s response to the financial crisis and the ensuing recession
“included some of the most aggressive fiscal and monetary policies in history,” said the
economists Mark Zandi and Alan Blinder. “Yet almost every one of these policy
initiatives remain controversial to this day, with critics calling them misguided, ineffective
or both.”
The government’s fiscal initiatives began soon after the recession started: the Economic
Stimulus Act of 2008, signed into law in February, provided roughly $170 billion in tax
rebates for households and tax incentives for businesses. In October 2008, at the height
of the crisis, the $700 billion TARP was enacted; and in early 2009, the American
Recovery and Reinvestment Act of 2009 was enacted to stimulate the weakening
economy, costing another $787 billion in tax cuts and government spending.
Beginning with the rate cuts in mid-2007 through the implementation of the TALF in early
2009, the Federal Reserve provided support to the economy throughout the crisis. Aside
from its emergency lending programs put in place during the financial crisis, the Fed put
about $1.7 trillion into the economy from September 2008 to October 2010 – primarily by
buying financial assets such as mortgages-backed securities and Treasury bonds, a
process known as “quantitative easing.” And in November 2010, officials announced
another $600 billion in easing, designed to keep long-term and short-term interest rates
In October 2010, the Treasury Department reported that the TARP program would cost
far less than the $700 billion that Congress had appropriated in the fall of 2008, because
banks had begun to repay the Treasury in 2009. In fact, Treasury said, TARP would
wind up costing about $29 billion, mostly owing to the bailout of the automakers General
Motors and Chrysler and the mortgage modification program. The latest estimates from
the Congressional Budget Office (CBO) put its cost at $25 billion. As reported earlier, the
CBO projects that the economic cost of the GSEs’ downfall, including the financial cost
of government support and actual dollar outlays, could reach $389 billion by 2019.
Overall, as spending increased and revenues declined during the recession, the federal
deficit grew from $459 billion in 2008 to $1.4 trillion in 2009. And it is estimated to have
risen to $1.6 trillion in 2010.
The Economic Fallout
V. The Financial Sector: “Almost Triple the Level of Three Years Earlier”
While the overall economy has struggled, the story for the financial sector is somewhat
different. Like other sectors of the economy, the financial industry has cut jobs. After
growing steadily for years, employment in the financial sector fell by 128,000 in 2007,
273,000 in 2008, and another 310,000 in 2009. Areas dependent on the financial
industry, such as Charlotte, North Carolina, have been hit hard. The unemployment rate
in the Charlotte area rose from 4.8% in 2006 to a recent peak of 12.8% in February
Between January 2009 and December 2010, 297 banks have failed; most were small
and medium-size banks. The number of small banks on the FDIC’s list of troubled
institutions rose from 829 in the second quarter of 2010 to 860 in the third quarter, the
largest number since March 1993. Though a number of large financial institutions failed
or nearly failed during the crisis, on the whole they have done better since the fall of
2008. Total financial sector profits peaked at $428 billion in 2006 and then fell to $128
billion in 2008, the lowest level since the early 1990s. They have since rebounded in
2009 and 2010, boosted by low interest rates and access to low cost government
borrowing. Financial sector profits were $242 billion in 2009 and reached an annual rate
of $369 billion in the fall of 2010.
Within the financial sector, commercial bank profits rose from $7.6 billion in the first
quarter of 2009 to $18.0 billion in the first quarter of 2010. The gains were concentrated
among the larger banks. For banks with assets greater than $1 billion, profits more than
doubled, from $6.3 billion to $14.5 billion, from the first quarter of 2009 to the first quarter
of 2010. For commercial banks with less than $1 billion in assets, profits rose only 26%,
from less than $1 billion to $1.2 billion.
The securities industry has reported record profits and is once again distributing large
bonuses. Just for those who work in New York City, bonuses at Wall Street securities
firms in 2009 were $20.3 billion, up 17% from the year before, with “average
compensation [rising] by 27 percent to more than $340,000.” After reporting $54 billion of
losses during 2007 and 2008, the New York State Comptroller reported that in 2009,
“industry profits reached a record $61.4 billion – almost triple the level of three years
The Economic Fallout
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. Which of the following was a factor in Americans spending less since 2008:
lack of consumer confidence
lower home prices
higher unemployment
all of the above
2. While most people found it much harder to get personal credit in the aftermath of the
financial meltdown, businesses still found credit easy to get.
a) true
b) false
3. Congress created the Term Asset-Backed Securities Loan Facility to assist in
securing what type of debt:
corporate bonds
residential mortgages
student and car loans
commercial mortgages
The Economic Fallout
1. A: Incorrect. Individuals whose home values had gone down and who saw people
out of work lacked the confidence to go out and buy. However, this is not the best
B: Incorrect. This made people feel like they had less money – which in many cases
was true – and also affected spending rates.
C: Incorrect. If you are out of work, you are certainly spending less. This is also true
if you fear being out of work. However, this is not the best answer.
D: Correct. All of the listed factors contributed to a serious decline in consumer
(See page 21-4 of the course material.)
2. A: True is incorrect. Credit in all arenas became challenging to come by.
B: False is correct. Businesses also felt tightening in the credit market and had
difficulty receiving loans for a variety of reasons, from acquisitions to operational
lines of credit needed for things like payroll.
(See page 21-5 of the course material.)
3. A: Incorrect. Consumer obligations and small business loans were the subject of this
legislation passed in 2009.
B: Incorrect. This program had no impact on mortgages.
C: Correct. These and other personal and small business loans were the subject of
the legislation.
D: Incorrect. Commercial mortgages were not affected by this legislation.
(See page 21-6 of the course material.)
The Economic Fallout
Chapter 22: The Foreclosure Crisis
I. Foreclosure on the Rise: “Hard to Talk About Any Recovery”
Since the housing bubble burst, about four million families have lost their homes to
foreclosure and another four and a half million have slipped into the foreclosure process
or are seriously behind on their mortgage payments. When the economic damage finally
abates, foreclosures may total between 8 million and more than 13 million, according to
various estimates. The foreclosure epidemic has hurt families and undermined home
values in entire zip codes, strained school systems as well as community support
services, and depleted state coffers. Even if the economy began suddenly booming the
country would need years to recover.
Prior to 2007, the foreclosure rate was historically less than 1%. But the trend since the
housing market collapsed has been dramatic: In 2009, 2.2% of all houses, or 1 out of 45,
received at least one foreclosure filing. In the fall of 2010, 1 in every 11 outstanding
residential mortgage loans in the United States was at least one payment past due but
not yet in foreclosure – an ominous warning that this wave may not have crested.
Distressed sales account for the majority of home sales in cities around the country,
including Las Vegas, Phoenix, Sacramento, and Riverside, California.
The causes of foreclosures have been analyzed by many academics and government
agencies. Two events are typically necessary for a mortgage default. First, monthly
payments become unaffordable owing to unemployment or other financial hardship, or
because mortgage payments increase. And second (in the opinion of many, now the
more important factor), the home’s value becomes less than the debt owed – in other
words, the borrower has negative equity.
After falling 32% from their peak in 2006 to the spring of 2009, home prices have
rebounded somewhat, but improvements are uneven across regions. Nationwide, 10.8
million households, or 22.5% of those with mortgages, owe more on their mortgages
than the market value of their house. In Nevada, 67% of homes with mortgages are
under water, the highest rate in the country; in California, the rate is 32%.
Given the extraordinary prevalence and extent of negative equity, the phenomenon of
“strategic defaults” has also been on the rise: homeowners purposefully walk away from
mortgage obligations when they perceive that their homes are worth less than what they
owe and they believe that the value will not be going up anytime soon.
By the fall of 2010, three states particularly hard hit by foreclosures – California, Florida,
and Nevada – reported some recent improvement in the initiation of foreclosures, but in
November Nevada’s rate was still five times higher than the national average.
Foreclosure starts climbed in 33 states from their levels a year earlier, with the largest
increases in Washington State (which has 9.2% unemployment), Indiana (9.8%
unemployment), and South Carolina (10.6% unemployment), according to the Mortgage
Bankers Association.
In Ohio, the city of Cleveland and surrounding Cuyahoga County are bulldozing blocks
of abandoned houses down to the dirt with the aim of creating a northeastern Ohio
“bank” of land preserved for the future. To do this, authorities seize blighted properties
The Foreclosure Crisis
for unpaid taxes, and they take donations of homes from the Department of Housing and
Urban Development, Fannie Mae, and some private lenders. Now, the county finds itself
under increasing duress, having endured 14,000 foreclosures in 2009. After years of
high unemployment and a fragile economy, the financial crisis took vulnerable residents
and “shoved them over the edge of the cliff,” Jim Rokakis, Cuyahoga’s treasurer, told the
In a spring 2010 survey, 85% of the responding mayors ranked the prevalence of
nonprime or subprime mortgages as either first or second on a list of factors causing
foreclosures in their cities. Almost all the mayors, 92%, said they expected the
foreclosure problems to stay the same or worsen in their cities over the next year.
II. Initiatives to Stem Foreclosure: “Persistently Disregard”
The same system that was so efficient at creating millions of mortgage loans over the
past decade has been ineffective at resolving problems in the housing market, including
the efforts of homeowners to modify their mortgages. As mortgage problems mounted,
the federal and state governments responded with financial incentives to encourage
banks to adjust interest rates, spread loan payments over longer terms, or simply write
down mortgage debts. But to date, federal auditors and independent consumer
watchdogs have given the federal government’s and the banks’ mortgage modification
programs poor grades.
The Home Affordable Modification Program (HAMP) is falling short of the 3 to 4 million
families targeted for help by the end of 2012. (The program’s resources come from the
federal TARP funds.) As of December 2010, HAMP has resulted in the permanent
modification of only 520,000 mortgages. Meanwhile, the banks report that they have
independently approved 3.4 million loan alterations of various kinds, although many of
these modifications simply roll missed payments into a new mortgage and thus result in
higher monthly payments.
The effectiveness of state mortgage modification and foreclosure assistance programs is
unclear. Some are just getting started. New Jersey, for instance, will begin a $112 million
“HomeKeeper Program” in 2011, to offer some residents who face foreclosure because
of unemployment or “substantial underemployment” a deferred-payment, no-interest
loan so that they can continue making payments on their mortgages.
During a series of hearings in communities around the country affected by the housing
crisis, the Commission heard from many witnesses about the extraordinary difficulties
they had encountered in seeking to modify their mortgages and stay in their homes.
Borrowers who have been paying down mortgages for years and have built up
substantial equity are especially susceptible to being turned down for loan modifications,
because the lender would prefer that they simply sell their homes.
Competing incentives may encourage banks to view foreclosure as quicker, cleaner, and
often cheaper than modifying the terms of existing mortgages. For them, foreclosure is a
prudent response to default because, the data suggest, many borrowers who receive
temporary or permanent forgiveness on their terms will slide into default again. Also,
servicers may receive substantial fees for guiding a mortgage through the foreclosure
process, creating an incentive to deny a modification.
The Foreclosure Crisis
Frequently, there’s another complication to attempting a foreclosure or modification: the
second mortgages that were layered onto first mortgages. The first mortgages were
commonly sold by banks into the securitization machine. The second mortgages were
often retained by the same lenders who typically service the mortgage: that is, they
process the monthly payments and provide customer service to borrowers. If a first
mortgage is modified or foreclosed on, the entire value of the second mortgage may be
wiped out. Under these circumstances, the lender holding that second lien has an
incentive to delay a modification into a new loan that would make the mortgage
payments more affordable to the borrower.
The country’s leading banks now hold on their books more than $400 billion in second
mortgages. To the extent the banks have reported these loans as performing, the loans
have not been marked down on their books. The actual value of these second
mortgages could be much less than their $400 billion-plus reported value. The danger of
future losses is self-evident. Some frustrated first-lien investors have sued servicers,
asserting they are not protecting investors’ financial interests. Instead, they claim that
because the servicer is holding the second lien, the servicers are looking after their own
balance sheets by encouraging borrowers to keep up the payments on their second
mortgage when they cannot afford to make payments on both obligations.
A number of other obstacles have made modifications difficult. For example, there are
competing interests among various investors in a mortgage-backed security. Proceeds
from a foreclosure may be enough to pay off the investors holding the highest-rated
tranches of securities, while the holders of the lower tranches would likely be wiped out.
As a result, the holders of the lower-rated tranches might prefer a modification, if it
produced more cash flow than a foreclosure.
Other efforts in the private and public sectors to address the foreclosure crisis have
focused on encouraging short sales. In theory, short sales should help borrowers,
neighborhoods, and lenders. Borrowers avoid foreclosure; neighborhoods avoid vacant,
dilapidated homes that encourage crime; and lenders avoid some of the costs of
foreclosure. Nonetheless, such deals frequently stall because the process is
cumbersome, demands coordination, and eats up resources. For example, lenders can
be reluctant to sign off on the buyer’s bid because they are not sure that the home is
being sold at the highest possible price. In addition, when there are two mortgages, the
holders of the first and second mortgages must both agree to the resolution.
III. Flaws in the Process: Speculation and Worst-Case Scenarios
In 2010, additional issues have come to the fore, as problems with individual
foreclosures have revealed systemic flaws in how lenders documented and processed
mortgages for securitization. Legal experts and consumer advocates told the
Commission that procedural and documentation problems with foreclosure have been
laid out in court cases and academic studies for years, but were ignored until the number
of foreclosures rose so dramatically.
All 50 of the nation’s state attorneys general banded together in the fall of 2010 to
investigate foreclosure irregularities, identify possible solutions, and explore potential
redress for borrowers who were harmed by improper foreclosures. For example, lenders
have relied on “robo-signers” who substituted speed for accuracy by signing, and
sometimes backdating, hundreds of affidavits claiming personal knowledge of facts
The Foreclosure Crisis
about mortgages that they did not actually know to be true. One such “robosigner,”
Jeffrey Stephan of GMAC, said that he signed 10,000 affidavits in a month – roughly 1
per minute, in a 40-hour workweek – making it highly unlikely that he verified payment
histories in each individual case of foreclosure. In addition, a number of court cases
have been filed alleging invalid notarizations, forged signatures, backdated mortgage
paperwork, and failure to demonstrate having legal standing to foreclose – that is, being
the entity with the right to repossess a home.
IV. Neighborhood Effects: “I’m Not Leaving”
For the millions of Americans who paid their bills, never flipped a house, and had never
heard of a CDO, the financial crisis has been long, bewildering, and painful. A crisis that
started with a housing boom that became a bubble has come back full circle to forests of
“for sale” signs – but this time attracting few buyers. Stores have shuttered; employers
have cut jobs; hopes have fled. Too many Americans today find themselves in suburban
ghost towns or urban wastelands, where properties are vacant and construction cranes
do not lift a thing for months.
Renters, who never bought into the madness, are also among the victims as lenders
seize property after landlords default on loans. Renters can lose the roof over their
heads as well as their security deposits. In Minneapolis, as many as 60% of buildings
with foreclosures in 2006 and 2007 were renter-occupied, according to statistics cited in
testimony by Deputy Assistant Secretary Erika Poethig from the U.S. Department of
Housing and Urban Development to the House of Representatives Subcommittee on
Housing and Community Opportunity.
For children, a repossessed house – whether rented or bought – is destabilizing. The
impact of foreclosures on children around the country has been enormous. One-third of
the children who experienced homelessness after the financial crisis did so because of
foreclosures of the housing that their parents owned or were renting, according to a
recent study. One school official in Nevada told the Commission about the significant
challenges to the educational system created by the economic crisis.
All around, the demand from people who need help is outstripping community resources.
Coast to coast, communities are trying to stretch housing aid budgets to help people
displaced by foreclosures. In Nevada, for example, Clark County, which contains 1.9
million people living in and around Las Vegas, was forced to cut its Financial Housing
Assistance program, despite the clear needs in the community. Gail Burks, the president
and chief executive of the Nevada Fair Housing Center, told the Commission that her
group finds that many they counsel through the foreclosure process are in despair. “It’s
very stressful. There are times that the couples we are helping end up divorcing,
sometimes before the process is over. . . . We’ve also seen threats of suicide.”
The Foreclosure Crisis
The following questions are designed to ensure that you have a complete understanding
of the information presented in the chapter. They do not need to be submitted in order to
receive CPE credit. They are included as an additional tool to enhance your learning
We recommend that you answer each review question and then compare your response
to the suggested solution before answering the final exam questions related to this
1. Which of the following is an important cause of homeowners going into default on
their mortgages:
their desire to move to a different location or a larger home
their inability to make their mortgage payment
the fact that their home is worth less than what they owe on it
both b and c above
2. When homeowners walk away from their home and the debt simply because it is
worth less than what they owe on it, it is referred to as:
a bad choice
strategic default
manipulative default
credit default swap
The Foreclosure Crisis
1. A: Incorrect. This is not one of the most important causes of mortgage default.
B: Incorrect. Inability to pay may be the result of several factors, including loss of job
or escalating payment. However, this is not the best answer.
C: Incorrect. Drops in home values below the amount owed on the home were a
major factor in defaults. However, this is not the best answer.
D: Correct. Both the inability to pay and being underwater in their home were
significant causes of mortgage default.
(See page 22-1 of the course material.)
2. A: Incorrect. For some people, it makes financial sense even though it places the
burden of their loan on the lender and the public as a whole.
B: Correct. This strategy has been employed by many, many people even though
they were able to make the mortgage payments.
C: Incorrect. This is not the correct term.
D: Incorrect. Credit default swaps had their role in the housing crash, but the correct
term here is a strategic default.
(See page 22-1 of the course material.)
The Foreclosure Crisis
Glossary of Terms
See asset-backed commercial paper
See asset-backed security
A series of derivatives indices constructed
from the prices of 20 credit default swaps
that each reference individual subprime
mortgage backed securities; akin to an
index like the Dow Jones Industrial
A mortgage whose interest rate changes
periodically over time
Goals originally set by the Department of
Housing and Urban Development (now by
the Federal Housing Finance Agency) for
Fannie Mae and Freddie Mac to allocate a
specified part of their mortgage business to