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THE

FINANCIAL CRISIS
FINANCIAL

INQUIRY REPORT
CRISIS

THE
INQUIRY REPORT

OFFICIAL
GOVERNMENT Final Report of the National Commission
EDITION on the Causes of the Financial and
I S B N 978-0-16-087727-8
Economic Crisis in the United States
90000

9 780160 877278
• OFFICIAL GOVERNMENT EDITION •

FC_cover.indd 1 1/20/11 2:07 PM

 THE
FINANCIAL
CRISIS
INQUIRY REPORT
 THE
FINANCIAL
CRISIS
INQUIRY REPORT
∞

FINAL REPORT OF THE NATIONAL COMMISSION

ON THE CAUSES OF THE FINANCIAL AND
ECONOMIC CRISIS IN THE UNITED STATES

Submitted by
THE FINANCIAL CRISIS INQUIRY COMMISSION
Pursuant to Public Law 111-21
January 2011

OFFICIAL GOVERNMENT EDITION

 For sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC area (202) 512-1800
Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC 20402-0001

I S B N 978-0-16-087727-8
 CONTENTS

Commissioners ...................................................................................................vii
Commissioner Votes...........................................................................................viii
Commission Staff List ..........................................................................................ix
Preface ................................................................................................................xi

C ONCLUSIONS OF T H E
F I NA N C IA L C R I S I S I N Q U I RY C O M M I S S I O N .....................xv

PA R T I : C R I S I S O N T H E H O R I Z O N

Chapter  Before Our Very Eyes .........................................................................

PA R T I I : S E T T I N G T H E S TA G E

Chapter  Shadow Banking ...............................................................................

Chapter  Securitization and Derivatives.......................................................
Chapter  Deregulation Redux .........................................................................
Chapter  Subprime Lending ............................................................................

PA R T I I I : T H E B O O M A N D B U S T

Chapter  Credit Expansion ..............................................................................

Chapter  The Mortgage Machine.................................................................
Chapter  The CDO Machine ........................................................................
Chapter  All In ..................................................................................................
Chapter  The Madness ...................................................................................
Chapter  The Bust............................................................................................
v
vi CONTENTS

PA R T I V : T H E U N R AV E L I N G

Chapter  Early : Spreading Subprime Worries.................................

Chapter  Summer : Disruptions in Funding....................................
Chapter  Late  to Early : Billions in Subprime Losses ...........
Chapter  March : The Fall of Bear Stearns........................................
Chapter  March to August : Systemic Risk Concerns....................
Chapter  September :
The Takeover of Fannie Mae and Freddie Mac..................
Chapter  September : The Bankruptcy of Lehman ........................
Chapter  September : The Bailout of AIG ........................................
Chapter  Crisis and Panic ..............................................................................

PA R T V : T H E A F T E R S H O C K S

Chapter  The Economic Fallout...................................................................

Chapter  The Foreclosure Crisis ..................................................................

DI S SE N T I NG V I E WS

By Keith Hennessey, Douglas Holtz-Eakin, and Bill Thomas ........................

By Peter J. Wallison....................................................................................................

Appendix A: Glossary ....................................................................................... 539

Appendix B: List of Hearings and Witnesses ...................................................... 545
Notes ................................................................................................................ 553
Index available online at www.publicaffairsbooks.com/fcicindex.pdf
 MEMBERS OF
THE FINANCIAL CRISIS INQUIRY COMMISSION

Phil Angelides
Chairman

Hon. Bill Thomas

Vice Chairman

Brooksley Born Douglas Holtz-Eakin

Commissioner Commissioner

Byron Georgiou Heather H. Murren, CFA

Commissioner Commissioner

Senator Bob Graham John W. Thompson

Commissioner Commissioner

Keith Hennessey Peter J. Wallison

Commissioner Commissioner
COMMISSIONERS VOTING TO ADOPT THE REPORT:

Phil Angelides, Brooksley Born, Byron Georgiou,

Bob Graham, Heather H. Murren, John W. Thompson

COMMISSIONERS DISSENTING FROM THE REPORT:

Keith Hennessey, Douglas Holtz-Eakin,

Bill Thomas, Peter J. Wallison
 COMMISSION STAFF

Wendy Edelberg, Executive Director

Gary J. Cohen, General Counsel
Chris Seefer, Director of Investigations
Greg Feldberg, Director of Research

Shaista I. Ahmed Michael Flagg Dixie Noonan

Hilary J. Allen Sean J. Flynn, Jr. Donna K. Norman
Jonathan E. Armstrong Scott C. Ganz Adam M. Paul
Rob Bachmann Thomas Greene Jane D. Poulin
Barton Baker Maryann Haggerty Andrew C. Robinson
Susan Baltake Robert C. Hinkley Steve Sanderford
Bradley J. Bondi Anthony C. Ingoglia Ryan Thomas Schulte
Sylvia Boone Ben Jacobs Lorretto J. Scott
Tom Borgers Peter Adrian Kavounas Skipper Seabold
Ron Borzekowski Michael Keegan Kim Leslie Shafer  
Mike Bryan Thomas J. Keegan Gordon Shemin
Ryan Bubb Brook L. Kellerman Stuart C. P. Shroff
Troy A. Burrus Sarah Knaus Alexis Simendinger
R. Richard Cheng Thomas L. Krebs Mina Simhai
Jennifer Vaughn Collins Jay N. Lerner Jeffrey Smith
Matthew Cooper Jane E. Lewin Thomas H. Stanton
Alberto Crego Susan Mandel Landon W. Stroebel
Victor J. Cunicelli Julie A. Marcacci Brian P. Sylvester
Jobe G. Danganan Alexander Maasry Shirley Tang
Sam Davidson Courtney Mayo Fereshteh Z. Vahdati
Elizabeth A. Del Real Carl McCarden Antonio A. Vargas Cornejo
Kirstin Downey Bruce G. McWilliams Melana Zyla Vickers   
Karen Dubas Menjie L. Medina George Wahl
Desi Duncker Joel Miller Tucker Warren
Bartly A. Dzivi Steven L. Mintz Cassidy D. Waskowicz
Michael E. Easterly Clara Morain Arthur E. Wilmarth, Jr.
Alice Falk Girija Natarajan Sarah Zuckerman
Megan L. Fasules Gretchen Kinney Newsom

ix
 PREFACE

The Financial Crisis Inquiry Commission was created to “examine the causes of the
current financial and economic crisis in the United States.” In this report, the Com-
mission presents to the President, the Congress, and the American people the results
of its examination and its conclusions as to the causes of the crisis.
More than two years after the worst of the financial crisis, our economy, as well as
communities and families across the country, continues to experience the after-
shocks. Millions of Americans have lost their jobs and their homes, and the economy
is still struggling to rebound. This report is intended to provide a historical account-
ing of what brought our financial system and economy to a precipice and to help pol-
icy makers and the public better understand how this calamity came to be.
The Commission was established as part of the Fraud Enforcement and Recovery
Act (Public Law -) passed by Congress and signed by the President in May
. This independent, -member panel was composed of private citizens with ex-
perience in areas such as housing, economics, finance, market regulation, banking,
and consumer protection. Six members of the Commission were appointed by the
Democratic leadership of Congress and four members by the Republican leadership.
The Commission’s statutory instructions set out  specific topics for inquiry and
called for the examination of the collapse of major financial institutions that failed or
would have failed if not for exceptional assistance from the government. This report
fulfills these mandates. In addition, the Commission was instructed to refer to the at-
torney general of the United States and any appropriate state attorney general any
person that the Commission found may have violated the laws of the United States in
relation to the crisis. Where the Commission found such potential violations, it re-
ferred those matters to the appropriate authorities. The Commission used the au-
thority it was given to issue subpoenas to compel testimony and the production of
documents, but in the vast majority of instances, companies and individuals volun-
tarily cooperated with this inquiry.
In the course of its research and investigation, the Commission reviewed millions
of pages of documents, interviewed more than  witnesses, and held  days of
public hearings in New York, Washington, D.C., and communities across the country

xi
xii P R E FA C E

that were hard hit by the crisis. The Commission also drew from a large body of ex-
isting work about the crisis developed by congressional committees, government
agencies, academics, journalists, legal investigators, and many others.
We have tried in this report to explain in clear, understandable terms how our
complex financial system worked, how the pieces fit together, and how the crisis oc-
curred. Doing so required research into broad and sometimes arcane subjects, such
as mortgage lending and securitization, derivatives, corporate governance, and risk
management. To bring these subjects out of the realm of the abstract, we conducted
case study investigations of specific financial firms—and in many cases specific facets
of these institutions—that played pivotal roles. Those institutions included American
International Group (AIG), Bear Stearns, Citigroup, Countrywide Financial, Fannie
Mae, Goldman Sachs, Lehman Brothers, Merrill Lynch, Moody’s, and Wachovia. We
looked more generally at the roles and actions of scores of other companies.
We also studied relevant policies put in place by successive Congresses and ad-
ministrations. And importantly, we examined the roles of policy makers and regula-
tors, including at the Federal Deposit Insurance Corporation, the Federal Reserve
Board, the Federal Reserve Bank of New York, the Department of Housing and Ur-
ban Development, the Office of the Comptroller of the Currency, the Office of Fed-
eral Housing Enterprise Oversight (and its successor, the Federal Housing Finance
Agency), the Office of Thrift Supervision, the Securities and Exchange Commission,
and the Treasury Department.
Of course, there is much work the Commission did not undertake. Congress did
not ask the Commission to offer policy recommendations, but required it to delve
into what caused the crisis. In that sense, the Commission has functioned somewhat
like the National Transportation Safety Board, which investigates aviation and other
transportation accidents so that knowledge of the probable causes can help avoid fu-
ture accidents. Nor were we tasked with evaluating the federal law (the Troubled As-
set Relief Program, known as TARP) that provided financial assistance to major
financial institutions. That duty was assigned to the Congressional Oversight Panel
and the Special Inspector General for TARP.
This report is not the sole repository of what the panel found. A website—
www.fcic.gov—will host a wealth of information beyond what could be presented here.
It will contain a stockpile of materials—including documents and emails, video of the
Commission’s public hearings, testimony, and supporting research—that can be stud-
ied for years to come. Much of what is footnoted in this report can be found on the
website. In addition, more materials that cannot be released yet for various reasons will
eventually be made public through the National Archives and Records Administration.
Our work reflects the extraordinary commitment and knowledge of the mem-
bers of the Commission who were accorded the honor of this public service. We also
benefited immensely from the perspectives shared with commissioners by thou-
sands of concerned Americans through their letters and emails. And we are grateful
to the hundreds of individuals and organizations that offered expertise, informa-
tion, and personal accounts in extensive interviews, testimony, and discussions with
the Commission.
 P R E FA C E xiii

We want to thank the Commission staff, and in particular, Wendy Edelberg, our
executive director, for the professionalism, passion, and long hours they brought to
this mission in service of their country. This report would not have been possible
without their extraordinary dedication.
With this report and our website, the Commission’s work comes to a close. We
present what we have found in the hope that readers can use this report to reach their
own conclusions, even as the comprehensive historical record of this crisis continues
to be written.
 CONCLUSIONS OF THE
FINANCIAL CRISIS INQUIRY COMMISSION

The Financial Crisis Inquiry Commission has been called upon to examine the finan-
cial and economic crisis that has gripped our country and explain its causes to the
American people. We are keenly aware of the significance of our charge, given the
economic damage that America has suffered in the wake of the greatest financial cri-
sis since the Great Depression.
Our task was first to determine what happened and how it happened so that we
could understand why it happened. Here we present our conclusions. We encourage
the American people to join us in making their own assessments based on the evi-
dence gathered in our inquiry. If we do not learn from history, we are unlikely to fully
recover from it. Some on Wall Street and in Washington with a stake in the status quo
may be tempted to wipe from memory the events of this crisis, or to suggest that no
one could have foreseen or prevented them. This report endeavors to expose the
facts, identify responsibility, unravel myths, and help us understand how the crisis
could have been avoided. It is an attempt to record history, not to rewrite it, nor allow
it to be rewritten.
To help our fellow citizens better understand this crisis and its causes, we also pres-
ent specific conclusions at the end of chapters in Parts III, IV, and V of this report.
The subject of this report is of no small consequence to this nation. The profound
events of  and  were neither bumps in the road nor an accentuated dip in
the financial and business cycles we have come to expect in a free market economic
system. This was a fundamental disruption—a financial upheaval, if you will—that
wreaked havoc in communities and neighborhoods across this country.
As this report goes to print, there are more than  million Americans who are
out of work, cannot find full-time work, or have given up looking for work. About
four million families have lost their homes to foreclosure and another four and a half
million have slipped into the foreclosure process or are seriously behind on their
mortgage payments. Nearly  trillion in household wealth has vanished, with re-
tirement accounts and life savings swept away. Businesses, large and small, have felt

xv
xvi F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

the sting of a deep recession. There is much anger about what has transpired, and jus-
tifiably so. Many people who abided by all the rules now find themselves out of work
and uncertain about their future prospects. The collateral damage of this crisis has
been real people and real communities. The impacts of this crisis are likely to be felt
for a generation. And the nation faces no easy path to renewed economic strength.
Like so many Americans, we began our exploration with our own views and some
preliminary knowledge about how the world’s strongest financial system came to the
brink of collapse. Even at the time of our appointment to this independent panel,
much had already been written and said about the crisis. Yet all of us have been
deeply affected by what we have learned in the course of our inquiry. We have been at
various times fascinated, surprised, and even shocked by what we saw, heard, and
read. Ours has been a journey of revelation.
Much attention over the past two years has been focused on the decisions by the
federal government to provide massive financial assistance to stabilize the financial
system and rescue large financial institutions that were deemed too systemically im-
portant to fail. Those decisions—and the deep emotions surrounding them—will be
debated long into the future. But our mission was to ask and answer this central ques-
tion: how did it come to pass that in  our nation was forced to choose between two
stark and painful alternatives—either risk the total collapse of our financial system
and economy or inject trillions of taxpayer dollars into the financial system and an
array of companies, as millions of Americans still lost their jobs, their savings, and
their homes?
In this report, we detail the events of the crisis. But a simple summary, as we see
it, is useful at the outset. While the vulnerabilities that created the potential for cri-
sis were years in the making, it was the collapse of the housing bubble—fueled by
low interest rates, easy and available credit, scant regulation, and toxic mortgages—
that was the spark that ignited a string of events, which led to a full-blown crisis in
the fall of . Trillions of dollars in risky mortgages had become embedded
throughout the financial system, as mortgage-related securities were packaged,
repackaged, and sold to investors around the world. When the bubble burst, hun-
dreds of billions of dollars in losses in mortgages and mortgage-related securities
shook markets as well as financial institutions that had significant exposures to
those mortgages and had borrowed heavily against them. This happened not just in
the United States but around the world. The losses were magnified by derivatives
such as synthetic securities.
The crisis reached seismic proportions in September  with the failure of
Lehman Brothers and the impending collapse of the insurance giant American Interna-
tional Group (AIG). Panic fanned by a lack of transparency of the balance sheets of ma-
jor financial institutions, coupled with a tangle of interconnections among institutions
perceived to be “too big to fail,” caused the credit markets to seize up. Trading ground
to a halt. The stock market plummeted. The economy plunged into a deep recession.
The financial system we examined bears little resemblance to that of our parents’
generation. The changes in the past three decades alone have been remarkable. The
 C O N C LU S I O N S OF THE F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N xvii

financial markets have become increasingly globalized. Technology has transformed

the efficiency, speed, and complexity of financial instruments and transactions. There
is broader access to and lower costs of financing than ever before. And the financial
sector itself has become a much more dominant force in our economy.
From  to , the amount of debt held by the financial sector soared from
 trillion to  trillion, more than doubling as a share of gross domestic product.
The very nature of many Wall Street firms changed—from relatively staid private
partnerships to publicly traded corporations taking greater and more diverse kinds of
risks. By , the  largest U.S. commercial banks held  of the industry’s assets,
more than double the level held in . On the eve of the crisis in , financial
sector profits constituted  of all corporate profits in the United States, up from
 in . Understanding this transformation has been critical to the Commis-
sion’s analysis.
Now to our major findings and conclusions, which are based on the facts con-
tained in this report: they are offered with the hope that lessons may be learned to
help avoid future catastrophe.

• We conclude this financial crisis was avoidable. The crisis was the result of human
action and inaction, not of Mother Nature or computer models gone haywire. The
captains of finance and the public stewards of our financial system ignored warnings
and failed to question, understand, and manage evolving risks within a system essen-
tial to the well-being of the American public. Theirs was a big miss, not a stumble.
While the business cycle cannot be repealed, a crisis of this magnitude need not have
occurred. To paraphrase Shakespeare, the fault lies not in the stars, but in us.
Despite the expressed view of many on Wall Street and in Washington that the
crisis could not have been foreseen or avoided, there were warning signs. The tragedy
was that they were ignored or discounted. There was an explosion in risky subprime
lending and securitization, an unsustainable rise in housing prices, widespread re-
ports of egregious and predatory lending practices, dramatic increases in household
mortgage debt, and exponential growth in financial firms’ trading activities, unregu-
lated derivatives, and short-term “repo” lending markets, among many other red
flags. Yet there was pervasive permissiveness; little meaningful action was taken to
quell the threats in a timely manner.
The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic
mortgages, which it could have done by setting prudent mortgage-lending standards.
The Federal Reserve was the one entity empowered to do so and it did not. The
record of our examination is replete with evidence of other failures: financial institu-
tions made, bought, and sold mortgage securities they never examined, did not care
to examine, or knew to be defective; firms depended on tens of billions of dollars of
borrowing that had to be renewed each and every night, secured by subprime mort-
gage securities; and major firms and investors blindly relied on credit rating agencies
as their arbiters of risk. What else could one expect on a highway where there were
neither speed limits nor neatly painted lines?
xviii F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

• We conclude widespread failures in financial regulation and supervision

proved devastating to the stability of the nation’s financial markets. The sentries
were not at their posts, in no small part due to the widely accepted faith in the self-
correcting nature of the markets and the ability of financial institutions to effectively
police themselves. More than 30 years of deregulation and reliance on self-regulation
by financial institutions, championed by former Federal Reserve chairman Alan
Greenspan and others, supported by successive administrations and Congresses, and
actively pushed by the powerful financial industry at every turn, had stripped away
key safeguards, which could have helped avoid catastrophe. This approach had
opened up gaps in oversight of critical areas with trillions of dollars at risk, such as
the shadow banking system and over-the-counter derivatives markets. In addition,
the government permitted financial firms to pick their preferred regulators in what
became a race to the weakest supervisor.
Yet we do not accept the view that regulators lacked the power to protect the fi-
nancial system. They had ample power in many arenas and they chose not to use it.
To give just three examples: the Securities and Exchange Commission could have re-
quired more capital and halted risky practices at the big investment banks. It did not.
The Federal Reserve Bank of New York and other regulators could have clamped
down on Citigroup’s excesses in the run-up to the crisis. They did not. Policy makers
and regulators could have stopped the runaway mortgage securitization train. They
did not. In case after case after case, regulators continued to rate the institutions they
oversaw as safe and sound even in the face of mounting troubles, often downgrading
them just before their collapse. And where regulators lacked authority, they could
have sought it. Too often, they lacked the political will—in a political and ideological
environment that constrained it—as well as the fortitude to critically challenge the
institutions and the entire system they were entrusted to oversee.
Changes in the regulatory system occurred in many instances as financial mar-
kets evolved. But as the report will show, the financial industry itself played a key
role in weakening regulatory constraints on institutions, markets, and products. It
did not surprise the Commission that an industry of such wealth and power would
exert pressure on policy makers and regulators. From  to , the financial
sector expended . billion in reported federal lobbying expenses; individuals and
political action committees in the sector made more than  billion in campaign
contributions. What troubled us was the extent to which the nation was deprived of
the necessary strength and independence of the oversight necessary to safeguard
financial stability.

• We conclude dramatic failures of corporate governance and risk management

at many systemically important financial institutions were a key cause of this cri-
sis. There was a view that instincts for self-preservation inside major financial firms
would shield them from fatal risk-taking without the need for a steady regulatory
hand, which, the firms argued, would stifle innovation. Too many of these institu-
tions acted recklessly, taking on too much risk, with too little capital, and with too
much dependence on short-term funding. In many respects, this reflected a funda-
 C O N C LU S I O N S OF THE F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N xix

mental change in these institutions, particularly the large investment banks and bank
holding companies, which focused their activities increasingly on risky trading activ-
ities that produced hefty profits. They took on enormous exposures in acquiring and
supporting subprime lenders and creating, packaging, repackaging, and selling tril-
lions of dollars in mortgage-related securities, including synthetic financial products.
Like Icarus, they never feared flying ever closer to the sun.
Many of these institutions grew aggressively through poorly executed acquisition
and integration strategies that made effective management more challenging. The
CEO of Citigroup told the Commission that a  billion position in highly rated
mortgage securities would “not in any way have excited my attention,” and the co-
head of Citigroup’s investment bank said he spent “a small fraction of ” of his time
on those securities. In this instance, too big to fail meant too big to manage.
Financial institutions and credit rating agencies embraced mathematical models
as reliable predictors of risks, replacing judgment in too many instances. Too often,
risk management became risk justification.
Compensation systems—designed in an environment of cheap money, intense
competition, and light regulation—too often rewarded the quick deal, the short-term
gain—without proper consideration of long-term consequences. Often, those systems
encouraged the big bet—where the payoff on the upside could be huge and the down-
side limited. This was the case up and down the line—from the corporate boardroom
to the mortgage broker on the street.
Our examination revealed stunning instances of governance breakdowns and irre-
sponsibility. You will read, among other things, about AIG senior management’s igno-
rance of the terms and risks of the company’s  billion derivatives exposure to
mortgage-related securities; Fannie Mae’s quest for bigger market share, profits, and
bonuses, which led it to ramp up its exposure to risky loans and securities as the hous-
ing market was peaking; and the costly surprise when Merrill Lynch’s top manage-
ment realized that the company held  billion in “super-senior” and supposedly
“super-safe” mortgage-related securities that resulted in billions of dollars in losses.

• We conclude a combination of excessive borrowing, risky investments, and lack

of transparency put the financial system on a collision course with crisis. Clearly,
this vulnerability was related to failures of corporate governance and regulation, but
it is significant enough by itself to warrant our attention here.
In the years leading up to the crisis, too many financial institutions, as well as too
many households, borrowed to the hilt, leaving them vulnerable to financial distress
or ruin if the value of their investments declined even modestly. For example, as of
, the five major investment banks—Bear Stearns, Goldman Sachs, Lehman
Brothers, Merrill Lynch, and Morgan Stanley—were operating with extraordinarily
thin capital. By one measure, their leverage ratios were as high as  to , meaning for
every  in assets, there was only  in capital to cover losses. Less than a  drop in
asset values could wipe out a firm. To make matters worse, much of their borrowing
was short-term, in the overnight market—meaning the borrowing had to be renewed
each and every day. For example, at the end of , Bear Stearns had . billion in
xx F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

equity and . billion in liabilities and was borrowing as much as  billion in
the overnight market. It was the equivalent of a small business with , in equity
borrowing . million, with , of that due each and every day. One can’t
really ask “What were they thinking?” when it seems that too many of them were
thinking alike.
And the leverage was often hidden—in derivatives positions, in off-balance-sheet
entities, and through “window dressing” of financial reports available to the investing
public.
The kings of leverage were Fannie Mae and Freddie Mac, the two behemoth gov-
ernment-sponsored enterprises (GSEs). For example, by the end of , Fannie’s
and Freddie’s combined leverage ratio, including loans they owned and guaranteed,
stood at  to .
But financial firms were not alone in the borrowing spree: from  to , na-
tional mortgage debt almost doubled, and the amount of mortgage debt per house-
hold rose more than  from , to ,, even while wages were
essentially stagnant. When the housing downturn hit, heavily indebted financial
firms and families alike were walloped.
The heavy debt taken on by some financial institutions was exacerbated by the
risky assets they were acquiring with that debt. As the mortgage and real estate mar-
kets churned out riskier and riskier loans and securities, many financial institutions
loaded up on them. By the end of , Lehman had amassed  billion in com-
mercial and residential real estate holdings and securities, which was almost twice
what it held just two years before, and more than four times its total equity. And
again, the risk wasn’t being taken on just by the big financial firms, but by families,
too. Nearly one in  mortgage borrowers in  and  took out “option ARM”
loans, which meant they could choose to make payments so low that their mortgage
balances rose every month.
Within the financial system, the dangers of this debt were magnified because
transparency was not required or desired. Massive, short-term borrowing, combined
with obligations unseen by others in the market, heightened the chances the system
could rapidly unravel. In the early part of the th century, we erected a series of pro-
tections—the Federal Reserve as a lender of last resort, federal deposit insurance, am-
ple regulations—to provide a bulwark against the panics that had regularly plagued
America’s banking system in the th century. Yet, over the past -plus years, we
permitted the growth of a shadow banking system—opaque and laden with short-
term debt—that rivaled the size of the traditional banking system. Key components
of the market—for example, the multitrillion-dollar repo lending market, off-bal-
ance-sheet entities, and the use of over-the-counter derivatives—were hidden from
view, without the protections we had constructed to prevent financial meltdowns. We
had a st-century financial system with th-century safeguards.
When the housing and mortgage markets cratered, the lack of transparency, the
extraordinary debt loads, the short-term loans, and the risky assets all came home to
roost. What resulted was panic. We had reaped what we had sown.
 C O N C LU S I O N S OF THE F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N xxi

• We conclude the government was ill prepared for the crisis, and its inconsistent
response added to the uncertainty and panic in the financial markets. As part of
our charge, it was appropriate to review government actions taken in response to the
developing crisis, not just those policies or actions that preceded it, to determine if
any of those responses contributed to or exacerbated the crisis.
As our report shows, key policy makers—the Treasury Department, the Federal
Reserve Board, and the Federal Reserve Bank of New York—who were best posi-
tioned to watch over our markets were ill prepared for the events of  and .
Other agencies were also behind the curve. They were hampered because they did
not have a clear grasp of the financial system they were charged with overseeing, par-
ticularly as it had evolved in the years leading up to the crisis. This was in no small
measure due to the lack of transparency in key markets. They thought risk had been
diversified when, in fact, it had been concentrated. Time and again, from the spring
of  on, policy makers and regulators were caught off guard as the contagion
spread, responding on an ad hoc basis with specific programs to put fingers in the
dike. There was no comprehensive and strategic plan for containment, because they
lacked a full understanding of the risks and interconnections in the financial mar-
kets. Some regulators have conceded this error. We had allowed the system to race
ahead of our ability to protect it.
While there was some awareness of, or at least a debate about, the housing bubble,
the record reflects that senior public officials did not recognize that a bursting of the
bubble could threaten the entire financial system. Throughout the summer of ,
both Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paul-
son offered public assurances that the turmoil in the subprime mortgage markets
would be contained. When Bear Stearns’s hedge funds, which were heavily invested
in mortgage-related securities, imploded in June , the Federal Reserve discussed
the implications of the collapse. Despite the fact that so many other funds were ex-
posed to the same risks as those hedge funds, the Bear Stearns funds were thought to
be “relatively unique.” Days before the collapse of Bear Stearns in March , SEC
Chairman Christopher Cox expressed “comfort about the capital cushions” at the big
investment banks. It was not until August , just weeks before the government
takeover of Fannie Mae and Freddie Mac, that the Treasury Department understood
the full measure of the dire financial conditions of those two institutions. And just a
month before Lehman’s collapse, the Federal Reserve Bank of New York was still
seeking information on the exposures created by Lehman’s more than , deriv-
atives contracts.
In addition, the government’s inconsistent handling of major financial institutions
during the crisis—the decision to rescue Bear Stearns and then to place Fannie Mae
and Freddie Mac into conservatorship, followed by its decision not to save Lehman
Brothers and then to save AIG—increased uncertainty and panic in the market.
In making these observations, we deeply respect and appreciate the efforts made
by Secretary Paulson, Chairman Bernanke, and Timothy Geithner, formerly presi-
dent of the Federal Reserve Bank of New York and now treasury secretary, and so
xxii F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

many others who labored to stabilize our financial system and our economy in the
most chaotic and challenging of circumstances.

• We conclude there was a systemic breakdown in accountability and ethics. The

integrity of our financial markets and the public’s trust in those markets are essential
to the economic well-being of our nation. The soundness and the sustained prosper-
ity of the financial system and our economy rely on the notions of fair dealing, re-
sponsibility, and transparency. In our economy, we expect businesses and individuals
to pursue profits, at the same time that they produce products and services of quality
and conduct themselves well.
Unfortunately—as has been the case in past speculative booms and busts—we
witnessed an erosion of standards of responsibility and ethics that exacerbated the fi-
nancial crisis. This was not universal, but these breaches stretched from the ground
level to the corporate suites. They resulted not only in significant financial conse-
quences but also in damage to the trust of investors, businesses, and the public in the
financial system.
For example, our examination found, according to one measure, that the percent-
age of borrowers who defaulted on their mortgages within just a matter of months
after taking a loan nearly doubled from the summer of  to late . This data
indicates they likely took out mortgages that they never had the capacity or intention
to pay. You will read about mortgage brokers who were paid “yield spread premiums”
by lenders to put borrowers into higher-cost loans so they would get bigger fees, of-
ten never disclosed to borrowers. The report catalogues the rising incidence of mort-
gage fraud, which flourished in an environment of collapsing lending standards and
lax regulation. The number of suspicious activity reports—reports of possible finan-
cial crimes filed by depository banks and their affiliates—related to mortgage fraud
grew -fold between  and  and then more than doubled again between
 and . One study places the losses resulting from fraud on mortgage loans
made between  and  at  billion.
Lenders made loans that they knew borrowers could not afford and that could
cause massive losses to investors in mortgage securities. As early as September ,
Countrywide executives recognized that many of the loans they were originating
could result in “catastrophic consequences.” Less than a year later, they noted that
certain high-risk loans they were making could result not only in foreclosures but
also in “financial and reputational catastrophe” for the firm. But they did not stop.
And the report documents that major financial institutions ineffectively sampled
loans they were purchasing to package and sell to investors. They knew a significant
percentage of the sampled loans did not meet their own underwriting standards or
those of the originators. Nonetheless, they sold those securities to investors. The
Commission’s review of many prospectuses provided to investors found that this crit-
ical information was not disclosed.

T HESE CONCLUSIONS must be viewed in the context of human nature and individual
and societal responsibility. First, to pin this crisis on mortal flaws like greed and
 C O N C LU S I O N S OF THE F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N xxiii

hubris would be simplistic. It was the failure to account for human weakness that is
relevant to this crisis.
Second, we clearly believe the crisis was a result of human mistakes, misjudg-
ments, and misdeeds that resulted in systemic failures for which our nation has paid
dearly. As you read this report, you will see that specific firms and individuals acted
irresponsibly. Yet a crisis of this magnitude cannot be the work of a few bad actors,
and such was not the case here. At the same time, the breadth of this crisis does not
mean that “everyone is at fault”; many firms and individuals did not participate in the
excesses that spawned disaster.
We do place special responsibility with the public leaders charged with protecting
our financial system, those entrusted to run our regulatory agencies, and the chief ex-
ecutives of companies whose failures drove us to crisis. These individuals sought and
accepted positions of significant responsibility and obligation. Tone at the top does
matter and, in this instance, we were let down. No one said “no.”
But as a nation, we must also accept responsibility for what we permitted to occur.
Collectively, but certainly not unanimously, we acquiesced to or embraced a system,
a set of policies and actions, that gave rise to our present predicament.

* * *
T HIS REPORT DESCRIBES THE EVENTS and the system that propelled our nation to-
ward crisis. The complex machinery of our financial markets has many essential
gears—some of which played a critical role as the crisis developed and deepened.
Here we render our conclusions about specific components of the system that we be-
lieve contributed significantly to the financial meltdown.

• We conclude collapsing mortgage-lending standards and the mortgage securi-

tization pipeline lit and spread the flame of contagion and crisis. When housing
prices fell and mortgage borrowers defaulted, the lights began to dim on Wall Street.
This report catalogues the corrosion of mortgage-lending standards and the securiti-
zation pipeline that transported toxic mortgages from neighborhoods across Amer-
ica to investors around the globe.
Many mortgage lenders set the bar so low that lenders simply took eager borrow-
ers’ qualifications on faith, often with a willful disregard for a borrower’s ability to
pay. Nearly one-quarter of all mortgages made in the first half of  were interest-
only loans. During the same year,  of “option ARM” loans originated by Coun-
trywide and Washington Mutual had low- or no-documentation requirements.
These trends were not secret. As irresponsible lending, including predatory and
fraudulent practices, became more prevalent, the Federal Reserve and other regula-
tors and authorities heard warnings from many quarters. Yet the Federal Reserve
neglected its mission “to ensure the safety and soundness of the nation’s banking and
financial system and to protect the credit rights of consumers.” It failed to build the
retaining wall before it was too late. And the Office of the Comptroller of the Cur-
rency and the Office of Thrift Supervision, caught up in turf wars, preempted state
regulators from reining in abuses.
xxiv F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

While many of these mortgages were kept on banks’ books, the bigger money came
from global investors who clamored to put their cash into newly created mortgage-re-
lated securities. It appeared to financial institutions, investors, and regulators alike that
risk had been conquered: the investors held highly rated securities they thought were
sure to perform; the banks thought they had taken the riskiest loans off their books;
and regulators saw firms making profits and borrowing costs reduced. But each step in
the mortgage securitization pipeline depended on the next step to keep demand go-
ing. From the speculators who flipped houses to the mortgage brokers who scouted
the loans, to the lenders who issued the mortgages, to the financial firms that created
the mortgage-backed securities, collateralized debt obligations (CDOs), CDOs
squared, and synthetic CDOs: no one in this pipeline of toxic mortgages had enough
skin in the game. They all believed they could off-load their risks on a moment’s no-
tice to the next person in line. They were wrong. When borrowers stopped making
mortgage payments, the losses—amplified by derivatives—rushed through the
pipeline. As it turned out, these losses were concentrated in a set of systemically im-
portant financial institutions.
In the end, the system that created millions of mortgages so efficiently has proven
to be difficult to unwind. Its complexity has erected barriers to modifying mortgages
so families can stay in their homes and has created further uncertainty about the
health of the housing market and financial institutions.

• We conclude over-the-counter derivatives contributed significantly to this

crisis. The enactment of legislation in 2000 to ban the regulation by both the federal
and state governments of over-the-counter (OTC) derivatives was a key turning
point in the march toward the financial crisis.
From financial firms to corporations, to farmers, and to investors, derivatives
have been used to hedge against, or speculate on, changes in prices, rates, or indices
or even on events such as the potential defaults on debts. Yet, without any oversight,
OTC derivatives rapidly spiraled out of control and out of sight, growing to  tril-
lion in notional amount. This report explains the uncontrolled leverage; lack of
transparency, capital, and collateral requirements; speculation; interconnections
among firms; and concentrations of risk in this market.
OTC derivatives contributed to the crisis in three significant ways. First, one type
of derivative—credit default swaps (CDS)—fueled the mortgage securitization
pipeline. CDS were sold to investors to protect against the default or decline in value
of mortgage-related securities backed by risky loans. Companies sold protection—to
the tune of  billion, in AIG’s case—to investors in these newfangled mortgage se-
curities, helping to launch and expand the market and, in turn, to further fuel the
housing bubble.
Second, CDS were essential to the creation of synthetic CDOs. These synthetic
CDOs were merely bets on the performance of real mortgage-related securities. They
amplified the losses from the collapse of the housing bubble by allowing multiple bets
on the same securities and helped spread them throughout the financial system.
Goldman Sachs alone packaged and sold  billion in synthetic CDOs from July ,
 C O N C LU S I O N S OF THE F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N xxv

, to May , . Synthetic CDOs created by Goldman referenced more than
, mortgage securities, and  of them were referenced at least twice. This is
apart from how many times these securities may have been referenced in synthetic
CDOs created by other firms.
Finally, when the housing bubble popped and crisis followed, derivatives were in
the center of the storm. AIG, which had not been required to put aside capital re-
serves as a cushion for the protection it was selling, was bailed out when it could not
meet its obligations. The government ultimately committed more than  billion
because of concerns that AIG’s collapse would trigger cascading losses throughout
the global financial system. In addition, the existence of millions of derivatives con-
tracts of all types between systemically important financial institutions—unseen and
unknown in this unregulated market—added to uncertainty and escalated panic,
helping to precipitate government assistance to those institutions.

• We conclude the failures of credit rating agencies were essential cogs in the
wheel of financial destruction. The three credit rating agencies were key enablers of
the financial meltdown. The mortgage-related securities at the heart of the crisis
could not have been marketed and sold without their seal of approval. Investors re-
lied on them, often blindly. In some cases, they were obligated to use them, or regula-
tory capital standards were hinged on them. This crisis could not have happened
without the rating agencies. Their ratings helped the market soar and their down-
grades through 2007 and 2008 wreaked havoc across markets and firms.
In our report, you will read about the breakdowns at Moody’s, examined by the
Commission as a case study. From  to , Moody’s rated nearly ,
mortgage-related securities as triple-A. This compares with six private-sector com-
panies in the United States that carried this coveted rating in early . In 
alone, Moody’s put its triple-A stamp of approval on  mortgage-related securities
every working day. The results were disastrous:  of the mortgage securities rated
triple-A that year ultimately were downgraded.
You will also read about the forces at work behind the breakdowns at Moody’s, in-
cluding the flawed computer models, the pressure from financial firms that paid for
the ratings, the relentless drive for market share, the lack of resources to do the job
despite record profits, and the absence of meaningful public oversight. And you will
see that without the active participation of the rating agencies, the market for mort-
gage-related securities could not have been what it became.

* * *
T HERE ARE MANY COMPETING VIEWS as to the causes of this crisis. In this regard, the
Commission has endeavored to address key questions posed to us. Here we discuss
three: capital availability and excess liquidity, the role of Fannie Mae and Freddie Mac
(the GSEs), and government housing policy.
First, as to the matter of excess liquidity: in our report, we outline monetary poli-
cies and capital flows during the years leading up to the crisis. Low interest rates,
widely available capital, and international investors seeking to put their money in real
xxvi F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

estate assets in the United States were prerequisites for the creation of a credit bubble.
Those conditions created increased risks, which should have been recognized by
market participants, policy makers, and regulators. However, it is the Commission’s
conclusion that excess liquidity did not need to cause a crisis. It was the failures out-
lined above—including the failure to effectively rein in excesses in the mortgage and
financial markets—that were the principal causes of this crisis. Indeed, the availabil-
ity of well-priced capital—both foreign and domestic—is an opportunity for eco-
nomic expansion and growth if encouraged to flow in productive directions.
Second, we examined the role of the GSEs, with Fannie Mae serving as the Com-
mission’s case study in this area. These government-sponsored enterprises had a
deeply flawed business model as publicly traded corporations with the implicit back-
ing of and subsidies from the federal government and with a public mission. Their
 trillion mortgage exposure and market position were significant. In  and
, they decided to ramp up their purchase and guarantee of risky mortgages, just
as the housing market was peaking. They used their political power for decades to
ward off effective regulation and oversight—spending  million on lobbying from
 to . They suffered from many of the same failures of corporate governance
and risk management as the Commission discovered in other financial firms.
Through the third quarter of , the Treasury Department had provided  bil-
lion in financial support to keep them afloat.
We conclude that these two entities contributed to the crisis, but were not a pri-
mary cause. Importantly, GSE mortgage securities essentially maintained their value
throughout the crisis and did not contribute to the significant financial firm losses
that were central to the financial crisis.
The GSEs participated in the expansion of subprime and other risky mortgages,
but they followed rather than led Wall Street and other lenders in the rush for fool’s
gold. They purchased the highest rated non-GSE mortgage-backed securities and
their participation in this market added helium to the housing balloon, but their pur-
chases never represented a majority of the market. Those purchases represented .
of non-GSE subprime mortgage-backed securities in , with the share rising to
 in , and falling back to  by . They relaxed their underwriting stan-
dards to purchase or guarantee riskier loans and related securities in order to meet
stock market analysts’ and investors’ expectations for growth, to regain market share,
and to ensure generous compensation for their executives and employees—justifying
their activities on the broad and sustained public policy support for homeownership.
The Commission also probed the performance of the loans purchased or guaran-
teed by Fannie and Freddie. While they generated substantial losses, delinquency
rates for GSE loans were substantially lower than loans securitized by other financial
firms. For example, data compiled by the Commission for a subset of borrowers with
similar credit scores—scores below —show that by the end of , GSE mort-
gages were far less likely to be seriously delinquent than were non-GSE securitized
mortgages: . versus ..
We also studied at length how the Department of Housing and Urban Develop-
ment’s (HUD’s) affordable housing goals for the GSEs affected their investment in
 C O N C LU S I O N S OF THE F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N xxvii

risky mortgages. Based on the evidence and interviews with dozens of individuals in-
volved in this subject area, we determined these goals only contributed marginally to
Fannie’s and Freddie’s participation in those mortgages.
Finally, as to the matter of whether government housing policies were a primary
cause of the crisis: for decades, government policy has encouraged homeownership
through a set of incentives, assistance programs, and mandates. These policies were
put in place and promoted by several administrations and Congresses—indeed, both
Presidents Bill Clinton and George W. Bush set aggressive goals to increase home-
ownership.
In conducting our inquiry, we took a careful look at HUD’s affordable housing
goals, as noted above, and the Community Reinvestment Act (CRA). The CRA was
enacted in  to combat “redlining” by banks—the practice of denying credit to in-
dividuals and businesses in certain neighborhoods without regard to their creditwor-
thiness. The CRA requires banks and savings and loans to lend, invest, and provide
services to the communities from which they take deposits, consistent with bank
safety and soundness.
The Commission concludes the CRA was not a significant factor in subprime lend-
ing or the crisis. Many subprime lenders were not subject to the CRA. Research indi-
cates only  of high-cost loans—a proxy for subprime loans—had any connection to
the law. Loans made by CRA-regulated lenders in the neighborhoods in which they
were required to lend were half as likely to default as similar loans made in the same
neighborhoods by independent mortgage originators not subject to the law.
Nonetheless, we make the following observation about government housing poli-
cies—they failed in this respect: As a nation, we set aggressive homeownership goals
with the desire to extend credit to families previously denied access to the financial
markets. Yet the government failed to ensure that the philosophy of opportunity was
being matched by the practical realities on the ground. Witness again the failure of
the Federal Reserve and other regulators to rein in irresponsible lending. Homeown-
ership peaked in the spring of  and then began to decline. From that point on,
the talk of opportunity was tragically at odds with the reality of a financial disaster in
the making.
* * *
W HEN THIS C OMMISSION began its work  months ago, some imagined that the
events of  and their consequences would be well behind us by the time we issued
this report. Yet more than two years after the federal government intervened in an
unprecedented manner in our financial markets, our country finds itself still grap-
pling with the aftereffects of the calamity. Our financial system is, in many respects,
still unchanged from what existed on the eve of the crisis. Indeed, in the wake of the
crisis, the U.S. financial sector is now more concentrated than ever in the hands of a
few large, systemically significant institutions.
While we have not been charged with making policy recommendations, the very
purpose of our report has been to take stock of what happened so we can plot a new
course. In our inquiry, we found dramatic breakdowns of corporate governance,
xxviii F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

profound lapses in regulatory oversight, and near fatal flaws in our financial system.
We also found that a series of choices and actions led us toward a catastrophe for
which we were ill prepared. These are serious matters that must be addressed and
resolved to restore faith in our financial markets, to avoid the next crisis, and to re-
build a system of capital that provides the foundation for a new era of broadly
shared prosperity.
The greatest tragedy would be to accept the refrain that no one could have seen
this coming and thus nothing could have been done. If we accept this notion, it will
happen again.
This report should not be viewed as the end of the nation’s examination of this
crisis. There is still much to learn, much to investigate, and much to fix.
This is our collective responsibility. It falls to us to make different choices if we
want different results.
 PART I

Crisis on the Horizon

 1
BEFORE OUR VERY EYES

In examining the worst financial meltdown since the Great Depression, the Financial
Crisis Inquiry Commission reviewed millions of pages of documents and questioned
hundreds of individuals—financial executives, business leaders, policy makers, regu-
lators, community leaders, people from all walks of life—to find out how and why it
happened.
In public hearings and interviews, many financial industry executives and top
public officials testified that they had been blindsided by the crisis, describing it as a
dramatic and mystifying turn of events. Even among those who worried that the
housing bubble might burst, few—if any—foresaw the magnitude of the crisis that
would ensue.
Charles Prince, the former chairman and chief executive officer of Citigroup Inc.,
called the collapse in housing prices “wholly unanticipated.” Warren Buffett, the
chairman and chief executive officer of Berkshire Hathaway Inc., which until 
was the largest single shareholder of Moody’s Corporation, told the Commission
that “very, very few people could appreciate the bubble,” which he called a “mass
delusion” shared by “ 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 , 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 abil-
ity 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.”
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


 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

were clanging inside financial institutions, regulatory offices, consumer service or-
ganizations, 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 govern-
ment officials in Washington and within state legislatures, pointing to what would
become a human disaster, not just an economic debacle.
“Everybody in the whole world knew that the mortgage bubble was there,” said
Richard Breeden, the former chairman of the Securities and Exchange Commission
appointed by President George H. W. Bush. “I mean, it wasn’t hidden. . . . You cannot
look at any of this and say that the regulators did their job. This was not some hidden
problem. It wasn’t out on Mars or Pluto or somewhere. It was right here. . . . You can’t
make trillions of dollars’ worth of mortgages and not have people notice.”
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 wor-
ried about “serious signs of bubbles” in ; they therefore sent out credit analysts to
 cities to do what he called “old-fashioned shoe-leather research,” talking to real es-
tate 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 accord-
ingly,” McCulley told the Commission. The company “severely limited” its participa-
tion 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 cer-
tain kinds of investments by .
William Martin, the vice chairman and chief executive officer of Service st Bank
of Nevada, told the FCIC that the desire for a “high and quick return” blinded people
to fiscal realities. “You may recall Tommy Lee Jones in Men in Black, where he holds a
device in the air, and with a bright flash wipes clean the memories of everyone who
has witnessed an alien event,” he said.
Unlike so many other bubbles—tulip bulbs in Holland in the s, South Sea
stocks in the s, Internet stocks in the late s—this one involved not just an-
other commodity but a building block of community and social life and a corner-
stone of the economy: the family home. Homes are the foundation upon which many
of our social, personal, governmental, and economic structures rest. Children usually
go to schools linked to their home addresses; local governments decide how much
money they can spend on roads, firehouses, and public safety based on how much
property tax revenue they have; house prices are tied to consumer spending. Down-
turns in the housing industry can cause ripple effects almost everywhere.
 B E F O R E O U R V E RY E Y E S 

When the Federal Reserve cut interest rates early in the new century and mort-
gage rates fell, home refinancing surged, climbing from  billion in  to .
trillion in , allowing people to withdraw equity built up over previous decades
and to consume more, despite stagnant wages. Home sales volume started to in-
crease, and average home prices nationwide climbed, rising  in eight years by one
measure and hitting a national high of , in early . Home prices in
many areas skyrocketed: prices increased nearly two and one-half times in Sacra-
mento, 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  metropol-
itan areas, including Phoenix, Atlantic City, Baltimore, Ft. Lauderdale, Los Angeles,
Poughkeepsie, San Diego, and West Palm Beach. Housing starts nationwide
climbed , from . million in  to more than  million in . Encouraged
by government policies, homeownership reached a record . in the spring of
, although it wouldn’t rise an inch further even as the mortgage machine kept
churning for another three years. By refinancing their homes, Americans extracted
. trillion in home equity between  and , including  billion in 
alone, more than seven times the amount they took out in . Real estate specula-
tors 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 , more
than one out of every ten home sales was to an investor, speculator, or someone buy-
ing a second home. Bigger was better, and even the structures themselves ballooned
in size; the floor area of an average new home grew by , to , square feet, in
the decade from  to .
Money washed through the economy like water rushing through a broken dam.
Low interest rates and then foreign capital helped fuel the boom. Construction work-
ers, 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 finan-
cial 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  of
homeowners pulled out cash to buy a vehicle and over  spent the cash on a catch-
all category including tax payments, clothing, gifts, and living expenses. Renters
used new forms of loans to buy homes and to move to suburban subdivisions, erect-
ing swing sets in their backyards and enrolling their children in local schools.
In an interview with the Commission, Angelo Mozilo, the longtime CEO of
Countrywide Financial—a lender brought down by its risky mortgages—said that a
“gold rush” mentality overtook the country during these years, and that he was swept
up in it as well: “Housing prices were rising so rapidly—at a rate that I’d never seen in
my  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 , . . . and talk at a cocktail party about it. . . . Housing
suddenly went from being part of the American dream to house my family to settle
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

down—it became a commodity. That was a change in the culture. . . . It was sudden,
unexpected.”
On the surface, it looked like prosperity. After all, the basic mechanisms making
the real estate machine hum—the mortgage-lending instruments and the financing
techniques that turned mortgages into investments called securities, which kept cash
flowing from Wall Street into the U.S. housing market—were tools that had worked
well for many years.
But underneath, something was going wrong. Like a science fiction movie in
which ordinary household objects turn hostile, familiar market mechanisms were be-
ing transformed. The time-tested -year fixed-rate mortgage, with a  down pay-
ment, went out of style. There was a burgeoning global demand for residential
mortgage–backed securities that offered seemingly solid and secure returns. In-
vestors around the world clamored to purchase securities built on American real es-
tate, seemingly one of the safest bets in the world.
Wall Street labored mightily to meet that demand. Bond salesmen earned multi-
million-dollar bonuses packaging and selling new kinds of loans, offered by new
kinds of lenders, into new kinds of investment products that were deemed safe but
possessed complex and hidden risks. Federal officials praised the changes—these
financial innovations, they said, had lowered borrowing costs for consumers and
moved risks away from the biggest and most systemically important financial insti-
tutions. But the nation’s financial system had become vulnerable and intercon-
nected 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 de-
fault on mortgages, even as their debt grew. Shaky loans had been bundled into in-
vestment products in ways that seemed to give investors the best of both
worlds—high-yield, risk-free—but instead, in many cases, would prove to be high-
risk and yield-free.
All this financial creativity was a lot “like cheap sangria,” said Michael Mayo, a
managing director and financial services analyst at Calyon Securities (USA) Inc. “A
lot of cheap ingredients repackaged to sell at a premium,” he told the Commission. “It
might taste good for a while, but then you get headaches later and you have no idea
what’s really inside.”
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; –s and –s; liar loans;
piggyback second mortgages; payment-option or pick-a-pay adjustable rate mort-
gages. 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 bor-
rower’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
 B E F O R E O U R V E RY E Y E S 

conscientious borrowers who tried to puzzle out their implications, and opening the
door for those who wanted in on the action.
Many people chose poorly. Some people wanted to live beyond their means, and by
mid-, 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—and
Florida and Georgia became a particular target for investors who used these loans to
acquire real estate. 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, finan-
cially secure people as a cash-management tool. Some had been targeted to borrow-
ers 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  and . The changed occurred “almost overnight,” Faith Schwartz, then an
executive at the subprime lender Option One and later the executive director of Hope
Now, a lending-industry foreclosure relief group, told the Federal Reserve’s Con-
sumer Advisory Council. “I would suggest most every lender in the country is in it,
one way or another.”
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 . trillion in  to . trillion in . The mortgage debt of
American households rose almost as much in the six years from  to  as it
had over the course of the country’s more than -year history. The amount of
mortgage debt per household rose from , in  to , in . With
a simple flourish of a pen on paper, millions of Americans traded away decades of eq-
uity 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 offi-
cers for companies that were expanding mortgage originations. He crisscrossed the
nation, coaching about , loan originators a year in auditoriums and classrooms.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

His clients included many of the largest lenders—Countrywide, Ameriquest, and

Ditech among them. Most of their new hires were young, with no mortgage experi-
ence, 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.
“I was a sales and marketing trainer in terms of helping people to know how to
sell these products to, in some cases, frankly unsophisticated and unsuspecting bor-
rowers,” he said. He taught them the new playbook: “You had no incentive whatso-
ever to be concerned about the quality of the loan, whether it was suitable for the
borrower or whether the loan performed. In fact, you were in a way encouraged not
to worry about those macro issues.” He added, “I knew that the risk was being
shunted off. I knew that we could be writing crap. But in the end it was like a game of
musical chairs. Volume might go down but we were not going to be hurt.”
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 docu-
ments 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 resi-
dential mortgage–backed securities that would mostly be stamped with triple-A rat-
ings by the credit rating agencies, and sold to investors. In many cases, the securities
were repackaged again into collateralized debt obligations (CDOs)—often com-
posed 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 s 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 mar-
ket increased.
The instruments grew more and more complex; CDOs were constructed out of
CDOs, creating CDOs squared. When firms ran out of real product, they started gen-
erating cheaper-to-produce synthetic CDOs—composed not of real mortgage securi-
ties 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 in-
vestors—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, de-
scribed 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
 B E F O R E O U R V E RY E Y E S 

money every night to finance Bear Stearns’s broader securities portfolio. In Septem-
ber , Cioffi created a hedge fund within Bear Stearns with a minimum invest-
ment of  million. As was common, he used borrowed money—up to  borrowed
for every  from investors—to buy CDOs. Cioffi’s first fund was extremely success-
ful; it earned  for investors in  and  in —after the annual manage-
ment fee and the  slice of the profit for Cioffi and his Bear Stearns team—and
grew to almost  billion by the end of . In the fall of , he created another,
more aggressive fund. This one would shoot for leverage of up to  to . By the end
of , the two hedge funds had  billion invested, half in securities issued by
CDOs centered on housing. As a CDO manager, Cioffi also managed another  bil-
lion of mortgage-related CDOs for other investors.
Cioffi’s investors and others like them wanted high-yielding mortgage securities.
That, in turn, required high-yielding mortgages. An advertising barrage bombarded
potential borrowers, urging them to buy or refinance homes. Direct-mail solicita-
tions flooded people’s mailboxes. Dancing figures, depicting happy homeowners,
boogied on computer monitors. Telephones began ringing off the hook with calls
from loan officers offering the latest loan products: One percent loan! (But only for
the first year.) No money down! (Leaving no equity if home prices fell.) No income
documentation needed! (Mortgages soon dubbed “liar loans” by the industry itself.)
Borrowers answered the call, many believing that with ever-rising prices, housing
was the investment that couldn’t lose.
In Washington, four intermingled issues came into play that made it difficult to ac-
knowledge the looming threats. First, efforts to boost homeownership had broad po-
litical 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 . 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 sec-
tors of the economy was dreary. Third, many top officials and regulators were reluc-
tant to challenge the profitable and powerful financial industry. And finally, policy
makers believed that even if the housing market tanked, the broader financial system
and economy would hold up.
As the mortgage market began its transformation in the late s, consumer ad-
vocates 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 , each time highlighting to him the growth of predatory lending prac-
tices 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  to , home prices in Cleveland rose , climb-
ing from a median of , to ,, while home prices nationally rose about
 in those same years; at the same time, the city’s unemployment rate, ranging
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

from . in  to . in , 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 “flip-
ping on mega-steroids,” with rings of real estate agents, appraisers, and loan origina-
tors 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 , a year in  to , a year in . 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 th cen-
tury,” 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  under the Home Ownership and Equity Protection Act (HOEPA) to issue
new mortgage lending rules. In March , Fed Governor Edward Gramlich, an ad-
vocate 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.”
Looking back, Rokakis remarked to the Commission, “I naively believed they’d go
back and tell Mr. Greenspan and presto, we’d have some new rules. . . . I thought it
would result in action being taken. It was kind of quaint.”
In , 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 Na-
tional Community Reinvestment Coalition, with the support of community leaders
from Nevada, Michigan, Maryland, Delaware, Chicago, Vermont, North Carolina,
New Jersey, and Ohio, went to the Office of Thrift Supervision (OTS), which regu-
lated 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 Commis-
sion. The nonprofit group had reviewed the loans of  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.
 B E F O R E O U R V E RY E Y E S 

There were government reports, too. The Department of Housing and Urban De-
velopment and the Treasury Department issued a joint report on predatory lending
in June  that made a number of recommendations for reducing the risks to bor-
rowers. In December , 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 cov-
ered only  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 is-
sues.” In , Gramlich noted again the “increasing reports of abusive, unethical
and in some cases, illegal, lending practices.”
Bair told the Commission that this was when “really poorly underwritten loans,
the payment shock loans” were beginning to proliferate, placing “pressure” on tradi-
tional 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 nontradi-
tional loans surged and lending standards declined. The companies issuing these
loans made profits that attracted envious eyes. New lenders entered the field. In-
vestors clamored for mortgage-related securities and borrowers wanted mortgages.
The volume of subprime and nontraditional lending rose sharply. In , the top 
nonprime lenders originated  billion in loans. Their volume rose to  billion
in , and then  billion in .
California, with its high housing costs, was a particular hotbed for this kind of
lending. In , nearly  billion, or  of all nontraditional loans nationwide,
were made in that state; California’s share rose to  by , with these kinds of
loans growing to  billion or by  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 Cali-
fornia was paying over  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 di-
rectly to Greenspan at this time, describing to him in person what she called the
“metamorphosis” in the lending industry. She told him that besides predatory lend-
ing practices such as flipping loans or misinforming seniors about reverse mortgages,
she also witnessed examples of growing sloppiness in paperwork: not crediting pay-
ments 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

about First Alliance Mortgage Company, a California-based mortgage lender. Con-

sumers 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 , and borrowers received 
million. First Alliance went out of business. But other firms stepped into the void.
State officials from around the country joined together again in  to investi-
gate another fast-growing lender, California-based Ameriquest. It became the na-
tion’s largest subprime lender, originating  billion in subprime loans in
—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 multi-
state investigation of Ameriquest revealed that the company engaged in the kinds of
fraudulent practices that other predatory lenders subsequently emulated on a wide
scale: inflating home appraisals; increasing the interest rates on borrowers’ loans or
switching their loans from fixed to adjustable interest rates at closing; and promising
borrowers that they could refinance their costly loans into loans with better terms in
just a few months or a year, even when borrowers had no equity to absorb another
refinance.”
Ed Parker, the former head of Ameriquest’s Mortgage Fraud Investigations De-
partment, told the Commission that he detected fraud at the company within one
month of starting his job there in January , 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 , he was downgraded from
“manager” to “supervisor,” and was laid off in May .
In late , Prentiss Cox, then a Minnesota assistant attorney general, asked
Ameriquest to produce information about its loans. He received about  boxes of
documents. He pulled one file at random, and stared at it. He pulled out another
and another. He noted file after file where the borrowers were described as “an-
tiques 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 s
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 Com-
mission. As he tried to figure out why Ameriquest would make such obviously fraud-
ulent 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.”
Ultimately,  states and the District of Columbia joined in the lawsuit against
Ameriquest, on behalf of “more than , borrowers.” The result was a  mil-
lion settlement. But during the years when the investigation was under way, between
 and , Ameriquest originated another . 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
 B E F O R E O U R V E RY E Y E S 

wild, taking applications over the Internet, not verifying peoples’ income or their
ability to have a job,” recalled Alphonso Jackson, the HUD secretary from  to
, 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 gen-
eral, told the Commission that one of the single biggest obstacles to effective state
regulation of unfair lending came from the federal government, particularly the Of-
fice 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
, 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 con-
sumer practices of nationally regulated institutions.
Two former OCC comptrollers, John Hawke and John Dugan, told the Commis-
sion that they were defending the agency’s constitutional obligation to block state ef-
forts 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  of the  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 con-
sumers from the coming crisis.”
Many states nevertheless pushed ahead in enforcing their own lending regula-
tions, as did some cities. In , 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 an-
nouncement, and Wachovia sued Michigan. The OCC, the American Bankers Asso-
ciation, and the Mortgage Bankers Association entered the fray on Wachovia’s side;
the other  states, Puerto Rico, and the District of Columbia aligned themselves
with Michigan. The legal battle lasted four years. The Supreme Court ruled – in
Wachovia’s favor on April , , 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.”
Nonprime lending surged to  billion in  and then . trillion in ,
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 , new mortgage brokers
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

began their jobs during the boom, and some were less than honorable in their deal-
ings with borrowers. According to an investigative news report published in ,
between  and , at least , people with criminal records entered the
field in Florida, for example, including , who had previously been convicted of
such crimes as fraud, bank robbery, racketeering, and extortion. J. Thomas Card-
well, the commissioner of the Florida Office of Financial Regulation, told the Com-
mission that “lax lending standards” and a “lack of accountability . . . created a
condition in which fraud flourished.” Marc S. Savitt, a past president of the Na-
tional Association of Mortgage Brokers, told the Commission that while most mort-
gage brokers looked out for borrowers’ best interests and steered them away from
risky loans, about , of the newcomers to the field nationwide were willing to do
whatever it took to maximize the number of loans they made. He added that some
loan origination firms, such as Ameriquest, were “absolutely” corrupt.
In Bakersfield, California, where home starts doubled and home values grew
even faster between  and , the real estate appraiser Gary Crabtree initially
felt pride that his birthplace,  miles north of Los Angeles, “had finally been dis-
covered” 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  in Bakersfield in ,  in ,  in ,
and  more in .
Crabtree, an appraiser for  years, started in  and  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 , he ended up identifying what he be-
lieved were  fraudulent transactions in Bakersfield; some, for instance, were al-
lowing 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 ,, and was recorded as selling for , with  financing,
though the real estate agent told Crabtree that it actually sold for ,. Crabtree
realized that the gap between the sales price and loan amount allowed these insiders
to pocket ,. 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 ,.
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
 B E F O R E O U R V E RY E Y E S 

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 Bu-
reau of Investigation. “I was screaming at the top of my lungs,” he said. He grew infu-
riated 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 di-
rector, was also trying to get people to pay attention to mortgage fraud. “It has the po-
tential to be an epidemic,” he said at a news conference in Washington in . “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  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 Fi-
nancial Crimes Enforcement Network (FinCEN), a bureau within the Treasury De-
partment. In November , the network published an analysis that found a -fold
increase in mortgage fraud reports between  and . 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  as the savings and loan crisis was unfolding.
Former attorney general Alberto Gonzales, who served from February  to
, 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  and , 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 foreclo-
sure cases at the Empire Justice Center in Rochester, New York, told Fed Governors
Bernanke, Susan Bies, and Roger Ferguson in October  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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

quality of the firms’ due diligence; otherwise, she said, serious questions could arise
about whether they could be forced to buy back bad loans that they had made or
securitized.
Maker told the board that she feared an “enormous economic impact” could re-
sult from a confluence of financial events: flat or declining incomes, a housing bub-
ble, 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 mod-
els 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 ap-
peared 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 , , the Economist
magazine’s cover story posited that the day of reckoning was at hand, with the head-
line “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 in-
stitutions had the backing of the U.S. government, were growing so large, with so lit-
tle 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 in-
troduction of other relatively exotic forms of adjustable rate mortgages, are develop-
ments 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 be-
ginning to add to the pressures in the marketplace. . . .
Although we certainly cannot rule out home price declines, espe-
cially 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
 B E F O R E O U R V E RY E Y E S 

that financial intermediation would be impaired than was the case in

prior episodes of regional house price corrections.

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 ,
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 ex-
pected 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  that
 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 gover-
nors. “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 , the Yale professor Robert Shiller, who along with Karl
Case developed the Case-Shiller Index, charted home prices to illustrate how precip-
itously 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 syn-
drome. Rajan added that investment strategies such as credit default swaps could
have disastrous consequences if the system became unstable, and that regulatory in-
stitutions might be unable to deal with the fallout.
He recalled to the FCIC that he was treated with scorn. Lawrence Summers, a for-
mer U.S. treasury secretary who was then president of Harvard University, called Ra-
jan 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 later.
Susan M. Wachter, a professor of real estate and finance at the University of Penn-
sylvania’s Wharton School, prepared a research paper in  suggesting that the
United States could have a real estate crisis similar to that suffered in Asia in the
s. 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.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

In , news reports were beginning to highlight indications that the real estate
market was weakening. Home sales began to drop, and Fitch Ratings reported signs
that mortgage delinquencies were rising. That year, the hedge fund manager Mark
Klipsch of Orix Credit Corp. told participants at the American Securitization Forum,
a securities trade group, that investors had become “over optimistic” about the mar-
ket. “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
 to , a coalition of appraisal organizations circulated and ultimately deliv-
ered to Washington officials a public petition; signed by , appraisers and in-
cluding 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 vet-
eran, told the Commission that lenders had opened subsidiaries to perform ap-
praisals, allowing them to extract extra fees from “unknowing” consumers and
making it easier to inflate home values. The steep hike in home prices and the un-
merited and inflated appraisals she was seeing in Northern California convinced her
that the housing industry was headed for a cataclysmic downturn. In , 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 go-
ing and going—ordering up loans, packaging them into securities, taking profits,
earning bonuses. By the third quarter of , home prices were falling and mortgage
delinquencies were rising, a combination that spelled trouble for mortgage-backed
securities. But from the third quarter of  on, banks created and sold some .
trillion in mortgage-backed securities and more than  billion in mortgage-
related CDOs.
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  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. An-
toncic, who was the firm’s chief risk officer from  to , was shunted aside: “At
the senior level, they were trying to push so hard that the wheels started to come off,”
she told the Commission. She was reassigned to a policy position working with gov-
 B E F O R E O U R V E RY E Y E S 

ernment regulators. Gelband left; Lehman officials blamed Gelband’s departure on

“philosophical differences.”
At Citigroup, meanwhile, Richard Bowen, a veteran banker in the consumer lend-
ing group, received a promotion in early  when he was named business chief
underwriter. He would go on to oversee loan quality for over  billion a year of
mortgages underwritten and purchased by CitiFinancial. These mortgages were sold
to Fannie Mae, Freddie Mac, and others. In June , Bowen discovered that as
much as  of the loans that Citi was buying were defective. They did not meet Citi-
group’s loan guidelines and thus endangered the company—if the borrowers were to
default on their loans, the investors could force Citi to buy them back. Bowen told the
Commission that he tried to alert top managers at the firm by “email, weekly reports,
committee presentations, and discussions”; but though they expressed concern, it
“never translated into any action.” Instead, he said, “there was a considerable push to
build volumes, to increase market share.” Indeed, Bowen recalled, Citi began to
loosen its own standards during these years up to : specifically, it started to pur-
chase stated-income loans. “So we joined the other lemmings headed for the cliff,” he
said in an interview with the FCIC.
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 IMMEDI-
ATELY” 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  that Citibank han-
dled 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 un-
derwriting reviews was revised.
Bowen told the Commission that after he alerted management by sending emails,
he went from supervising  people to supervising only , 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 se-
curitization 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.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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.”
Similarly, Lewis Ranieri, a mortgage finance veteran who helped engineer the Wall
Street mortgage securitization machine in the s, said he didn’t like what he called
“the madness” that had descended on the real estate market. Ranieri told the Commis-
sion, “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 .
Other industry veterans inside the business also acknowledged that the rules of
the game were being changed. “Poison” was the word famously used by Country-
wide’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 in-
ternal email. Others at the bank argued in response that they were offering prod-
ucts “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 , regulators decided to take a look at the changing mortgage market.
Sabeth Siddique, the assistant director for credit risk in the Division of Banking Su-
pervision and Regulation at the Federal Reserve Board, was charged with investigat-
ing how broadly loan patterns were changing. He took the questions directly to large
banks in  and asked them how many of which kinds of loans they were making.
Siddique found the information he received “very alarming,” he told the Commis-
sion. In fact, nontraditional loans made up  percent of originations at Coun-
trywide,  percent at Wells Fargo,  at National City,  at Washington
Mutual, . at CitiFinancial, and . at Bank of America. Moreover, the banks
expected that their originations of nontraditional loans would rise by  in , to
. 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 non-
traditional loans made by the banks in  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 re-
called the response by the Fed governors and regional board directors as divided
from the beginning. “Some people on the board and regional presidents . . . just
wanted to come to a different answer. So they did ignore it, or the full thrust of it,” she
told the Commission.
 B E F O R E O U R V E RY E Y E S 

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 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 avail-
able 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 Con-
gress pushed back. Some of our internal people at the Fed pushed back.”
The Mortgage Insurance Companies of America, which represents mortgage in-
surance 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 . “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 conserva-
tive 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 per-
spective. We were there when the mortgage markets turned sharply down during the
mid-s especially in the oil patch and the early s 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 , 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 Hous-
ing 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 impli-
cations on our total economy as well.”
At the next meeting of the Fed’s Consumer Advisory Council, held in June 
and attended by Bernanke, Bies, Olson, and Warsh, several consumer advocates de-
scribed to the Fed governors alarming incidents that were now occurring all over the
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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.”
The balance was tipping. According to Siddique, before Greenspan left his post as
Fed chairman in January , he had indicated his willingness to accept the guid-
ance. 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 began discussing the guidance, and after the
housing market had peaked, it was issued in September  as an interagency warn-
ing that affected banks, thrifts, and credit unions nationwide. Dozens of states fol-
lowed, directing their versions of the guidance to tens of thousands of state-chartered
lenders and mortgage brokers.
Then, in July , long after the risky, nontraditional mortgage market had dis-
appeared 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 require-
ment 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  and  reached . 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 under-
stand how dangerously exposed major firms and markets had become to the poten-
tial 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 , most of the subprime lenders had failed or been acquired, in-
cluding New Century Financial, Ameriquest, and American Home Mortgage. In Jan-
uary , 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.
 B E F O R E O U R V E RY E Y E S 

Before the summer was over, Fannie Mae and Freddie Mac would be put into conser-
vatorship. Then, in September, Lehman Brothers failed and the remaining invest-
ment 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. In-
dyMac had already failed over the summer; in September, Washington Mutual be-
came 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 na-
tion’s largest financial institutions.
The crisis that befell the country in  had been years in the making. In testi-
mony to the Commission, former Fed chairman Greenspan defended his record and
said most of his judgments had been correct. “I was right  of the time but I was
wrong  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 devasta-
tion is continuing. The officially reported unemployment rate hovered at almost 
in November , 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 . And the share of unemployed workers who have been out
of work for more than six months was just above . Of large metropolitan areas,
Las Vegas, Nevada, and Riverside–San Bernardino, California, had the highest un-
employment—their rates were above .
The loans were as lethal as many had predicted, and it has been estimated that ul-
timately as many as  million households in the United States may lose their homes
to foreclosure. As of , foreclosure rates were highest in Florida and Nevada; in
Florida, nearly  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 .
Households have lost  trillion in wealth since .
As Mark Zandi, the chief economist of Moody’s Economy.com, testified to the
Commission, “The financial crisis has dealt a very serious blow to the U.S. economy.
The immediate impact was the Great Recession: the longest, broadest and most se-
vere downturn since the Great Depression of the s. . . . 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

think are going to be able to pay that off—than was true , ,  years ago? I mean,
what’s changed in the world? There were a lot of things that didn’t require any inves-
tigation 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 No-
vember , 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.
 PART II

Setting the Stage

 2
SHADOW BANKING

CONTENTS

Commercial paper and repos: “Unfettered markets”............................................

The savings and loan crisis: “They put a lot of
pressure on their regulators” ............................................................................

The financial crisis of  and  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 dis-
missed. 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, in-
vestors panicked—and the danger inherent in the whole system became manifest. Fi-
nancial 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-re-
sponse 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 finan-
cial system over recent decades. It is a fascinating story with profound conse-
quences—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 essen-
tials 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  and the Great Depression.


 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 tra-
ditional mold and join the feverish growth. As a result, two parallel financial sys-
tems 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 (k)s. Shadow banks and commer-
cial banks were codependent competitors. Their new activities were very prof-
itable—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 par-
ticipants appeared to provide a safer and more dynamic alternative to the era of tradi-
tional 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 dis-
place many 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 de-
spite 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 as-
sume 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 -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 corpora-
tions 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: securitiza-
tion, structured finance, and derivatives—words that entered the national vocabu-
lary as the financial markets unraveled through  and . 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 de-
pended 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  years earlier, were the first dominoes to fall in the finan-
cial sector.
 SHA D OW BA N K I NG 

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 , at
the dawn of a decade of promise and peril.

COMMERCIAL PAPER AND REPOS:

“UNFETTERED MARKETS”
For most of the th 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 be-
fore the Civil War and then occurred in , , , , , and . To
stabilize financial markets, Congress created the Federal Reserve System in ,
which acted as the lender of last resort to banks.
But the creation of the Fed was not enough to avert bank runs and sharp contrac-
tions in the financial markets in the s and s. So in  Congress passed the
Glass-Steagall Act, which, among other changes, established the Federal Deposit In-
surance Corporation. The FDIC insured bank deposits up to ,—an amount that
covered the vast majority of deposits at the time; that limit would climb to , by
, where it stayed until it was raised to , during the crisis in October .
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 Re-
serve, even when they could borrow nowhere else. The Fed, acting as lender of last re-
sort, 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 fail-
ures, 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 in-
stitutions 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-s,
however, inflation started to increase, pushing up interest rates. For example, the
rates that banks paid other banks for overnight loans had rarely exceeded  in the
decades before , when it reached . However, thanks to Regulation Q, banks
and thrifts were stuck offering roughly less than  on most deposits. Clearly, this
was an untenable bind for the depository institutions, which could not compete on
the most basic level of the interest rate offered on a deposit.
Compete with whom? In the s, 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 Ex-
change Commission (SEC) abolished fixed commissions on stock trades in —
created money market mutual funds that invested these depositors’ money in
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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: cus-
tomers bought shares redeemable daily at a stable value. In , Merrill Lynch in-
troduced something even more like a bank account: “cash management accounts”
allowed customers to write checks. Other money market mutual funds quickly
followed.
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  net asset value of a share. The
funds would not “break the buck,” in Wall Street terms. Even without FDIC insur-
ance, then, depositors considered these funds almost as safe as deposits in a bank or
thrift. Business boomed, and so was born a key player in the shadow banking indus-
try, the less-regulated market for capital that was growing up beside the traditional
banking system. Assets in money market mutual funds jumped from  billion in
 to more than  billion in  and . trillion by .
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 ap-
petite for two booming markets: the “commercial paper” and “repo” markets.
Through these instruments, Merrill Lynch, Morgan Stanley, and other Wall Street in-
vestment banks could broker and provide (for a fee) short-term financing to large
corporations. Commercial paper was unsecured corporate debt—meaning that it was
backed not by a pledge of collateral but only by the corporation’s promise to pay.
These loans were cheaper because they were short-term—for less than nine months,
sometimes as short as two weeks and, eventually, as short as one day; the borrowers
usually “rolled them over” when the loan came due, and then again and again. Be-
cause only financially stable corporations were able to issue commercial paper, it was
considered a very safe investment; companies such as General Electric and IBM, in-
vestors 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 s.
This market, though, underwent a crisis that demonstrated that capital markets,
too, were vulnerable to runs. Yet that crisis actually strengthened the market. In ,
the Penn Central Transportation Company, the sixth-largest nonfinancial corpora-
tion in the U.S., filed for bankruptcy with  million in commercial paper out-
standing. 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  million in emergency loans and with interest rate cuts. The Fed’s ac-
tions 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 pa-
per—the borrowers—typically set up standby lines of credit with major banks to en-
 SHA D OW BA N K I NG 

able them to pay off their debts should there be another shock. These moves reas-
sured investors that commercial paper was a safe investment.
In the s, the commercial paper market jumped more than sevenfold. Then in
the s, 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 , commercial
paper had risen to . trillion from less than  billion in .
The second major shadow banking market that grew significantly was the market
for repos, or repurchase agreements. Like commercial paper, repos have a long his-
tory, but they proliferated quickly in the s. 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 transac-
tion—in essence a loan—made it inexpensive and convenient for Wall Street firms to
borrow. Because these deals were essentially collateralized loans, the securities deal-
ers borrowed nearly the full value of the collateral, minus a small “haircut.” Like com-
mercial 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 , 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 -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, es-
sentially protecting the collateral and the funds by putting them in escrow. This
mechanism would have severe consequences in  and . In the s, how-
ever, 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  to
, “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.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Traditional and Shadow Banking Systems

The funding available through the shadow banking system grew sharply in the
2000s, exceeding the traditional banking system in the years before the crisis.
IN TRILLIONS OF DOLLARS
$15
$13.0
Traditional
12 Banking

9
$8.5
Shadow
6 Banking

0
1980 1985 1990 1995 2000 2005 2010

NOTE: Shadow banking funding includes commercial paper and other short-term borrowing (bankers
acceptances), repo, net securities loaned, liabilities of asset-backed securities issuers, and money market mutual
fund assets.
SOURCE: Federal Reserve Flow of Funds Report

Figure .

Figure . shows that during the s the shadow banking system steadily
gained ground on the traditional banking sector—and actually surpassed the bank-
ing sector for a brief time after .
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 s, when banks sold highly speculative securities
to depositors. In , Congress also imposed new regulatory requirements on banks
owned by holding companies, in order to prevent a holding company from endan-
gering any of its deposit-taking banks.
Bank supervisors monitored banks’ leverage—their assets relative to equity—
because excessive leverage endangered a bank. Leverage, used by nearly every finan-
cial institution, amplifies returns. For example, if an investor uses  of his own
money to purchase a security that increases in value by , he earns . However,
if he borrows another  and invests  times as much (,), the same  in-
crease in value yields a profit of , double his out-of-pocket investment. If the
investment sours, though, leverage magnifies the loss just as much. A decline of 
costs the unleveraged investor , leaving him with , but wipes out the leveraged
investor’s . An investor buying assets worth  times his capital has a leverage
 SHA D OW BA N K I NG 

ratio of :, with the numbers representing the total money invested compared to
the money the investor has committed to the deal.
In , bank supervisors established the first formal minimum capital standards,
which mandated that capital—the amount by which assets exceed debt and other lia-
bilities—should be at least  of assets for most banks. Capital, in general, reflects
the value of shareholders’ investment in the bank, which bears the first risk of any po-
tential 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 invest-
ment 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 fed-
erally 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 , 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 re-
strictions 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 im-
pose 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 invest-
ment 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 chair-
man 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 reassur-
ances, 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 disadvan-
tage and in danger of losing their dominant position. Their bind was labeled “disin-
termediation,” and many critics of the financial regulatory system concluded that
policy makers, all the way back to the Depression, had trapped depository institu-
tions in this unprofitable straitjacket not only by capping the interest rates they could
pay depositors and imposing capital requirements but also by preventing the institu-
tions from competing against the investment banks (and their money market mutual
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 ar-
gue that unfettered markets create a degree of wealth that fosters a more civilized ex-
istence. I have always found that insight compelling.”

THE SAVINGS AND LOAN CRISIS:

“THEY PUT A LOT OF PRESSURE ON THEIR REGULATORS”
Traditional financial institutions continued to chafe against the regulations still in
place. The playing field wasn’t level, which “put a lot of pressure on institutions to get
higher-rate performing assets,” former SEC Chairman Richard Breeden told the
FCIC. “And they put a lot of pressure on their regulators to allow this to happen.”
The banks and the S&Ls went to Congress for help. In , the Depository Insti-
tutions Deregulation and Monetary Control Act repealed the limits on the interest
rates that depository institutions could offer on their deposits. Although this law re-
moved a significant regulatory constraint on banks and thrifts, it could not restore
their competitive advantage. Depositors wanted a higher rate of return, which banks
and thrifts were now free to pay. But the interest banks and thrifts could earn off of
mortgages and other long-term loans was largely fixed and could not match their
new costs. While their deposit base increased, they now faced an interest rate
squeeze. In , the difference in interest earned on the banks’ and thrifts’ safest in-
vestments (one-year Treasury notes) over interest paid on deposits was almost .
percentage points; by , it was only . percentage points. The institutions lost al-
most  percentage points of the advantage they had enjoyed when the rates were
capped. The  legislation had not done enough to reduce the competitive pres-
sures facing the banks and thrifts.
That legislation was followed in  by the Garn-St. Germain Act, which signifi-
cantly 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 -year, fixed-rate mortgages. But the interest on fixed-rate mortgages
on their books fell short as inflation surged in the mid-s and early s 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, bal-
loon-payment, and adjustable-rate mortgages (ARMs), even in states where state
laws forbade these loans. For consumers, interest-only and balloon mortgages made
homeownership more affordable, but only in the short term. Borrowers with ARMs
enjoyed lower mortgage rates when interest rates decreased, but their rates would
rise when interest rates rose. For banks and thrifts, ARMs offered an interest rate
that floated in relationship to the rates they were paying to attract money from de-
positors. The floating mortgage rate protected banks and S&Ls from the interest rate
 SHA D OW BA N K I NG 

squeeze caused by inflation, but it effectively transferred the risk of rising interest
rates to borrowers.
Then, beginning in , the Federal Reserve accommodated a series of requests
from the banks to undertake activities forbidden under Glass-Steagall and its modifi-
cations. The new rules permitted nonbank subsidiaries of bank holding companies to
engage in “bank-ineligible” activities, including selling or holding certain kinds of se-
curities 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  of the assets or revenue of any subsidiary. Over time, however, the Fed re-
laxed these restrictions. By , bank-ineligible securities could represent up to 
of assets or revenues of a securities subsidiary, and the Fed also weakened or elimi-
nated other firewalls between traditional banking subsidiaries and the new securities
subsidiaries of bank holding companies.
Meanwhile, the OCC, the regulator of banks with national charters, was expand-
ing the permissible activities of national banks to include those that were “function-
ally 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  and , the OCC broad-
ened the derivatives in which banks might deal to include those related to debt secu-
rities (), interest and currency exchange rates (), stock indices (),
precious metals such as gold and silver (), and equity stocks ().
Fed Chairman Greenspan and many other regulators and legislators supported
and encouraged this shift toward deregulated financial markets. They argued that fi-
nancial institutions had strong incentives to protect their shareholders and would
therefore regulate themselves through improved risk management. Likewise, finan-
cial markets would exert strong and effective discipline through analysts, credit rat-
ing agencies, and investors. Greenspan argued that the urgent question about
government regulation was whether it strengthened or weakened private regulation.
Testifying before Congress in , he framed the issue this way: financial “modern-
ization” was needed to “remove outdated restrictions that serve no useful purpose,
that decrease economic efficiency, and that . . . limit choices and options for the con-
sumer of financial services.” Removing the barriers “would permit banking organiza-
tions 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 s and early s, banks and thrifts expanded into higher-risk
loans with higher interest payments. They made loans to oil and gas producers, fi-
nanced 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 Amer-
ica. Those markets offered potentially higher profits, but were much riskier than the
banks’ traditional lending. The consequences appeared almost immediately—espe-
cially in the real estate markets, with a bubble and massive overbuilding in residential
and commercial sectors in certain regions. For example, house prices rose  per
year in Texas from  to . In California, prices rose  annually from 
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

to . The bubble burst first in Texas in  and , but the trouble rapidly
spread across the Southeast to the mid-Atlantic states and New England, then swept
back across the country to California and Arizona. Before the crisis ended, house
prices had declined nationally by . from July  to February —the first
such fall since the Depression—driven by steep drops in regional markets. In the
s, 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 indus-
try was shattered.
Almost , commercial banks and thrifts failed in what became known as the
S&L crisis of the s and early s. By comparison, only  banks had failed
between  and . By , one-sixth of federally insured depository institu-
tions had either closed or required financial assistance, affecting  of the banking
system’s assets. More than , bank and S&L executives were convicted of
felonies. By the time the government cleanup was complete, the ultimate cost of the
crisis was  billion.
Despite new laws passed by Congress in  and  in response to the S&L
crisis that toughened supervision of thrifts, the impulse toward deregulation contin-
ued. The deregulatory movement focused in part on continuing to dismantle regula-
tions that limited depository institutions’ activities in the capital markets. In ,
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 finan-
cial system that will provide important benefits to the consumer and important pro-
tections to the taxpayer.”
The biggest banks pushed Congress to adopt Treasury’s recommendations. Op-
posed were insurance agents, real estate brokers, and smaller banks, who felt threat-
ened by the possibility that the largest banks and their huge pools of deposits would
be unleashed to compete without restraint. The House of Representatives rejected
Treasury’s proposal in , but similar proposals were adopted by Congress later in
the s.
In dealing with the banking and thrift crisis of the s and early s, Con-
gress was greatly concerned by a spate of high-profile bank bailouts. In , federal
regulators rescued Continental Illinois, the nation’s th-largest bank; in , First
Republic, number ; in , MCorp, number ; in , Bank of New England,
number . These banks had relied heavily on uninsured short-term financing to ag-
gressively expand into high-risk lending, leaving them vulnerable to abrupt with-
drawals once confidence in their solvency evaporated. Deposits covered by the FDIC
were protected from loss, but regulators felt obliged to protect the uninsured deposi-
tors—those whose balances exceeded the statutorily protected limits—to prevent po-
 SHA D OW BA N K I NG 

tential runs on even larger banks that reportedly may have lacked sufficient assets to
satisfy their obligations, such as First Chicago, Bank of America, and Manufacturers
Hanover.
During a hearing on the rescue of Continental Illinois, Comptroller of the Cur-
rency C. Todd Conover stated that federal regulators would not allow the  largest
“money center banks” to fail. This was a new regulatory principle, and within mo-
ments it had a catchy name. Representative Stewart McKinney of Connecticut re-
sponded, “We have a new kind of bank. It is called ‘too big to fail’—TBTF—and it is a
wonderful bank.”
In , during this era of federal rescues of large commercial banks, Drexel
Burnham Lambert—once the country’s fifth-largest investment bank—failed. Crip-
pled 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 , 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 ad-
dressed a concern raised by some Wall Street investment banks, Goldman Sachs in
particular: the reluctance of commercial banks to help securities firms during previ-
ous 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 in-
vestment banks by extending loans collateralized by the investment banks’
securities.
In the end, the  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, 
years later.
 3
SECURITIZATION AND DERIVATIVES

CONTENTS
Fannie Mae and Freddie Mac: “The whole army of lobbyists”.............................
Structured finance: “It wasn’t reducing the risk”...................................................
The growth of derivatives: “By far the most significant event
in finance during the past decade” ...................................................................

FANNIE MAE AND FREDDIE MAC:

“THE WHOLE ARMY OF LOBBYISTS”
The crisis in the thrift industry created an opening for Fannie Mae and Freddie Mac,
the two massive government-sponsored enterprises (GSEs) created by Congress to
support the mortgage market.
Fannie Mae (officially, the Federal National Mortgage Association) was chartered
by the Reconstruction Finance Corporation during the Great Depression in  to
buy mortgages insured by the Federal Housing Administration (FHA). The new gov-
ernment agency was authorized to purchase mortgages that adhered to the FHA’s un-
derwriting standards, thereby virtually guaranteeing the supply of mortgage credit
that banks and thrifts could extend to homebuyers. Fannie Mae either held the mort-
gages in its portfolio or, less often, resold them to thrifts, insurance companies, or
other investors. After World War II, Fannie Mae got authority to buy home loans
guaranteed by the Veterans Administration (VA) as well.
This system worked well, but it had a weakness: Fannie Mae bought mortgages by
borrowing. By , Fannie’s mortgage portfolio had grown to . billion and its
debt weighed on the federal government. To get Fannie’s debt off of the government’s
balance sheet, the Johnson administration and Congress reorganized it as a publicly
traded corporation and created a new government entity, Ginnie Mae (officially, the
Government National Mortgage Association) to take over Fannie’s subsidized mort-
gage programs and loan portfolio. Ginnie also began guaranteeing pools of FHA and
VA mortgages. The new Fannie still purchased federally insured mortgages, but it
was now a hybrid, a “government-sponsored enterprise.”
Two years later, in , the thrifts persuaded Congress to charter a second GSE,
Freddie Mac (officially, the Federal Home Loan Mortgage Corporation), to help the


 S E C U R I T I Z AT I O N AND D E R I VAT I V E S 

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 borrow-
ers could get them more quickly and with lower fees. Still, the conventional mort-
gages did have to conform to the GSEs’ loan size limits and underwriting guidelines,
such as debt-to-income and loan-to-value ratios. The GSEs purchased only these
“conforming” mortgages.
Before , 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  and  laws gave Ginnie, Fannie, and Freddie another
option: securitization. Ginnie was the first to securitize mortgages, in . A lender
would assemble a pool of mortgages and issue securities backed by the mortgage
pool. Those securities would be sold to investors, with Ginnie guaranteeing timely
payment of principal and interest. Ginnie charged a fee to issuers for this guarantee.
In , Freddie got into the business of buying mortgages, pooling them, and then
selling mortgage-backed securities. Freddie collected fees from lenders for guaran-
teeing timely payment of principal and interest. In , after a spike in interest rates
caused large losses on Fannie’s portfolio of mortgages, Fannie followed. During the
s and s, the conventional mortgage market expanded, the GSEs grew in im-
portance, and the market share of the FHA and VA declined.
Fannie and Freddie had dual missions, both public and private: support the mort-
gage market and maximize returns for shareholders. They did not originate mort-
gages; 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 . billion line of credit each from the Treasury. The Federal Reserve
provided services such as electronically clearing payments for GSE debt and securi-
ties as if they were Treasury bonds. So Fannie and Freddie could borrow at rates al-
most 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 re-
quired to hold very little capital to protect against losses: only . to back their
guarantees of mortgage-backed securities and . to back the mortgages in their
portfolios. This compared to bank and thrift capital requirements of at least  of
mortgages assets under capital standards. Such privileges led investors and creditors
to believe that the government implicitly guaranteed the GSEs’ mortgage-backed se-
curities 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

bought its mortgage portfolio by borrowing short- and medium-term. In ,

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 s, the Department of Housing and Urban Development (HUD) estimated
Fannie had a negative net worth of  billion. Freddie emerged unscathed be-
cause unlike Fannie then, its primary business was guaranteeing mortgage-backed
securities, not holding mortgages in its portfolio. In guaranteeing mortgage-
backed securities, Freddie Mac avoided taking the interest rate risk that hit Fannie’s
portfolio.
In , Congress provided tax relief and HUD relaxed Fannie’s capital require-
ments to help the company avert failure. These efforts were consistent with lawmak-
ers’ repeated proclamations that a vibrant market for home mortgages served the
best interests of the country, but the moves also reinforced the impression that the
government would never abandon Fannie and Freddie. Fannie and Freddie would
soon buy and either hold or securitize mortgages worth hundreds of billions, then
trillions, of dollars. Among the investors were U.S. banks, thrifts, investment funds,
and pension funds, as well as central banks and investment funds around the world.
Fannie and Freddie had become too big to fail.
While the government continued to favor Fannie and Freddie, they toughened
regulation of the thrifts following the savings and loan crisis. Thrifts had previously
dominated the mortgage business as large holders of mortgages. In the Financial In-
stitutions Reform, Recovery, and Enforcement Act of  (FIRREA), Congress
imposed tougher, bank-style capital requirements and regulations on thrifts. By con-
trast, in the Federal Housing Enterprises Financial Safety and Soundness Act of ,
Congress created a supervisor for the GSEs, the Office of Federal Housing Enterprise
Oversight (OFHEO), without legal powers comparable to those of bank and thrift
supervisors in enforcement, capital requirements, funding, and receivership. Crack-
ing down on thrifts while not on the GSEs was no accident. The GSEs had shown
their immense political power during the drafting of the  law. “OFHEO was
structurally weak and almost designed to fail,” said Armando Falcon Jr., a former di-
rector of the agency, to the FCIC.
All this added up to a generous federal subsidy. One  study put the value of
that subsidy at  billion or more and estimated that more than half of these bene-
fits 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 mort-
gage-backed securities grew from  billion in  to . trillion in  and
. trillion in .
The legislation that transformed Fannie in  also authorized HUD to prescribe
affordable housing goals for Fannie: to “require that a reasonable portion of the cor-
poration’s mortgage purchases be related to the national goal of providing adequate
 S E C U R I T I Z AT I O N AND D E R I VAT I V E S 

housing for low and moderate income families, but with reasonable economic return
to the corporation.” In , 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  Federal Housing Enterprises
Financial Safety and Soundness Act, Congress extended HUD’s authority to set af-
fordable housing goals for Fannie and Freddie. Congress also changed the language to
say that in the pursuit of affordable housing, “a reasonable economic return . . . may
be less than the return earned on other activities.” The law required HUD to consider
“the need to maintain the sound financial condition of the enterprises.” The act now
ordered HUD to set goals for Fannie and Freddie to buy loans for low- and moderate-
income housing, special affordable housing, and housing in central cities, rural areas,
and other underserved areas. Congress instructed HUD to periodically set a goal for
each category as a percentage of the GSEs’ mortgage purchases.
In , President Bill Clinton announced an initiative to boost homeownership
from . to . of families by , and one component raised the affordable
housing goals at the GSEs. Between  and , almost . million households
entered the ranks of homeowners, nearly twice as many as in the previous two years.
“But we have to do a lot better,” Clinton said. “This is the new way home for the
American middle class. We have got to raise incomes in this country. We have got to
increase security for people who are doing the right thing, and we have got to make
people believe that they can have some permanence and stability in their lives even as
they deal with all the changing forces that are out there in this global economy.” The
push to expand homeownership continued under President George W. Bush, who,
for example, introduced a “Zero Down Payment Initiative” that under certain cir-
cumstances could remove the  down payment rule for first-time home buyers with
FHA-insured mortgages.
In describing the GSEs’ affordable housing loans, Andrew Cuomo, secretary of
Housing and Urban Development from  to  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, preda-
tory loans at all.”
Fannie and Freddie were now crucial to the housing market, but their dual mis-
sions—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  to , the two reported spending more than  million on lob-
bying, and their employees and political action committees contributed  million
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

to federal election campaigns. The “Fannie and Freddie political machine resisted
any meaningful regulation using highly improper tactics,” Falcon, who regulated
them from  to , 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  through
, 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 secre-
tary Mel Martinez described to the FCIC “the whole army of lobbyists that continu-
ally paraded in a bipartisan fashion through my offices. . . . It’s pretty amazing the
number of people that were in their employ.”
In , that army helped secure new regulations allowing the GSEs to count to-
ward their affordable housing goals not just their whole loans but mortgage-related
securities issued by other companies, which the GSEs wanted to purchase as invest-
ments. Still, Congressional Budget Office Director June O’Neill declared in  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 Hous-
ing Administration devote a larger proportion of their mortgage lending to targeted
borrowers and areas than do the enterprises.”
Something else was clear: Fannie and Freddie, with their low borrowing costs and
lax capital requirements, were immensely profitable throughout the s. In ,
Fannie had a return on equity of ; Freddie, . That year, Fannie and Freddie
held or guaranteed more than  trillion of mortgages, backed by only . billion
of shareholder equity.

STRUCTURED FINANCE:
“IT WASN’ T REDUCING THE RISK”
While Fannie and Freddie enjoyed a near-monopoly on securitizing fixed-rate mort-
gages that were within their permitted loan limits, in the s 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 se-
curities and sold them to investors, who received investment returns funded by the
principal and interest payments from the loans. Investors held or traded these securi-
ties, which were often more complicated than the GSEs’ basic mortgage-backed secu-
rities; 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 mar-
kets—often from money market mutual funds—to make loans, packaging them into
securities to sell to investors.
 S E C U R I T I Z AT I O N AND D E R I VAT I V E S 

For commercial banks, the benefits were large. By moving loans off their books,
the banks reduced the amount of capital they were required to hold as protection
against losses, thereby improving their earnings. Securitization also let banks rely
less on deposits for funding, because selling securities generated cash that could be
used to make loans. Banks could also keep parts of the securities on their books as
collateral for borrowing, and fees from securitization became an important source of
revenues.
Lawrence Lindsey, a former Federal Reserve governor and the director of the Na-
tional Economic Council under President George W. Bush, told the FCIC that previ-
ous housing downturns made regulators worry about banks’ holding whole loans on
their books. “If you had a regional . . . real estate downturn it took down the banks in
that region along with it, which exacerbated the downturn,” Lindsey said. “So we said
to ourselves, ‘How on earth do we get around this problem?’ And the answer was,
‘Let’s have a national securities market so we don’t have regional concentration.’ . . . It
was intentional.”
Private securitizations, or structured finance securities, had two key benefits to in-
vestors: pooling and tranching. If many loans were pooled into one security, a few de-
faults would have minimal impact. Structured finance securities could also be sliced
up and sold in portions—known as tranches—which let buyers customize their pay-
ments. Risk-averse investors would buy tranches that paid off first in the event of de-
fault, but had lower yields. Return-oriented investors bought riskier tranches with
higher yields. Bankers often compared it to a waterfall; the holders of the senior
tranches—at the top of the waterfall—were paid before the more junior tranches.
And if payments came in below expectations, those at the bottom would be the first
to be left high and dry.
Securitization was designed to benefit lenders, investment bankers, and investors.
Lenders earned fees for originating and selling loans. Investment banks earned fees
for issuing mortgage-backed securities. These securities fetched a higher price than if
the underlying loans were sold individually, because the securities were customized
to investors’ needs, were more diversified, and could be easily traded. Purchasers of
the safer tranches got a higher rate of return than ultra-safe Treasury notes without
much extra risk—at least in theory. However, the financial engineering behind these
investments made them harder to understand and to price than individual loans. To
determine likely returns, investors had to calculate the statistical probabilities that
certain kinds of mortgages might default, and to estimate the revenues that would be
lost because of those defaults. Then investors had to determine the effect of the losses
on the payments to different tranches.
This complexity transformed the three leading credit rating agencies—Moody’s,
Standard & Poor’s (S&P), and Fitch—into key players in the process, positioned be-
tween the issuers and the investors of securities. Before securitization became com-
mon, the credit rating agencies had mainly helped investors evaluate the safety of
municipal and corporate bonds and commercial paper. Although evaluating proba-
bilities was their stock-in-trade, they found that rating these securities required a
new type of analysis.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Participants in the securitization industry realized that they needed to secure favor-
able credit ratings in order to sell structured products to investors. Investment banks
therefore paid handsome fees to the rating agencies to obtain the desired ratings. “The
rating agencies were important tools to do that because you know the people that we
were selling these bonds to had never really had any history in the mortgage busi-
ness. . . . They were looking for an independent party to develop an opinion,” Jim Calla-
han told the FCIC; Callahan is CEO of PentAlpha, which services the securitization
industry, and years ago he worked on some of the earliest securitizations.
With these pieces in place—banks that wanted to shed assets and transfer risk, in-
vestors 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 , when the market was  years old,
about  billion worth of securitizations, beyond those done by Fannie, Freddie,
and Ginnie, were outstanding (see figure .). That included  billion of automo-
bile loans and over  billion of credit card debt; nearly  billion worth of secu-
rities 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 Broth-
ers and Morgan Stanley became major players in these complex markets and relied
increasingly on quantitative analysts, called “quants.” As early as the s, 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, au-
thor 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,” Pat-
terson said.
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  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 ad-
dressed 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  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  to , told the Commission that regula-
tors were concerned as early as the late s that once banks began selling instead of
holding the loans they were making, they would care less about loan quality. Yet as
 S E C U R I T I Z AT I O N AND D E R I VAT I V E S 

Asset-Backed Securities Outstanding

In the 1990s, many kinds of loans were packaged into asset-backed securities.
IN BILLIONS OF DOLLARS
$1,000

Other
800
Student
loans
600
Manufactured
housing
400 Home equity
Equipment and other
residential
200
Credit card

Automobile
0
’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99

NOTE: Residential loans do not include loans securitized by government-sponsored enterprises.

SOURCE: Securities Industry and Financial Markets Association

Figure .

these instruments became increasingly complex, regulators increasingly relied on the

banks to police their own risks. “It was all tied up in the hubris of financial engineers,
but the greater hubris let markets take care of themselves,” Volcker said. Vincent
Reinhart, a former director of the Fed’s Division of Monetary Affairs, told the Com-
mission that he and other regulators failed to appreciate the complexity of the new fi-
nancial instruments and the difficulties that complexity posed in assessing risk.
Securitization “was diversifying the risk,” said Lindsey, the former Fed governor.
“But it wasn’t reducing the risk. . . . You as an individual can diversify your risk. The sys-
tem as a whole, though, cannot reduce the risk. And that’s where the confusion lies.”

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,
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 com-
mon are over-the-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 move-
ments. Losses suffered because of price movements can be recouped through gains
on the derivatives contract. Institutional investors that are risk-averse sometimes use
interest rate swaps to reduce the risk to their investment portfolios of inflation and
rising interest rates by trading fixed interest payments for floating payments with
risk-taking entities, such as hedge funds. Hedge funds may use these swaps for the
purpose of speculating, in hopes of profiting on the rise or fall of a price or interest
rate.
The derivatives markets are organized as exchanges or as over-the-counter (OTC)
markets, although some recent electronic trading facilities blur the distinctions. The
oldest U.S. exchange is the Chicago Board of Trade, where futures and options are
traded. Such exchanges are regulated by federal law and play a useful role in price
discovery—that is, in revealing the market’s view on prices of commodities or rates
underlying futures and options. OTC derivatives are traded by large financial institu-
tions—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—trad-
ing 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 , which originally applied only to derivatives on domestic agricultural
products. In , Congress amended the act to require that futures and options con-
tracts 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 s. The large financial institutions acting as OTC deriva-
tives 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 , the CFTC sought to address these concerns by exempting cer-
tain nonstandardized OTC derivatives from that requirement and from certain other
provisions of the Commodity Exchange Act, except for prohibitions against fraud
and manipulation.
As the OTC market grew following the CFTC’s exemption, a wave of significant
losses and scandals hit the market. Among many examples, in  Procter & Gamble,
 S E C U R I T I Z AT I O N AND D E R I VAT I V E S 

a leading consumer products company, reported a pretax loss of  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 Com-
mission (SEC) fined Bankers Trust  million for misleading Gibson Greeting Cards
on interest rate swaps resulting in a mark-to-market loss of  million, larger than
Gibson’s prior-year profits. In late , Orange County, California, announced it had
lost . 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 
million to settle claims. In response, the U.S. General Accounting Office issued a re-
port on financial derivatives that found dangers in the concentration of OTC deriva-
tives activity among  major dealers, concluding that “the sudden failure or abrupt
withdrawal from trading of any one of these large dealers could cause liquidity prob-
lems 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 lob-
bying by the OTC derivatives dealers and opposition by Fed Chairman Greenspan.
In , Japan’s Sumitomo Corporation lost . billion on copper derivatives
traded on a London exchange. The CFTC charged the company with using deriva-
tives to manipulate copper prices, including using OTC derivatives contracts to dis-
guise the speculation and to finance the scheme. Sumitomo settled for  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  million.
Debate intensified in . 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 . The
CFTC requested comments. It got them.
Some came from other regulators, who took the unusual step of publicly criticiz-
ing 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 ac-
tion may increase the legal uncertainty concerning certain types of OTC deriva-
tives.” 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 regula-
tion of derivatives dealers under the banking and securities laws, regulation of deriv-
atives transactions that are privately negotiated by professionals is unnecessary.”
In September, the Federal Reserve Bank of New York orchestrated a . billion
recapitalization of Long-Term Capital Management (LTCM) by  major OTC
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

derivatives dealers. An enormous hedge fund, LTCM had amassed more than 
trillion in notional amount of OTC derivatives and  billion of securities on .
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 in-
volved with LTCM.”
Nonetheless, just weeks later, in October , Congress passed the requested
moratorium.
Greenspan continued to champion derivatives and advocate deregulation of the
OTC market and the exchange-traded market. “By far the most significant event in
finance during the past decade has been the extraordinary development and expan-
sion of financial derivatives,” Greenspan said at a Futures Industry Association con-
ference in March . “The fact that the OTC markets function quite effectively
without the benefits of [CFTC regulation] provides a strong argument for develop-
ment 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 deriv-
atives broadly and to reduce CFTC regulation of exchange-traded derivatives as well.
In December , in response, Congress passed and President Clinton signed
the Commodity Futures Modernization Act of  (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 de-
rivatives 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 exam-
ple, under a  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 , when the CFMA was
passed, the notional amount of OTC derivatives outstanding globally was . tril-
lion, and the gross market value was . trillion. In the seven and a half years from
then until June , when the market peaked, outstanding OTC derivatives in-
creased more than sevenfold to a notional amount of . trillion; their gross mar-
ket value was . trillion.
Greenspan testified to the FCIC that credit default swaps—a small part of the
 S E C U R I T I Z AT I O N AND D E R I VAT I V E S 

market when Congress discussed regulating derivatives in the s—“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  our regulatory
framework with respect to derivatives was manifestly inadequate,” and that “the de-
rivatives that proved to be by far the most serious, those associated with credit default
swaps, increased  fold between  and .”
One reason for the rapid growth of the derivatives market was the capital require-
ments 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 com-
puter 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 
amendment to the regulatory regime known as the Basel International Capital Ac-
cord, or “Basel I.”
Meeting in Basel, Switzerland, in , the world’s central banks and bank super-
visors adopted principles for banks’ capital standards, and U.S. banking regulators
made adjustments to implement them. Among the most important was the require-
ment 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 re-
quirements 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.
These international capital standards accommodated the shift to increased lever-
age. In , large banks sought more favorable capital treatment for their trading,
and the Basel Committee on Banking Supervision adopted the Market Risk Amend-
ment 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 mim-
icked the returns of someone who owned the actual stock may have had some up-
front 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, audi-
tors, and investors to understand—indeed, he concluded, “I don’t think I could man-
age” a complex derivatives book.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 poten-
tially 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 re-
turn, 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 typi-
cally 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 , in re-
sponse 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 re-
quire 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 expo-
sure. In the run-up to the crisis, AIG, the largest U.S. insurance company, would ac-
cumulate 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 . trillion at the end of  to a peak of
. trillion at the end of . 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,  of the notional amount of OTC derivatives, millions of contracts,
were traded by just five large institutions (in , JPMorgan Chase, Citigroup, Bank
of America, Wachovia, and HSBC)—many of the same firms that would find them-
selves 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 rev-
enues and profits generated by their derivatives operations, some firms did provide
estimates. For example, Goldman Sachs estimated that between  and  of its
revenues from  through  were generated by derivatives, including  to
 S E C U R I T I Z AT I O N AND D E R I VAT I V E S 

 of the firm’s commodities business, and half or more of its interest rate and cur-
rencies business. From May  through November ,  billion, or , of
the  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 fail-
ure in , 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 finan-
cial system from collapsing.
 4
DEREGULATION REDUX

CONTENTS
Expansion of banking activities: “Shatterer of Glass-Steagall” .............................
Long-Term Capital Management:
“That’s what history had proved to them” .....................................................
Dot-com crash: “Lay on more risk”......................................................................
The wages of finance: “Well, this one’s doing it, so how can I not do it?” ..............
Financial sector growth:
“I think we overdid finance versus the real economy”....................................

EXPANSION OF BANKING ACTIVITIES:

“SHATTERER OF GLASSSTEAGALL”
By the mid-s, 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, telecom-
munications, and information services created economies of scale and scope in fi-
nance 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 re-
maining barriers to growth and competition. They had much success. In  Con-
gress 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  and
,  “megamergers” occurred involving banks with assets of more than  bil-
lion each. Meanwhile the  largest jumped from owning  of the industry’s assets


 D E R E G U L AT I O N R E D U X 

to . From  to , the combined assets of the five largest U.S. banks—Bank
of America, Citigroup, JP Morgan, Wachovia, and Wells Fargo—more than tripled,
from . trillion to . trillion. And investment banks were growing bigger, too.
Smith Barney acquired Shearson in  and Salomon Brothers in , while Paine
Webber purchased Kidder, Peabody in . 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  trillion in  to  tril-
lion in .
In , the Economic Growth and Regulatory Paperwork Reduction Act re-
quired federal regulators to review their rules every decade and solicit comments on
“outdated, unnecessary, or unduly burdensome” rules. Some agencies responded
with gusto. In , the Federal Deposit Insurance Corporation’s annual report in-
cluded a photograph of the vice chairman, John Reich; the director of the Office of
Thrift Supervision (OTS), James Gilleran; and three banking industry representa-
tives using a chainsaw and pruning shears to cut the “red tape” binding a large stack
of documents representing regulations.
Less enthusiastic agencies felt heat. Former Securities and Exchange Commission
chairman Arthur Levitt told the FCIC that once word of a proposed regulation got
out, industry lobbyists would rush to complain to members of the congressional
committee with jurisdiction over the financial activity at issue. According to Levitt,
these members would then “harass” the SEC with frequent letters demanding an-
swers to complex questions and appearances of officials before Congress. These re-
quests consumed much of the agency’s time and discouraged it from making
regulations. Levitt described it as “kind of a blood sport to make the particular
agency look stupid or inept or venal.”
However, others said interference—at least from the executive branch—was mod-
est. John Hawke, a former comptroller of the currency, told the FCIC he found the
Treasury Department “exceedingly sensitive” to his agency’s independence. His suc-
cessor, John Dugan, said “statutory firewalls” prevented interference from the execu-
tive branch.
Deregulation went beyond dismantling regulations; its supporters were also disin-
clined to adopt new regulations or challenge industry on the risks of innovations.
Federal Reserve officials argued that financial institutions, with strong incentives to
protect shareholders, would regulate themselves by carefully managing their own
risks. In a  speech, Fed Vice Chairman Roger Ferguson praised “the truly im-
pressive improvement in methods of risk measurement and management and the
growing adoption of these technologies by mostly large banks and other financial in-
termediaries.” Likewise, Fed and other officials believed that markets would self-reg-
ulate 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 . “The self-interest of market participants generates private market
regulation. Thus, the real question is not whether a market should be regulated.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Rather, the real question is whether government intervention strengthens or weakens

private regulation.”
Richard Spillenkothen, the Fed’s director of Banking Supervision and Regulation
from  to , discussed banking supervision in a memorandum submitted to
the FCIC: “Supervisors understood that forceful and proactive supervision, espe-
cially early intervention before management weaknesses were reflected in poor finan-
cial performance, might be viewed as i) overly-intrusive, burdensome, and
heavy-handed, ii) an undesirable constraint on credit availability, or iii) inconsistent
with the Fed’s public posture.”
To create checks and balances and keep any agency from becoming arbitrary or
inflexible, senior policy makers pushed to keep multiple regulators. In ,
Greenspan testified against proposals to consolidate bank regulation: “The current
structure provides banks with a method . . . of shifting their regulator, an effective
test that provides a limit on the arbitrary position or excessively rigid posture of any
one regulator. The pressure of a potential loss of institutions has inhibited excessive
regulation and acted as a countervailing force to the bias of a regulatory agency to
overregulate.” Further, some regulators, including the OTS and Office of the Comp-
troller of the Currency (OCC), were funded largely by assessments from the institu-
tions they regulated. As a result, the larger the number of institutions that chose these
regulators, the greater their budget.
Emboldened by success and the tenor of the times, the largest banks and their reg-
ulators continued to oppose limits on banks’ activities or growth. The barriers sepa-
rating 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 sepa-
rated banks, securities firms, and insurance companies.
In the spring of , after years of opposing repeal of Glass-Steagall, the Securi-
ties Industry Association—the trade organization of Wall Street firms such as Gold-
man 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. Edward Yingling, the CEO of the American
Bankers Association (a lobbying organization), said, “Because we had knocked so
many holes in the walls separating commercial and investment banking and insur-
ance, we were able to aggressively enter their businesses—in some cases more aggres-
sively than they could enter ours. So first the securities industry, then the insurance
companies, and finally the agents came over and said let’s negotiate a deal and work
together.”
In , 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 Glass-Steagall Act, once and for all?
 D E R E G U L AT I O N R E D U X 

As Congress began fashioning legislation, the banks were close at hand. In ,
the financial sector spent  million lobbying at the federal level, and individuals
and political action committees (PACs) in the sector donated  million to federal
election campaigns in the  election cycle. From  through , federal lob-
bying by the financial sector reached . billion; campaign donations from individ-
uals and PACs topped  billion.
In November , Congress passed and President Clinton signed the Gramm-
Leach-Bliley Act (GLBA), which lifted most of the remaining Glass-Steagall-era re-
strictions. 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  feet wide—etched with his portrait and the
words ‘The Shatterer of Glass-Steagall.’”
Now, as long as bank holding companies satisfied certain safety and soundness
conditions, they could underwrite and sell banking, securities, and insurance prod-
ucts and services. Their securities affiliates were no longer bound by the Fed’s 
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 finan-
cial services), and more competitive with large foreign banks, which already offered
loans, securities, and insurance products. The legislation’s opponents warned that al-
lowing banks to combine with securities firms would promote excessive speculation
and could trigger a crisis like the crash of . John Reed, former co-CEO of Citi-
group, acknowledged to the FCIC that, in hindsight, “the compartmentalization that
was created by Glass-Steagall would be a positive factor,” making less likely a “cata-
strophic failure” of the financial system.
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 deposi-
tory institution with stricter limits on its activities. Through them, securities firms
could access FDIC-insured deposits without supervision by the Fed. Some securities
firms immediately expanded their industrial loan company and thrift subsidiaries.
Merrill’s industrial loan company grew from less than  billion in assets in  to
 billion in , and to  billion in . Lehman’s thrift grew from  million
in  to  billion in , and its assets rose as high as  billion in .
For institutions regulated by the Fed, the new law also established a hybrid regula-
tory 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, secu-
rities firms, and insurance companies. The expressed intent of Fed-Lite was to elimi-
nate 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.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Indeed, the regulators, including the Fed, would fail to identify excessive risks and
unsound practices building up in nonbank subsidiaries of financial holding compa-
nies such as Citigroup and Wachovia.
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 commer-
cial 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 us-
ing their deposits. After , 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 s further proved his point, Greenspan said.
The new regime encouraged growth and consolidation within and across bank-
ing, 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 re-
semble 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 s until the outbreak of the financial cri-
sis in . However, Greenspan’s “spare tire” that had helped make the system less
vulnerable would be gone when the financial crisis emerged—all the wheels of the
system would be spinning on the same axle.

LONGTERM CAPITAL MANAGEMENT:

“THAT’S WHAT HISTORY HAD PROVED TO THEM”
In August , Russia defaulted on part of its national debt, panicking markets. Rus-
sia announced it would restructure its debt and postpone some payments. In the af-
termath, investors dumped higher-risk securities, including those having nothing to
do with Russia, and fled to the safety of U.S. Treasury bills and FDIC-insured de-
posits. In response, the Federal Reserve cut short-term interest rates three times in
seven weeks. With the commercial paper market in turmoil, it was up to the com-
mercial banks to take up the slack by lending to corporations that could not roll over
their short-term paper. Banks loaned  billion in September and October of
—about . times the usual amount—and helped prevent a serious disruption
from becoming much worse. The economy avoided a slump.
Not so for Long-Term Capital Management, a large U.S. hedge fund. LTCM had
devastating losses on its  billion portfolio of high-risk debt securities, including
the junk bonds and emerging market debt that investors were dumping. To buy
these securities, the firm had borrowed  for every  of investors’ equity; lenders
 D E R E G U L AT I O N R E D U X 

included Merrill Lynch, JP Morgan, Morgan Stanley, Lehman Brothers, Goldman

Sachs, and Chase Manhattan. The previous four years, LTCM’s leveraging strategy
had produced magnificent returns: ., ., ., and ., while the S&P
 yielded an average .
But leverage works both ways, and in just one month after Russia’s partial default,
the fund lost more than  billion—or more than  of its nearly  billion in capi-
tal. Its debt was about  billion. The firm faced insolvency.
If it were only a matter of less than  billion, LTCM’s failure might have been
manageable. But the firm had further leveraged itself by entering into derivatives
contracts with more than  trillion in notional amount—mostly interest rate and
equity derivatives. With very little capital in reserve, it threatened to default on its
obligations to its derivatives counterparties—including many of the largest commer-
cial and investment banks. Because LTCM had negotiated its derivatives transactions
in the opaque over-the-counter market, the markets did not know the size of its posi-
tions or the fact that it had posted very little collateral against those positions. As the
Fed noted then, if all the fund’s counterparties had tried to liquidate their positions
simultaneously, asset prices across the market might have plummeted, which would
have created “exaggerated” losses. This was a classic setup for a run: losses were likely,
but nobody knew who would get burned. The Fed worried that with financial mar-
kets already fragile, these losses would spill over to investors with no relationship to
LTCM, and credit and derivatives markets might “cease to function for a period of
one or more days and maybe longer.”
To avert such a disaster, the Fed called an emergency meeting of major banks and
securities firms with large exposures to LTCM. On September , after considerable
urging,  institutions agreed to organize a consortium to inject . billion into
LTCM in return for  of its stock. The firms contributed between  million
and  million each, although Bear Stearns declined to participate. An orderly
liquidation of LTCM’s securities and derivatives followed.
William McDonough, then president of the New York Fed, insisted “no Federal
Reserve official pressured anyone, and no promises were made.” The rescue in-
volved no government funds. Nevertheless, the Fed’s orchestration raised a question:
how far would it go to forestall what it saw as a systemic crisis?
The Fed’s aggressive response had precedents in the previous two decades. In
, the Fed had supported the commercial paper market; in , dealers in silver
futures; in , the repo market; in , the stock market after the Dow Jones In-
dustrial Average fell by  percent in three days. All provided a template for future
interventions. Each time, the Fed cut short-term interest rates and encouraged finan-
cial firms in the parallel banking and traditional banking sectors to help ailing mar-
kets. And sometimes it organized a consortium of financial institutions to rescue
firms.
During the same period, federal regulators also rescued several large banks that
they viewed as “too big to fail” and protected creditors of those banks, including
uninsured depositors. Their rationale was that major banks were crucial to the finan-
cial markets and the economy, and regulators could not allow the collapse of one
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

large bank to trigger a panic among uninsured depositors that might lead to more
bank failures.
But it was a completely different proposition to argue that a hedge fund could be
considered too big to fail because its collapse might destabilize capital markets. Did
LTCM’s rescue indicate that the Fed was prepared to protect creditors of any type of
firm if its collapse might threaten the capital markets? Harvey Miller, the bankruptcy
counsel for Lehman Brothers when it failed in , told the FCIC that “they [hedge
funds] expected the Fed to save Lehman, based on the Fed’s involvement in LTCM’s
rescue. That’s what history had proved to them.”
For Stanley O’Neal, Merrill’s CFO during the LTCM rescue, the experience was
“indelible.” He told the FCIC, “The lesson I took away from it though was that had
the market seizure and panic and lack of liquidity lasted longer, there would have
been a lot of firms across the Street that were irreparably harmed, and Merrill would
have been one of those.”
Greenspan argued that the events of  had confirmed the spare tire theory. He
said in a  speech that the successful resolution of the  crisis showed that “di-
versity within the financial sector provides insurance against a financial problem
turning into economy-wide distress.” The President’s Working Group on Financial
Markets came to a less definite conclusion. In a  report, the group noted that
LTCM and its counterparties had “underestimated the likelihood that liquidity,
credit, and volatility spreads would move in a similar fashion in markets across the
world at the same time.” Many financial firms would make essentially the same mis-
take a decade later. For the Working Group, this miscalculation raised an important
issue: “As new technology has fostered a major expansion in the volume and, in some
cases, the leverage of transactions, some existing risk models have underestimated
the probability of severe losses. This shows the need for insuring that decisions about
the appropriate level of capital for risky positions become an issue that is explicitly
considered.”
The need for risk management grew in the following decade. The Working Group
was already concerned that neither the markets nor their regulators were prepared
for tail risk—an unanticipated event causing catastrophic damage to financial institu-
tions and the economy. Nevertheless, it cautioned that overreacting to threats such as
LTCM would diminish the dynamism of the financial sector and the real economy:
“Policy initiatives that are aimed at simply reducing default likelihoods to extremely
low levels might be counterproductive if they unnecessarily disrupt trading activity
and the intermediation of risks that support the financing of real economic activity.”
Following the Working Group’s findings, the SEC five years later would issue a
rule expanding the number of hedge fund advisors—to include most advisors—that
needed to register with the SEC. The rule would be struck down in  by the
United States Court of Appeals for the District of Columbia after the SEC was sued
by an investment advisor and hedge fund.
Markets were relatively calm after , Glass-Steagall would be deemed unnec-
essary, OTC derivatives would be deregulated, and the stock market and the econ-
omy would continue to prosper for some time. Like all the others (with the exception
 D E R E G U L AT I O N R E D U X 

of the Great Depression), this crisis soon faded into memory. But not before, in Feb-
ruary , Time magazine featured Robert Rubin, Larry Summers, and Alan
Greenspan on its cover as “The Committee to Save the World.” Federal Reserve
Chairman Greenspan became a cult hero—the “Maestro”—who had handled every
emergency since the  stock market crash.

DOTCOM CRASH: “LAY ON MORE RISK”

The late s was a good time for investment banking. Annual public underwrit-
ings and private placements of corporate securities in U.S. markets almost quadru-
pled, from  billion in  to . trillion in . Annual initial public offerings
of stocks (IPOs) soared from  billion in  to  billion in  as banks and
securities firms sponsored IPOs for new Internet and telecommunications compa-
nies—the dot-coms and telecoms. A stock market boom ensued comparable to the
great bull market of the s. The value of publicly traded stocks rose from . tril-
lion in December  to . trillion in March . The boom was particularly
striking in recent dot-com and telecom issues on the NASDAQ exchange. Over this
period, the NASDAQ skyrocketed from  to ,.
In the spring of , 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  and March , the NASDAQ fell by almost
two-thirds. This slump accelerated after the terrorist attacks on September  as the
nation slipped into recession. Investors were further shaken by revelations of ac-
counting frauds and other scandals at prominent firms such as Enron and World-
com. Some leading commercial and investment banks settled with regulators over
improper practices in the allocation of IPO shares during the bubble—for spinning
(doling out shares in “hot” IPOs in return for reciprocal business) and laddering
(doling out shares to investors who agreed to buy more later at higher prices). The
regulators also found that public research reports prepared by investment banks’ ana-
lysts 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  firms for  million, forbade certain practices, and
instituted reforms.
The sudden collapses of Enron and WorldCom were shocking; with assets of 
billion and  billion, respectively, they were the largest corporate bankruptcies
before the default of Lehman Brothers in .
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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

evaluations of Enron. The scandal cost Citigroup, JP Morgan, CIBC, Merrill Lynch,
and other financial institutions more than  million in settlements with the SEC;
Citigroup, JP Morgan, CIBC, Lehman Brothers, and Bank of America paid another
. billion to investors to settle class action lawsuits. In response, the Sarbanes-
Oxley Act of  required the personal certification of financial reports by CEOs
and CFOs; independent audit committees; longer jail sentences and larger fines for
executives who misstate financial results; and protections for whistleblowers.
Some firms that lent to companies that failed during the stock market bust were
successfully hedged, having earlier purchased credit default swaps on these firms.
Regulators seemed to draw comfort from the fact that major banks had succeeded in
transferring losses from those relationships to investors through these and other
hedging transactions. In November , Fed Chairman Greenspan said credit de-
rivatives “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.”
The following year, Fed Vice Chairman Roger Ferguson noted that “the most re-
markable fact regarding the banking industry during this period is its resilience and
retention of fundamental strength.”
This resilience led many executives and regulators to presume the financial sys-
tem 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 of-
ficials. In a memorandum to the FCIC, Richard Spillenkothen described a presenta-
tion to the Board of Governors in which some Fed governors received details of the
banks’ complicity “coolly” and were “clearly unimpressed” by analysts’ findings. “The
message to some supervisory staff was neither ambiguous nor subtle,” Spillenkothen
wrote. Earlier in the decade, he remembered, senior economists at the Fed had called
Enron an example of a derivatives market participant successfully regulated by mar-
ket discipline without government oversight.
The Fed cut interest rates aggressively in order to contain damage from the dot-
com and telecom bust, the terrorist attacks, and the financial market scandals. In Jan-
uary , the federal funds rate, the overnight bank-to-bank lending rate, was ..
By mid-, the Fed had cut that rate to just , the lowest in half a century, where
it stayed for another year. In addition, to offset the market disruptions following the
/ attacks, the Fed flooded the financial markets with money by purchasing more
than  billion in government securities and lending  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 , just as it had done
during the  stock market crash and the  Russian crisis.
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 , 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
 D E R E G U L AT I O N R E D U X 

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. “Instead of trying to contain a
putative bubble by drastic actions with largely unpredictable consequences,” he said
in , when housing prices were ballooning, “we chose . . . to focus on policies ‘to
mitigate the fallout when it occurs and, hopefully, ease the transition to the next
expansion.’”
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 un-
limited while the full power and influence of the Fed protected their downside (at
least against catastrophic losses)? Greenspan himself warned about this in a 
speech, noting that higher asset prices were “in part the indirect result of investors
accepting lower compensation for risk” and cautioning that “newly abundant liquid-
ity 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 , although, as he pointed out
in the same  speech, this had little effect.
And the markets were undeterred. “We had convinced ourselves that we were in a
less risky world,” former Federal Reserve governor and National Economic Council
director under President George W. Bush Lawrence Lindsey told the Commission.
“And how should any rational investor respond to a less risky world? They should lay
on more risk.”

THE WAGES OF FINANCE:

“WELL, THIS ONE’S DOING IT, SO HOW CAN I NOT DO IT? ”
As figure . demonstrates, for almost half a century after the Great Depression, pay
inside the financial industry and out was roughly equal. Beginning in , they di-
verged. By , financial sector compensation was more than  greater than in
other businesses—a considerably larger gap than before the Great Depression.
Until , 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 invest-
ment 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 part-
ners, they took risk very seriously,” Solomon said. Brian Leach, formerly an execu-
tive at Morgan Stanley, described to FCIC staff Morgan Stanley’s compensation
practices before it issued stock and became a public corporation: “When I first
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T


           

Compensation in the financial sector outstripped pay elsewhere,
a pattern not seen since the years before the Great Depression.
ANNUAL AVERAGE, IN 2009 DOLLARS

$120,000
$102,069
100,000 Financial

80,000

$58,666
60,000 

40,000

20,000

0
1929 1940 1950 1960 1970 1980 1990 2000 2009

NOTE: Average compensation includes wages, salaries, commissions, tips, bonuses, and payments for

       

          
   
SOURCES: Bureau of Economic Analysis, Bureau of Labor Statistics, CPI-Urban, FCIC calculations

Figure .

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 s and s, the close rela-
tionship 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 incen-
tives, 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
 D E R E G U L AT I O N R E D U X 

only . a year during the  years after World War II, lagging companies’ increasing
size. But the rate picked up during the s and rose faster each decade, reaching
 a year from  to . Much of the change reflected higher earnings in the
financial sector, where by  executives’ pay averaged . 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  million in compensation.
Both before and after going public, investment banks typically paid out half their
revenues in compensation. For example, Goldman Sachs spent between  and 
a year between  and , when Morgan Stanley allotted between  and .
Merrill paid out similar percentages in  and , but gave  in —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 s, received . million in
 as CEO of Salomon Brothers. Stanley O’Neal’s package was worth more than
 million in , the last full year he was CEO of Merrill Lynch. In , Lloyd
Blankfein, CEO at Goldman Sachs, received . million; Richard Fuld, CEO of
Lehman Brothers, and Jamie Dimon, CEO of JPMorgan Chase, received about 
million and  million, respectively. That year Wall Street paid workers in New
York roughly  billion in year-end bonuses alone. Total compensation for the ma-
jor U.S. banks and securities firms was estimated at  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  legislation making compensation in excess of 
million taxable to the corporation unless performance-based. Stock options had po-
tentially 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 in-
crease 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 lever-
age, 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 develop-
ments, 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 Com-
mission, “I think if you look at the results of what happened on Wall Street, it became,
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

‘Well, this one’s doing it, so how can I not do it, if I don’t do it, then the people are go-
ing to leave my place and go someplace else.’” Managing risk “became less of an im-
portant function in a broad base of companies, I would guess.”
And regulatory entities, one source of checks on excessive risk taking, had chal-
lenges recruiting financial experts who could otherwise work in the private sector.
Lord Adair Turner, chairman of the U.K. Financial Services Authority, told the Com-
mission, “It’s not easy. This is like a continual process of, you know, high-skilled
people versus high-skilled people, and the poachers are better paid than the game-
keepers.” 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.”
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 
years to . [per share]. A large part of the executives’ compensation was tied to
meeting that goal.” Achieving it brought CEO Franklin Raines  million of his 
million pay from  to . However, Falcon said, the goal “turned out to be un-
achievable without breaking rules and hiding risks. Fannie and Freddie executives
worked hard to persuade investors that mortgage-related assets were a riskless invest-
ment, while at the same time covering up the volatility and risks of their own mort-
gage portfolios and balance sheets.” Fannie’s estimate of how many mortgage holders
would pay off was off by  million at year-end , which meant no bonuses. So
Fannie counted only half the  million on its books, enabling Raines and other
executives to meet the earnings target and receive  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 prac-
tice . . . was based on the volume of loans originated rather than the performance and
quality of the loans made.” She concluded, “The crisis has shown that most financial-
institution compensation systems were not properly linked to risk management. For-
mula-driven compensation allows high short-term profits to be translated into
generous bonus payments, without regard to any longer-term risks.” 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 in-
vestors and taxpayers.”

FINANCIAL SECTOR GROWTH:

“I THINK WE OVERDID FINANCE VERSUS THE REAL ECONOMY”
For about two decades, beginning in the early s, the financial sector grew faster
than the rest of the economy—rising from about  of gross domestic product
(GDP) to about  in the early st century. In , financial sector profits were
about  of corporate profits. In , they hit a high of  but fell back to 
 D E R E G U L AT I O N R E D U X 

in , on the eve of the financial crisis. The largest firms became considerably
larger. JP Morgan’s assets increased from  billion in  to . trillion in
, a compound annual growth rate of . Bank of America and Citigroup grew
by  and  a year, respectively, with Citigroup reaching . trillion in assets in
 (down from . trillion in ) and Bank of America . trillion. The in-
vestment banks also grew significantly from  to , often much faster than
commercial banks. Goldman’s assets grew from  billion in  to . trillion
by , an annual growth rate of . At Lehman, assets rose from  billion to
 billion, or .
Fannie and Freddie grew quickly, too. Fannie’s assets and guaranteed mortgages
increased from . trillion in  to . trillion in , or  annually. At Fred-
die, they increased from  trillion to . trillion, or  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 . of assets plus . of
the mortgage-backed securities they guaranteed. So they could borrow more than
 for each dollar of capital used to guarantee mortgage-backed securities. If they
wanted to own the securities, they could borrow  for each dollar of capital. Com-
bined, Fannie and Freddie owned or guaranteed . trillion of mortgage-related as-
sets at the end of  against just . billion of capital, a ratio of :.
From  to , large banks and thrifts generally had  to  in assets for
each dollar of capital, for leverage ratios between : and :. For some banks,
leverage remained roughly constant. JP Morgan’s reported leverage was between :
and :. Wells Fargo’s generally ranged between : and :. Other banks upped
their leverage. Bank of America’s rose from : in  to : in . Citigroup’s
increased from : to :, then shot up to : by the end of , when Citi
brought off-balance sheet assets onto the balance sheet. More than other banks, Citi-
group held assets off of its balance sheet, in part to hold down capital requirements.
In , even after bringing  billion worth of assets on balance sheet, substantial
assets remained off. If those had been included, leverage in  would have been
:, or about  higher. In comparison, at Wells Fargo and Bank of America, in-
cluding off-balance-sheet assets would have raised the  leverage ratios  and
, 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 : in  to : in . Morgan
Stanley and Lehman increased about  and , respectively, and both reached
: by the end of . 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, in-
vestment banks advised and underwrote equity and debt for corporations, financial
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

institutions, investment funds, governments, and individuals. An increasing amount

of the investment banks’ revenues and earnings was generated by trading and invest-
ments, including securitization and derivatives activities. At Goldman, revenues from
trading and principal investments increased from  of the total in  to  in
. At Merrill Lynch, they generated  of revenue in , up from  in .
At Lehman, similar activities generated up to  of pretax earnings in , up from
 in . At Bear Stearns, they accounted for more than  of pretax earnings
in some years after  because of pretax losses in other businesses.
Between  and , debt held by financial companies grew from  trillion to
 trillion, more than doubling from  to  of GDP. Former Treasury Secre-
tary 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  or  years it had become too large. Financial firms had grown
mainly by simply lending to each other, he said, not by creating opportunities for in-
vestment. In , financial companies borrowed  in the credit markets for
every  borrowed by nonfinancial companies. By , financial companies were
borrowing  for every . “We have a lot more debt than we used to have, which
means we have a much bigger financial sector,” said Snow. “I think we overdid fi-
nance versus the real economy and got it a little lopsided as a result.”
 5
SUBPRIME LENDING

CONTENTS
Mortgage securitization: “This stuff is so complicated how is
anybody going to know?” ..............................................................................
Greater access to lending: “A business where we can make some money”.............
Subprime lenders in turmoil: “Adverse market conditions”..................................
The regulators: “Oh, I see” ...................................................................................

In the early s, subprime lenders such as Household Finance Corp. and thrifts
such as Long Beach Savings and Loan made home equity loans, often second mort-
gages, 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 borrow-
ers, 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., tes-
tified 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 ad-
vantages of a mortgage over other forms of debt were solidified in  with the Tax
Reform Act, which barred deducting interest payments on consumer loans but kept
the deduction for mortgage interest payments.
In the s and into the early s, 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 mort-
gage 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 pay-
ments, closing costs, and reserves), and collateral (value and condition of the prop-
erty). Their decisions depended on judgments about how strength in one area, such
as collateral, might offset weaknesses in others, such as credit. They underwrote bor-
rowers one at a time, out of local offices.


 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 ex-
tending the warehouse lines. Meanwhile, the S&Ls that originated subprime loans
generally financed their own mortgage operations and kept the loans on their bal-
ance sheets.

MORTGAGE SECURITIZATION: “THIS STUFF IS

SO COMPLICATED HOW IS ANYBODY GOING TO KNOW? ”
Debt outstanding in U.S. credit markets tripled during the s, reaching . tril-
lion in ;  was securitized mortgages and GSE debt. Later, mortgage securities
made up  of the debt markets, overtaking government Treasuries as the single
largest component—a position they maintained through the financial crisis.
In the s mortgage companies, banks, and Wall Street securities firms began
securitizing mortgages (see figure .). 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 Fred-
die’s standards. Selling these required investors to adjust expectations. With securiti-
zations 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 Calla-
han 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 rat-
ing services in the business.”
Non-agency securitizations were only a few years old when they received a pow-
erful stimulus from an unlikely source: the federal government. The savings and
loan crisis had left Uncle Sam with  billion in loans and real estate from failed
thrifts and banks. Congress established the Resolution Trust Corporation (RTC) in
 to offload mortgages and real estate, and sometimes the failed thrifts them-
selves, now owned by the government. While the RTC was able to sell . 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 documen-
tation errors or servicing problems, not unlike the low-documentation loans that
later became popular.
 SUBPRIME LENDING 

Funding for Mortgages

The sources of funds for mortgages changed over the decades.
IN PERCENT, BY SOURCE
Savings & loans Government-sponsored enterprises

60%
54%

50

40

30

20
4%
10

0
’70 ’80 ’90 ’00 ’10 ’70 ’80 ’90 ’00 ’10

Commercial banks & others Non-agency securities

60%

50

40
29%

30
13%
20

10

0
’70 ’80 ’90 ’00 ’10 ’70 ’80 ’90 ’00 ’10

SOURCE: Federal Reserve Flow of Funds Report

Figure .

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  bil-
lion in residential mortgages. The RTC in effect helped expand the securitization of
mortgages ineligible for GSE guarantees. In the early s, as investors became
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Subprime Mortgage Originations

In 2006, $600 billion of subprime loans were originated, most of which were
securitized. That year, subprime lending accounted for 23.5% of all mortgage
originations.

IN BILLIONS OF DOLLARS
23.5%
$700
Subprime share of entire 22.7%
20.9%
mortgage market
600
Securitized
500 Non-securitized
8.3%
400
10.6% 10.1%
10.4% 7.6% 7.4%
300
9.2%
9.5% 9.8%
200

100
1.7%
0
’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08

   



       



      
2007, securities issued exceeded originations.
SOURCE: Inside Mortgage Finance

Figure .

more familiar with the securitization of these assets, mortgage specialists and Wall
Street bankers got in on the action. Securitization and subprime originations grew
hand in hand. As figure . shows, subprime originations increased from  billion
in  to  billion in . The proportion securitized in the late s peaked at
, and subprime mortgage originations’ share of all originations hovered around
.
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 dif-
ferent streams of principal and interest in different orders.
Most of the earliest private-label deals, in the late s and early s, used a
rudimentary form of tranching. There were typically two tranches in each deal. The
 SUBPRIME LENDING 

less risky tranche received principal and interest payments first and was usually guaran-
teed by an insurance company. The more risky tranche received payments second, was
not guaranteed, and was usually kept by the company that originated the mortgages.
Within a decade, securitizations had become much more complex: they had more
tranches, each with different payment streams and different risks, which were tai-
lored 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 partici-
pants alike took for granted that it efficiently allocated risk to those best able and will-
ing to bear that risk.
To demonstrate how this process worked, we’ll describe a typical deal, named
CMLTI -NC, involving  million in mortgage-backed bonds. In , New
Century Financial, a California-based lender, originated and sold , 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 , mortgages carried the rights to the borrowers’ monthly payments,
which the Citigroup entity divided into  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 securitiza-
tion 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 as-
signs 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 distin-
guishes 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 agencies.
Below the senior tranches and next in line for payments were eleven “mezzanine”
tranches—so named because they sat between the riskiest and the safest tranches.
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 inter-
est payments less valuable. As a result, they paid a correspondingly higher interest
rate. Three of these tranches in the Citigroup deal were rated AA, three were A, three
were BBB (the lowest investment-grade rating), and two were BB, or junk.
The last to be paid was the most junior tranche, called the “equity,” “residual,” or
“first-loss” tranche, set up to receive whatever cash flow was left over after all the
other investors had been paid. This tranche would suffer the first losses from any
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

defaults of the mortgages in the pool. Commensurate with this high risk, it provided
the highest yields (see figure .). 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.
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,  million, or , was rated triple-A.

GREATER ACCESS TO LENDING:

“A BUSINESS WHERE WE CAN MAKE SOME MONEY”
As private-label securitization began to take hold, new computer and modeling tech-
nologies were reshaping the mortgage market. In the mid-s, standardized data
with loan-level information on mortgage performance became more widely avail-
able. Lenders underwrote mortgages using credit scores, such as the FICO score, de-
veloped by Fair Isaac Corporation. In , Freddie Mac rolled out Loan Prospector,
an automated system for mortgage underwriting for use by lenders, and Fannie Mae
released its own system, Desktop Underwriter, two months later. The days of labori-
ous, slow, and manual underwriting of individual mortgage applicants were over,
lowering cost and broadening access to mortgages.
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 s, technology also affected implementation of the Community Rein-
vestment Act (CRA). Congress enacted the CRA in  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 en-
gage in new businesses.
The CRA encouraged banks to lend to borrowers to whom they may have previ-
ously denied credit. While these borrowers often had lower-than-average income, a
 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 sound-
ness have been compromised by such lending, and bankers often report sound busi-
ness opportunities,” Federal Reserve Chairman Alan Greenspan said of CRA lending
in .
 SUBPRIME LENDING 

Residential Mortgage-Backed Securities

Financial institutions packaged subprime, Alt-A and other mortgages into securities. As long
as the housing market continued to boom, these securities would perform. But when the
economy faltered and the mortgages defaulted, lower-rated tranches were left worthless.

1 Originate RMBS
Lenders extend mortgages, including TRANCHES
subprime and Alt-A loans. Low risk, low yield

Pool of
Mortgages
2 Pool
SENIOR
Securities firms AAA
TRANCHES
purchase these loans
and pool them.
First claim to cash flow
from principal & interest
payments…

3 Tranche
Residential mortgage-backed
securities are sold to
investors, giving them the
next
right to the principal and
claim…
interest from the mortgages.
These securities are sold in MEZZANINE
tranches, or slices. The flow TRANCHES
of cash determines the rating These tranches
AA
of the securities, with AAA were often
next… purchased by
tranches getting the first cut etc. CDOs. See page
of principal and interest
128 for an
payments, then AA, then A, explanation.
and so on. A
BBB
BB
EQUITY TRANCHES Collateralized
High risk, high yield Debt
Obligation

Figure .
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

In , President Bill Clinton asked regulators to improve banks’ CRA perform-
ance while responding to industry complaints that the regulatory review process for
compliance was too burdensome and too subjective. In , 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 re-
sults. Regulators and community advocates could now point to objective, observable
numbers that measured banks’ compliance with the law.
Former comptroller John Dugan told FCIC staff that the impact of the CRA had
been lasting, because it encouraged banks to lend to people who in the past might not
have had access to credit. He said, “There is a tremendous amount of investment that
goes on in inner cities and other places to build things that are quite impressive. . . .
And the bankers conversely say, ‘This is proven to be a business where we can make
some money; not a lot, but when you factor that in plus the good will that we get
from it, it kind of works.’”
Lawrence Lindsey, a former Fed governor who was responsible for the Fed’s Divi-
sion 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 under-
write 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 lend-
ing were very, very low,” he said. Indeed, default rates were low during the prosper-
ous s, and regulators, bankers, and lenders in the shadow banking system took
note of this success.

SUBPRIME LENDERS IN TURMOIL:

“ADVERSE MARKET CONDITIONS”
Among nonbank mortgage originators, the late s 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 de-
mand among investors for risky assets, including subprime securitizations. The rate
of subprime mortgage securitization dropped from . in  to . in .
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 imme-
diate problems. For example, Southern Pacific Funding (SFC), an Oregon-based sub-
prime lender that securitized its loans, reported relatively positive second-quarter
 SUBPRIME LENDING 

results in August . Then, in September, SFC notified investors about “recent ad-
verse 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 short-term financing from the capital markets also filed for bank-
ruptcy in  and . In the two years following the Russian default crisis,  of the
top  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 . billion after it bought The Money Store. First Union eventually shut
down or sold off most of The Money Store’s operations.
Conseco, a leading insurance company, purchased Green Tree Financial, another
subprime lender. Disruptions in the securitization markets, as well as unexpected
mortgage defaults, eventually drove Conseco into bankruptcy in December . 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. Key-
stone, a small national bank in West Virginia that made and securitized subprime
mortgage loans, failed in . In the securitization process—as was common prac-
tice in the s—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 , after dis-
covering “fraud committed by the bank management,” as executives had overstated
the value of the residual tranches and other bank assets. Perhaps the most signifi-
cant failure occurred at Superior Bank, one of the most aggressive subprime mort-
gage 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 s 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 Citi-
group, and Household bought Beneficial Mortgage before it was itself acquired by
HSBC in .
With the subprime market disrupted, subprime originations totaled  billion
in , down from  billion two years earlier. Over the next few years, however,
subprime lending and securitization would more than rebound.

THE REGULATORS: “OH, I SEE”

During the s, various federal agencies had taken increasing notice of abusive
subprime lending practices. But the regulatory system was not well equipped to re-
spond 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

banks. The OCC supervised the national banks. The OTS or state regulators were re-
sponsible 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 . In , the
Fed adopted Regulation Z for the purpose of implementing the act. But while Regu-
lation Z applied to all lenders, its enforcement was divided among America’s many fi-
nancial 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, in-
cluding the authority to supervise their nonbank subsidiaries. The Federal Trade
Commission was given explicit authority by Congress to enforce the consumer pro-
tections 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 commensu-
rate 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.”
Glenn Loney, deputy director of the Fed’s Consumer and Community Affairs
Division from  to , told the FCIC that ever since he joined the agency in
, 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 , with any real force until
after the housing bubble burst.
The  legislation that gave the Fed new responsibilities was the Home Owner-
ship and Equity Protection Act (HOEPA), passed by Congress and signed by Presi-
dent 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 -year-old homeowner, who testified at a hearing
that she paid more than , in upfront finance charges on a , second
mortgage. In addition, the monthly payments on the mortgage exceeded her
income.
HOEPA prohibited abusive practices relating to certain high-cost refinance mort-
gage loans, including prepayment penalties, negative amortization, and balloon pay-
 SUBPRIME LENDING 

ments with a term of less than five years. The legislation also prohibited lenders from
making high-cost refinance loans based on the collateral value of the property alone
and “without regard to the consumers’ repayment ability, including the consumers’
current and expected income, current obligations, and employment.” However, only
a small percentage of mortgages were initially subject to the HOEPA restrictions, be-
cause 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 , two years after HOEPA took effect, the Fed held the first set of pub-
lic hearings required under the act. The venues were Los Angeles, Atlanta, and Wash-
ington, 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 , 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 op-
portunity for widespread abuses. The report stated, “Creditors that package and se-
curitize 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 , it formalized
its long-standing policy of “not routinely conducting consumer compliance examina-
tions of nonbank subsidiaries of bank holding companies,” a decision that would be
criticized by a November  General Accounting Office report for creating a “lack
of regulatory oversight.” The July  report also made recommendations on
mortgage reform. While preparing draft recommendations for the report, Fed staff
wrote to the Fed’s Committee on Consumer and Community Affairs that “given the
Board’s traditional reluctance to support substantive limitations on market behavior,
the draft report discusses various options but does not advocate any particular ap-
proach to addressing these problems.”
In the end, although the two agencies did not agree on the full set of recommen-
dations 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 commu-
nity outreach efforts and consumer education and counseling. But Congress did not
act on these recommendations.
The Fed-Lite provisions under the Gramm-Leach-Bliley Act affirmed the Fed’s
hands-off approach to the regulation of mortgage lending. Even so, the shakeup in
the subprime industry in the late s 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 , .
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 examina-
tions. It explained that “recent turmoil in the equity and asset-backed securities mar-
ket has caused some non-bank subprime specialists to exit the market, thus creating
increased opportunities for financial institutions to enter, or expand their participa-
tion 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 , 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 associa-
tions representing mortgage lenders, brokers, and appraisers; local and state officials;
and academics. As the Fed had done three years earlier, this new entity took to the
field, conducting hearings in Atlanta, Los Angeles, New York, Baltimore, and
Chicago. The task force found “patterns” of abusive practices, reporting “substantial
evidence of too-frequent abuses in the subprime lending market.” Questionable prac-
tices included loan flipping (repeated refinancing of borrowers’ loans in a short
time), high fees and prepayment penalties that resulted in borrowers’ losing the eq-
uity in their homes, and outright fraud and abuse involving deceptive or high-pres-
sure 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, mi-
norities, 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.
Consumer protection groups took the same message to public officials. In inter-
views 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 agen-
cies multiple times about their concerns over unfair and deceptive lending prac-
tices. “It was apparent on the ground as early as ’ or ’ . . . that the market for
low-income consumers was being flooded with inappropriate products,” Diane
Thompson of the NCLC told the Commission.
The HUD-Treasury task force recommended a set of reforms aimed at protecting
 SUBPRIME LENDING 

borrowers from the most egregious practices in the mortgage market, including bet-
ter disclosure, improved financial literacy, strengthened enforcement, and new leg-
islative 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 re-
port as a senior Treasury official and is currently the chairman of the Commodity Fu-
tures Trading Commission, told the FCIC that the report’s recommendations “lasted
on Capitol Hill a very short time. . . . There wasn’t much appetite or mood to take
these recommendations.”
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  to . In testimony to the Commission, she observed that
these poor-quality loans pulled market share from traditional banks and “created
negative competitive pressure for the banks and thrifts to start following suit.” She
added,

[Subprime lending] was started and the lion’s share of it occurred in the
nonbank sector, but it clearly created competitive pressures on
banks. . . . I think nipping this in the bud in  and  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 re-
pay 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 mort-
gage 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 op-
portunity 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 con-
cerns, to enlist his help in getting companies to abide by these rules. Bair said that
Gramlich didn’t talk out of school but made it clear to her that the Fed avenue wasn’t
going to happen. Similarly, Sandra Braunstein, the director of the Division of Con-
sumer 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 , three of every
four subprime mortgages was a first mortgage, and of those  were used for refi-
nancing rather than a home purchase. Fifty-nine percent of those refinancings were
cash-outs, helping to fuel consumer spending while whittling away homeowners’
equity.
 PART III

The Boom and Bust

 6
CREDIT EXPANSION

CONTENTS
Housing: “A powerful stabilizing force” ................................................................
Subprime loans: “Buyers will pay a high premium” .............................................
Citigroup: “Invited regulatory scrutiny” ...............................................................
Federal rules: “Intended to curb unfair or abusive lending” .................................
States: “Long-standing position”...........................................................................
Community-lending pledges: “What we do is reaffirm our intention” .................
Bank capital standards: “Arbitrage” .....................................................................

By the end of , the economy had grown  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, pro-
tected from catastrophe by sophisticated new techniques of managing risk.
The housing market was also strong. Between  and , prices rose at an an-
nual rate of .; over the next five years, the rate would hit .. Lower interest
rates for mortgage borrowers were partly the reason, as was greater access to mort-
gage 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, borrow-
ing against the equity. The effect was unprecedented debt: between  and ,
mortgage debt nationally nearly doubled. Household debt rose from  of dispos-
able personal income in  to almost  by mid-. More than three-quarters


 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

of this increase was mortgage debt. Part of the increase was from new home pur-
chases, 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  and
. Afterward, the biggest banks moved in. In , Citigroup, with  billion in
assets, paid  billion for Associates First Capital, the second-biggest subprime
lender. Still, subprime lending remained only a niche, just . of new mortgages
in .
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  the Fed
fined Citigroup  million for lending violations, it only minimally revised the rules
for a narrow set of high-cost mortgages. Following losses by several banks in sub-
prime securitization, the Fed and other regulators revised capital standards.

HOUSING: “A POWERFUL STABILIZING FORCE”

By the beginning of , the economy was slowing, even though unemployment re-
mained at a -year low of . To stimulate borrowing and spending, the Federal
Reserve’s Federal Open Market Committee lowered short-term interest rates aggres-
sively. On January , , 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 cut-
ting throughout the year— times in all—to ., the lowest in  years.
In the end, the recession of  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 .. 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 . “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 -year lows, housing kicked into
high gear—again. The nation would lose more than , nonfarm jobs in 
but make small gains in construction. In states where bubbles soon appeared, con-
struction picked up quickly. California ended  with a total of only , more
jobs, but with , new construction jobs. In Florida,  of net job growth was in
construction. In , builders started more than . million single-family dwellings,
a rate unseen since the late s. From  to , residential construction con-
tributed three times more to the economy than it had contributed on average since
.
 C R E D I T E X PA N S I O N 

But elsewhere the economy remained sluggish, and employment gains were frus-
tratingly small. Experts began talking about a “jobless recovery”—more production
without a corresponding increase in employment. For those with jobs, wages stag-
nated. Between  and , weekly private nonfarm, nonsupervisory wages actu-
ally fell by  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 con-
cerned, the Fed believed deflation would be avoided. In a widely quoted  speech,
Bernanke said the chances of deflation were “extremely small” for two reasons. First,
the economy’s natural resilience: “Despite the adverse shocks of the past year, our
banking system remains healthy and well-regulated, and firm and household balance
sheets are for the most part in good shape.” Second, the Fed would not allow it. “I am
confident that the Fed would take whatever means necessary to prevent significant
deflation in the United States. . . . [T]he U.S. government has a technology, called a
printing press (or, today, its electronic equivalent), that allows it to produce as many
U.S. dollars as it wishes at essentially no cost.”
The Fed’s monetary policy kept short-term interest rates low. During , the
strongest U.S. companies could borrow for  days in the commercial paper market
at an average ., compared with . just three years earlier; rates on three-month
Treasury bills dropped below  in mid- from  in .
Low rates cut the cost of homeownership: interest rates for the typical -year
fixed-rate mortgage traditionally moved with the overnight fed funds rate, and from
 to , this relationship held (see figure .). By , creditworthy home buy-
ers could get fixed-rate mortgages for .,  percentage points lower than three
years earlier. The savings were immediate and large. For a home bought at the me-
dian price of ,, with a  down payment, the monthly mortgage payment
would be  less than in . Or to turn the perspective around—as many people
did—for the same monthly payment of ,, a homeowner could move up from a
, home to a , one.
An adjustable-rate mortgage (ARM) gave buyers even lower initial payments or
made a larger house affordable—unless interest rates rose. In , just  of prime
borrowers with new mortgages chose ARMs; in ,  did. In , the propor-
tion rose to . Among subprime borrowers, already heavy users of ARMs, it rose
from around  to .
As people jumped into the housing market, prices rose, and in hot markets they
really took off (see figure .). In Florida, average home prices gained . annually
from  to  and then . annually from  to . In California, those
numbers were even higher: . and .. In California, a house bought for
, in  was worth , nine years later. However, soaring prices were
not necessarily the norm. In Washington State, prices continued to appreciate, but
more slowly: . annually from  to , . annually from  to . In
Ohio, the numbers were . and .. Nationwide, home prices rose . annu-
ally from  to —historically high, but well under the fastest-growing
markets.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Bank Borrowing and Mortgage Interest Rates

Rates for both banks and homeowners have been low in recent years.
IN PERCENT
20%

15

10

30-year
conventional
5 mortgage rate

0 Effective
federal funds
1975 1980 1985 1990 1995 2000 2005 2010 rate

SOURCE: Federal Reserve Bank of St. Louis, Federal Reserve Economic Database

Figure .

Homeownership increased steadily, peaking at . of households in . Be-

cause 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  of
households by net worth, of whom  owned their homes, saw the value of their
primary residences rise between  and  from , to , (adjusted
for inflation), an increase of more than ,. Median net worth for all households
in the top , after accounting for other housing value and assets, as well as all lia-
bilities, was . million in . Homeownership rates for the bottom  of house-
holds ticked up from  to  between  and ; the median value of their
primary residences rose from , to ,, an increase of more than ,.
Median net worth for households in the bottom  was , in .
Historically, every , increase in housing wealth boosted consumer spending
by an estimated  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 equity.
Higher home prices and low mortgage rates brought a wave of refinancing to the
prime mortgage market. In  alone, lenders refinanced over  million mort-
gages, more than one in four—an unprecedented level. Many homeowners took out
cash while cutting their interest rates. From  through , cash-out refinanc-
 C R E D I T E X PA N S I O N 

U.S. Home Prices

INDEX VALUE: JANUARY 2000 = 100

300
Sand states U.S. April 2006 201
250 U.S. total
Non-sand states
200
150
100
U.S. August 2010 145
50
0
1976 1980 1985 1990 1995 2000 2005 2010

NOTE: Sand states are Arizona, California, Florida, and Nevada.

SOURCE: CoreLogic and U.S. Census Bureau: 2007 American Community Survey, FCIC calculations

Figure .

ings netted these households an estimated  billion; homeowners accessed an-
other  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 conven-
ience of an actual plastic card.
According to the Fed’s  Survey of Consumer Finances, . of homeowners
who tapped their equity used that money for expenses such as medical bills, taxes, elec-
tronics, and vacations, or to consolidate debt; another . used it for home improve-
ments; and the rest purchased more real estate, cars, investments, clothing, or jewelry.
A Congressional Budget Office paper from  reported on the recent history:
“As housing prices surged in the late s and early s, consumers boosted their
spending faster than their income rose. That was reflected in a sharp drop in the per-
sonal savings rate.” Between  and , increased consumer spending ac-
counted for between  and  of GDP growth in any year—rising above 
in years when spending growth offset declines elsewhere in the economy. Meanwhile,
the personal saving rate dropped from . to .. 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 , it had weathered the brief re-
cession of  and the dot-com bust, which had caused the largest loss of wealth in
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

decades. With new financial products like the home equity line of credit, households
could borrow against their homes to compensate for investment losses or unemploy-
ment. Deflation, against which the Fed had struck preemptively, did not materialize.
At a congressional hearing in November , 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 stim-
ulated the economy by encouraging home sales and housing starts with “mortgage
interest rates that are at lows not seen in decades.” As Greenspan explained, “Mort-
gage markets have also been a powerful stabilizing force over the past two years of
economic distress by facilitating the extraction of some of the equity that home-
owners had built up.” In February , he reiterated his point, referring to “a large
extraction of cash from home equity.”

SUBPRIME LOANS: “BUYERS WILL PAY A HIGH PREMIUM”

The subprime market roared back from its shakeout in the late s. The value of
subprime loans originated almost doubled from  through , to  billion.
In ,  of these were securitized; in , . Low interest rates spurred this
boom, which would have long-term repercussions, but so did increasingly wide-
spread computerized credit scores, the growing statistical history on subprime bor-
rowers, 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 , the top  subprime
lenders made  of all subprime loans, up from  in .
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—Citi-
group, National City Bank, HSBC, and Washington Mutual—spent billions on boost-
ing 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.
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. For-
mer 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 dis-
tribute. 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 differ-
ent domestic lenders between  and , including BNC and Aurora. Bear
Stearns, the fifth-largest, ramped up its subprime lending arm and eventually ac-
quired three subprime originators in the United States, including Encore. In ,
Merrill Lynch acquired First Franklin, and Morgan Stanley bought Saxon Capital; in
, Goldman Sachs upped its stake in Senderra Funding, a small subprime lender.
Meanwhile, several independent mortgage companies took steps to boost growth.
 C R E D I T E X PA N S I O N 

New Century and Ameriquest were especially aggressive. New Century’s “Focus
” 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 , New Century sold . bil-
lion in whole loans, up from . billion three years before, launching the firm from
tenth to second place among subprime originators. Three-quarters went to two secu-
ritizing 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 . The company cut costs elsewhere in the origina-
tion 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
. what competing originators charged securitizing firms, according to an indus-
try analyst’s estimate. Between  and , Ameriquest loan origination rose
from an estimated  billion to  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 . By , Countrywide
was third on the list.
The subprime players followed diverse strategies. Lehman and Countrywide pur-
sued 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 other-
wise—known as originate-to-distribute—they no longer risked losses if the loan de-
faulted. As long as they made accurate representations and warranties, the only risk
was to their reputations if a lot of their loans went bad—but during the boom, loans
were not going bad. In total, this originate-to-distribute pipeline carried more than
half of all mortgages before the crisis, and a much larger piece of subprime mortgages.
For decades, a version of the originate-to-distribute model produced safe mort-
gages. Fannie and Freddie had been buying prime, conforming mortgages since the
s, 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 re-
sponsible to anybody,” Lewis Ranieri, an early leader in securitization, told the FCIC,
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 self-evident.”
The starting point for many mortgages was a mortgage broker. These independ-
ent 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 ex-
tended 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 be-
lieved 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 for-
mer 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 
of borrowers with adjustable-rate mortgages did not understand how much their in-
terest 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- and end up with a no-doc loan simply because the broker was getting
paid more and the lender was getting paid more and there was extra yield left over for
Wall Street because the loan carried a higher interest rate.”
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 ac-
counts, making late credit card payments, or exceeding limits on credit card charges,”
Annamaria Lusardi, a professor of economics at Dartmouth College, told the FCIC.
“Comparing terms of financial contracts and shopping around before making finan-
cial decisions are not at all common among the population.”
Recall our case study securitization deal discussed earlier—in which New Cen-
tury sold , mortgages to Citigroup, which then sold them to the securitization
trust, which then bundled them into  tranches for sale to investors. Out of those
, mortgages, brokers originated , on behalf of New Century. For each, the
 C R E D I T E X PA N S I O N 

brokers received an average fee from the borrowers of ,, or . of the loan
amount. On top of that, the brokers also received yield spread premiums from New
Century for , of these loans, averaging , each. In total, the brokers received
more than . million in fees for the , loans.
Critics argued that with this much money at stake, mortgage brokers had every in-
centive 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 hous-
ing and mortgage market boomed, so did the brokers. Wholesale Access, which tracks
the mortgage industry, reported that from  to , the number of brokerage
firms rose from about , to ,. In , brokers originated  of loans; in
, they peaked at . JP Morgan CEO Jamie Dimon testified to the FCIC that
his firm eventually ended its broker-originated business in  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 , that an appraiser
says is actually worth only ,. In this case, a bank won’t lend a borrower, say,
, to buy the home. The deal dies. Sure enough, appraisers began feeling pres-
sure. One  survey found that  of the appraisers had felt pressed to inflate the
value of homes; by , this had climbed to . The pressure came most fre-
quently 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 ap-
praisal meant losing the client. Dennis J. Black, president of the Florida appraisal
and brokerage services firm D. J. Black & Co. and an appraiser with  years’ experi-
ence, held continuing education sessions all over the country for the National Associ-
ation 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  years’ experience, explained in testi-
mony to the FCIC. In , 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
, to , the minimum home value at which an appraisal from a li-
censed professional was required. In addition, Mann cited the lack of oversight of ap-
praisers, noting, “We had a vast increase of licensed appraisers in [California] in spite
of the lack of qualified/experienced trainers.” The Bakersfield appraiser Gary Crab-
tree told the FCIC that California’s Office of Real Estate Appraisers had eight investi-
gators to supervise , appraisers.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

In , 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  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 pro-
duction staff “hand-pick appraisers who bring in appraisal values high enough to
permit WaMu’s loans to close, and improperly permit[ted] WaMu to pressure . . .
appraisers to change appraisal values that are too low to permit loans to close.”

CITIGROUP: “INVITED REGULATORY SCRUTINY”

As subprime originations grew, Citigroup decided to expand, with troubling conse-
quences. Barely a year after the Gramm-Leach-Bliley Act validated its  merger
with Travelers, Citigroup made its next big move. In September , it paid  bil-
lion for Associates First, then the second-largest subprime lender in the country (af-
ter 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 Associ-
ates First, including high prepayment penalties, excessive fees, and other opaque
charges in loan documents—all targeting unsophisticated borrowers who typically
could not evaluate the forms. “It’s simply unacceptable to have the largest bank in
America take over the icon of predatory lending,” said Martin Eakes, founder of a
nonprofit community lender in North Carolina.
Advocates for the merger argued that a large bank under a rigorous regulator
could reform the company, and Citigroup promised to take strong actions. Regula-
tors approved the merger in November , 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 [con-
troversial] cases,” said Pam Flaherty, a Citigroup senior vice president for community
relations and outreach.
The merger exposed Citigroup to enhanced regulatory scrutiny. In , the Fed-
eral Trade Commission, which regulates independent mortgage companies’ compli-
ance with consumer protection laws, launched an investigation into Associates First’s
premerger business and found that the company had pressured borrowers to refi-
nance into expensive mortgages and to buy expensive mortgage insurance. In ,
Citigroup reached a record  million civil settlement with the FTC over Associ-
ates’ “systematic and widespread deceptive and abusive lending practices.”
In , the New York Fed used the occasion of Citigroup’s next proposed acqui-
sition—European American Bank on Long Island, New York—to launch its own in-
 C R E D I T E X PA N S I O N 

vestigation of CitiFinancial, which now contained Associates First. “The manner in

which [Citigroup] approached that transaction invited regulatory scrutiny,” former
Fed Governor Mark Olson told the FCIC. “They bought a passel of problems for
themselves and it was at least a two-year [issue].” The Fed eventually accused Citi-
Financial of converting unsecured personal loans (usually for borrowers in financial
trouble) into home equity loans without properly assessing the borrower’s ability to
repay. Reviewing lending practices from  and , 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  assessed  million in penalties. The company said it expected to pay an-
other  million in restitution to borrowers.

FEDERAL RULES:
“INTENDED TO CURB UNFAIR OR ABUSIVE LENDING”
As Citigroup was buying Associates First in , 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 subse-
quently 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, de-
ception, or misrepresentations.
Despite evidence of predatory tactics from their own hearings and from the re-
cently released HUD-Treasury report, Fed officials remained divided on how aggres-
sively to strengthen borrower protections. They grappled with the same trade-off that
the HUD-Treasury report had recently noted. “We want to encourage the growth in
the subprime lending market,” Fed Governor Edward Gramlich remarked at the Fi-
nancial Services Roundtable in early . “But we also don’t want to encourage the
abuses; indeed, we want to do what we can to stop these abuses.” Fed General Coun-
sel 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 appro-
priate underwriting standards, should not necessarily be regarded as improper,” he
said, “and on the contrary facilitated the national policy of making homeownership
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

more broadly available.” Instead, at least for certain violations of consumer protec-
tion laws, he suggested another approach: “If there is egregious fraud, if there is egre-
gious 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  to the end of Greenspan’s tenure in , the Fed re-
ferred to the Justice Department only three institutions for fair lending violations re-
lated to mortgages: First American Bank, in Carpentersville, Illinois; Desert
Community Bank, in Victorville, California; and the New York branch of Société
Générale, a large French bank.
Fed officials rejected the staff proposals. After some wrangling, in December 
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 unnec-
essary 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  to as much as  un-
der the new regulations. But lenders changed the terms of mortgages to avoid the
new rules’ revised interest rate and fee triggers. By late , it was clear that the new
regulations would end up covering only about  of subprime loans. Nevertheless,
reflecting on the Federal Reserve’s efforts, Greenspan contended in an FCIC inter-
view 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 , the staff of the Fed’s Division of Consumer and Com-
munity 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 ex-
plicitly give the Fed enforcement authority in this area.
The Fed resisted routine examinations of these companies, and despite the sup-
port 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 direc-
tor, 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
 C R E D I T E X PA N S I O N 

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 mis-
leading message to the firms and the market; if you examine an organization incom-
pletely, 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 sub-
ject 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 super-
vision of all subprime lenders—including units of banks, thrifts, bank holding com-
panies, 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 , Gramlich told the Wall Street Journal
that he privately urged Greenspan to clamp down on predatory lending. Greenspan
demurred and, lacking support on the board, Gramlich backed away. Gramlich told
the Journal, “He was opposed to it, so I did not really pursue it.” (Gramlich died in
 of leukemia, at age .)
The Fed’s failure to stop predatory practices infuriated consumer advocates and
some members of Congress. Critics charged that accounts of abuses were brushed off
as anecdotal. Patricia McCoy, a law professor at the University of Connecticut who
served on the Fed’s Consumer Advisory Council between  and , was famil-
iar 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 
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  HUD-Treasury report and
reports issued by the General Accounting Office in  and . The Fed did not
begin routinely examining subprime subsidiaries until a pilot program in July ,
under new chairman Ben Bernanke. The Fed did not issue new rules under HOEPA
until July , 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

to pay, and required companies to verify income and assets. The rules would not take
effect until October , , 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 identi-
fied problem. . . . We were in the reactive mode because that’s what the mind-set was
of the ‘s and the early s.” The strong housing market also reassured people. Al-
varez noted the long history of low mortgage default rates and the desire to help
people who traditionally had few dealings with banks become homeowners.

STATES: “LONGSTANDING 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 , North Carolina led the way, establishing a fee trigger of : that is, for
the most part any mortgage with points and fees at origination of more than  of
the loan qualified as “high-cost mortgage” subject to state regulations. This was con-
siderably lower than the  set by the Fed’s  HOEPA regulations. Other provi-
sions addressed an even broader class of loans, banning prepayment penalties for
mortgage loans under , and prohibiting repeated refinancing, known as loan
“flipping.”
These rules did not apply to federally chartered thrifts. In , the Office of
Thrift Supervision reasserted its “long-standing position” that its regulations “occupy
the entire field of lending regulation for federal savings associations, leaving no room
for state regulation.” Exempting states from “a hodgepodge of conflicting and over-
lapping state lending requirements,” the OTS said, would let thrifts deliver “low-cost
credit to the public free from undue regulatory duplication and burden.” Meanwhile,
“the elaborate network of federal borrower-protection statutes” would protect
consumers.
Nevertheless, other states copied North Carolina’s tactic. State attorneys general
launched thousands of enforcement actions, including more than , in 
alone. By ,  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 , for example, a suit by Illinois, Massachusetts, and
Minnesota recovered more than  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  million in penalties and restitu-
tion to consumers. In , a coalition of  states and the District of Columbia
settled with Ameriquest for  million and required the company to follow restric-
tions on its lending practices.
As we will see, however, these efforts would be severely hindered with respect to
national banks when the OCC in  officially joined the OTS in constraining states
 C R E D I T E X PA N S I O N 

from taking such actions. “The federal regulators’ refusal to reform [predatory] prac-
tices and products served as an implicit endorsement of their legality,” Illinois Attor-
ney General Lisa Madigan testified to the Commission.

COMMUNITYLENDING PLEDGES:
“WHAT WE DO IS REAFFIRM OUR INTENTION”
While consumer groups unsuccessfully lobbied the Fed for more protection against
predatory lenders, they also lobbied the banks to invest in and loan to low- and mod-
erate-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 ; 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 st century. One of the most notable promises was
made by Citigroup soon after its merger with Travelers in : a  billion lending
and investment commitment, some of which would include mortgages. Later, Citi-
group made a  billion commitment when it acquired California Federal Bank in
. When merging with FleetBoston Financial Corporation in , Bank of Amer-
ica announced its largest commitment to date:  billion over  years. Chase an-
nounced commitments of . billion and  billion, respectively, in its mergers
with Chemical Bank and Bank One. The National Community Reinvestment Coali-
tion, an advocacy group, eventually tallied more than . trillion in commitments
from  to ; 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 com-
mitments.” In response, the banks indicated they had fulfilled most promises. Ac-
cording to the documents provided, the value of commitments to community groups
was much smaller than the larger unilateral pledges by the banks. Further, the
pledges generally covered broader categories than did the CRA, including mortgages
to minority borrowers and to borrowers with up-to-median income. For example,
only  of the mortgages made under JP Morgan’s  billion “community devel-
opment 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

income and weak or subprime credit are not the same. In fact, Citigroup’s  pledge
of  billion in mortgage lending “consisted of entirely prime loans” to low- and
moderate-income households, low- and moderate-income neighborhoods, and mi-
nority borrowers. These loans performed well. JP Morgan’s largest commitment to a
community group was to the Chicago CRA Coalition:  billion in loans over 
years. Of loans issued between  and , fewer than  have been -or-more-
days delinquent, even as of late . Wachovia made  billion in mortgage loans
between  and  under its  billion in unilateral pledges: only about .
were ever more than  days delinquent over the life of the loan, compared with an
estimated national average of . The better performance was partly the result of
Wachovia’s lending concentration in the relatively stable Southeast, and partly a re-
flection 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 , when the board denied Continental Bank’s applica-
tion to merge with Grand Canyon State Bank, saying the bank’s commitment to im-
prove community service could not offset its poor lending record. In April , 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 con-
sidered 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 en-
force 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  changes to the CRA made it clear that the
Federal Reserve would not consider promises to third parties or enforce prior agree-
ments 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 cri-
terion.” Still, the banks highlighted past acts and assurances for the future. In ,
for example, when NationsBank said it was merging with BankAmerica, it also an-
nounced a -year,  billion initiative that included pledges of  billion for af-
fordable housing,  billion for consumer lending,  billion for small businesses,
and  and  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 , com-
ments. 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 fa-
cilitated, monitored, judged, required, or enforced agreements or specific portions of
agreements. . . . NationsBank remains obligated to meet the credit needs of its entire
 C R E D I T E X PA N S I O N 

community, including [low- and moderate-income] areas, with or without private

agreements.”
In its public order approving the merger, the Federal Reserve mentioned the com-
mitment 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 demon-
strated 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  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 con-
tinue to lend and invest so that the communities where we live and work will con-
tinue 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 commu-
nity groups had the assurance that they would.

BANK CAPITAL STANDARDS: “ARBITRAGE”

Although the Federal Reserve had decided against stronger protections for con-
sumers, it internalized the lessons of  and , when the first generation of sub-
prime lenders put themselves at serious risk; some, such as Keystone Bank and
Superior Bank, collapsed when the values of the subprime securitized assets they
held proved to be inflated. In response, the Federal Reserve and other regulators re-
worked the capital requirements on securitization by banks and thrifts.
In October , they introduced the “Recourse Rule” governing how much capi-
tal 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  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 cap-
ital charge on residual interests , 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.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

The Recourse Rule also imposed a new framework for asset-backed securities.
The capital requirement would be directly linked to the rating agencies’ assessment
of the tranches. Holding securities rated AAA or AA required far less capital than
holding lower-rated investments. For example,  invested in AAA or AA mort-
gage-backed securities required holding only . in capital (the same as for securi-
ties backed by government-sponsored enterprises). But the same amount invested in
anything with a BB rating required  in capital, or  times more.
Banks could reduce the capital they were required to hold for a pool of mortgages
simply by securitizing them, rather than holding them on their books as whole loans.
If a bank kept  in mortgages on its books, it might have to set aside about , in-
cluding  in capital against unexpected losses and  in reserves against expected
losses. But if the bank created a  mortgage-backed security, sold that security in
tranches, and then bought all the tranches, the capital requirement would be about
.. “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 , in an
FCIC interview. But “it is not the only thing that matters.”
And a final comparison: under bank regulatory capital standards, a  triple-A
corporate bond required  in capital—five times as much as the triple-A mortgage-
backed security. Unlike the corporate bond, it was ultimately backed by real estate.
The new requirements put the rating agencies in the driver’s seat. How much
capital a bank held depended in part on the ratings of the securities it held. Tying
capital standards to the views of rating agencies would come in for criticism after
the crisis began. It was “a dangerous crutch,” former Treasury Secretary Henry
Paulson testified to the Commission. 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 ar-
guing 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 oc-
cur 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.
 C R E D I T E X PA N S I O N 

COMMISSION CONCLUSIONS ON CHAPTER 6

The Commission concludes that there was untrammeled growth in risky mort-
gages. Unsustainable, toxic loans polluted the financial system and fueled the
housing bubble.
Subprime lending was supported in significant ways by major financial insti-
tutions. Some firms, such as Citigroup, Lehman Brothers, and Morgan Stanley,
acquired subprime lenders. In addition, major financial institutions facilitated the
growth in subprime mortgage–lending companies with lines of credit, securitiza-
tion, purchase guarantees and other mechanisms.
Regulators failed to rein in risky home mortgage lending. In particular, the
Federal Reserve failed to meet its statutory obligation to establish and maintain
prudent mortgage lending standards and to protect against predatory lending.
 7
THE MORTGAGE MACHINE

CONTENTS
Foreign investors: “An irresistible profit opportunity” .........................................
Mortgages: “A good loan” ...................................................................................
Federal regulators: “Immunity from many state laws is a significant benefit” ....
Mortgage securities players: “Wall Street was very hungry for our product” ......
Moody’s: “Given a blank check”..........................................................................
Fannie Mae and Freddie Mac: “Less competitive in the marketplace”................

In , commercial banks, thrifts, and investment banks caught up with Fannie
Mae and Freddie Mac in securitizing home loans. By , they had taken the lead.
The two government-sponsored enterprises maintained their monopoly on securitiz-
ing 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 mar-
ket—“subprime” loans for borrowers with weak credit and “Alt-A” loans, with charac-
teristics riskier than prime loans, to borrowers with strong credit.
By  and , 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 , reaching . trillion in ;  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
higher-yield mortgages—those loans made to subprime borrowers, those with non-
traditional 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 hind-
sight, more and more of it was of lower and lower quality. And at the end of that


 T H E MORTG AG E M AC H I N E 

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 obvi-
ously participated in that flow of activity.”
The origination and securitization of these mortgages also relied on short-term fi-
nancing from the shadow banking system. Unlike banks and thrifts with access to de-
posits, 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 al-
ready up  from  to , this flood of money and the securitization appara-
tus helped boost home prices another  from the beginning of  until the peak
in April —even as homeownership was falling. The biggest gains over this pe-
riod were in the “sand states”: places like the Los Angeles suburbs (), Las Vegas
(), and Orlando ().

FOREIGN INVESTORS:
“AN IRRESISTIBLE PROFIT OPPORTUNITY”
From June  through June , the Federal Reserve kept the federal funds rate
low at  to stimulate the economy following the  recession. Over the next two
years, as deflation fears waned, the Fed gradually raised rates to . in  quarter-
point increases.
In the view of some, the Fed simply kept rates too low too long. John Taylor, a
Stanford economist and former under secretary of treasury for international affairs,
blamed the crisis primarily on this action. If the Fed had followed its usual pattern,
he told the FCIC, short-term interest rates would have been much higher, discourag-
ing 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 long-term rates had become de-linked. “Between  and , the fed
funds rate and the mortgage rate moved in lock-step,” Greenspan said. When the
Fed started to raise rates in , officials expected mortgage rates to rise, too, slow-
ing growth. Instead, mortgage rates continued to fall for another year. The construc-
tion industry continued to build houses, peaking at an annualized rate of . million
starts in January —more than a -year high.
As Greenspan told Congress in , 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 coun-
tries placed their savings in apparently safe and high-yield securities in the United
States. Fed Chairman Bernanke called it a “global savings glut.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

As the United States ran a large current account deficit, flows into the country
were unprecedented. Over six years from  to , U.S. Treasury debt held by
foreign official public entities rose from . trillion to . trillion; as a percentage
of U.S. debt held by the public, these holdings increased from . to .. For-
eigners also bought securities backed by Fannie and Freddie, which, with their im-
plicit government guarantee, seemed nearly as safe as Treasuries. As the Asian
financial crisis ended in , foreign holdings of GSE securities held steady at the
level of almost  years earlier, about  billion. By —just two years later—
foreigners owned  billion in GSE securities; by ,  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 pour-
ing from the Wall Street mortgage securitization machine. As overseas demand drove
up prices for securitized debt, it “created an irresistible profit opportunity for the U.S.
financial system: to engineer ‘quasi’ safe debt instruments by bundling riskier assets
and selling the senior tranches,” Pierre-Olivier Gourinchas, an economist at the Uni-
versity of California, Berkeley, told the FCIC.
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.

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 ag-
gressive, mortgage products that brought higher yields for investors but correspond-
ingly greater risks for borrowers. “Holding a subprime loan has become something of
a high-stakes wager,” the Center for Responsible Lending warned in .
Subprime mortgages rose from  of mortgage originations in  to  in
.About  of subprime borrowers used hybrid adjustable-rate mortgages
(ARMs) such as /s and /s—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  from  to . In general, these loans made borrowers’ monthly
 T H E MORTG AG E M AC H I N E 

mortgage payments on ever more expensive homes affordable—at least initially. Pop-
ular 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 fixed-rate mortgage, increasing the
monthly payment—perhaps dramatically. Option ARMs rose from  of mortgages
in  to  in . 
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 
of all mortgages purchased in  to  in , and down to  by . Tak-
ing their place were private-label securitizations—meaning those not issued and
guaranteed by the GSEs.
In this new market, originators competed fiercely; Countrywide Financial Corpo-
ration took the crown. It was the biggest mortgage originator from  until the
market collapsed in . 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 -year-old company to the Commission as
having helped  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 dif-
ference 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.” Countrywide’s essential business strategy was
“originating what was salable in the secondary market.” The company sold or secu-
ritized  of the . trillion in mortgages it originated between  and .
In , Mozilo announced a very aggressive goal of gaining “market dominance”
by capturing  of the origination market. His share at the time was . But Coun-
trywide was not unique: Ameriquest, New Century, Washington Mutual, and others all
pursued loans as aggressively. They competed by originating types of mortgages cre-
ated years before as niche products, but now transformed into riskier, mass-market ver-
sions. “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.

/s and /s: “Adjust for the affordability”

Historically, /s or /s, also known as hybrid ARMs, let credit-impaired borrow-
ers 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

could double or even triple, leaving borrowers with few alternatives: if they had es-
tablished 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 default.
But as house prices rose after , the /s and /s acquired a new role: help-
ing 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 securitiza-
tion market.
Consumer protection groups such as the Leadership Conference on Civil Rights
railed against /s and /s, which, they said, neither rehabilitated credit nor
turned renters into owners. David Berenbaum from the National Community Rein-
vestment Coalition testified to Congress in the summer of : “The industry has
flooded the market with exotic mortgage lending such as / and / 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 low-income borrowers. The loans came with big fees that got rolled
into the mortgage, increasing the chances that the mortgage could be larger than the
home’s value at the reset date. If the borrower could not refinance, the lender would
foreclose—and then own the home in a rising real estate market.

Option ARMs: “Our most profitable mortgage loan”

When they were originally introduced in the s, option ARMs were niche prod-
ucts, too, but by  they too became loans of choice because their payments were
lower than more traditional mortgages. During the housing boom, many borrowers
repeatedly made only the minimum payments required, adding to the principal bal-
ance of their loan every month.
An early seller of option ARMs was Golden West Savings, an Oakland, Califor-
nia–based thrift founded in  and acquired in  by Marion and Herbert San-
dler. In , the Sandlers merged Golden West with World Savings; Golden West
Financial Corp., the parent company, operated branches under the name World Sav-
ings Bank. The thrift issued about  billion in option ARMs between  and
. 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 —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 attrib-
uted Golden West’s performance to its diligence in running simulations about what
 T H E MORTG AG E M AC H I N E 

would happen to its loans under various scenarios—for example, if interest rates
went up or down or if house prices dropped , even . “For a quarter of a cen-
tury, 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  and the housing market soured, charge-offs on the Pick-a-Pay
portfolio would suddenly jump from . to . by September . And fore-
closures 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  years, or if the
principal balance grew to  of its original size, the Pick-a-Pay mortgage would
recast into a new fixed-rate mortgage. At Countrywide and Washington Mutual, the
new loans would recast in as little as five years, or when the balance hit just  of
the original size. They also offered lower teaser rates—as low as —and loan-to-
value ratios as high as . All of these features raised the chances that the bor-
rower’s required payment could rise more sharply, more quickly, and with less
cushion.
In , Washington Mutual was the second-largest mortgage originator, just
ahead of Countrywide. It had offered the option ARM since , and in , as
cited by the Senate Permanent Subcommittee on Investigations, the originator con-
ducted a study “to explore what Washington Mutual could do to increase sales of Op-
tion 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 it-
self.” The study found “the best selling point for the Option Arm” was to show con-
sumers “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 re-
marked, “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  billion in  to  billion in , 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 , 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 California.
Countrywide’s option ARM business peaked at . billion in originations in the
second quarter of , about  of all its loans originated that quarter. But it had
to relax underwriting standards to get there. In July , Countrywide decided it
would lend up to  of a home’s appraised value, up from , and reduced the
minimum credit score to as low as . In early , Countrywide eased standards
again, increasing the allowable combined loan-to-value ratio (including second liens)
to .
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

The risk in these loans was growing. From  to , the average loan-to-
value ratio rose about , the combined loan-to-value ratio rose about , and debt-
to-income ratios had risen from  to : borrowers were pledging more of their
income to their mortgage payments. Moreover,  of these two originators’ option
ARMs had low documentation in . The percentage of these loans made to in-
vestors 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  and August , 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  billion in  to  billion
in  and peaking in  at  billion. Finding these loans very profitable,
through , WaMu also retained option ARMs—more than  billion with the
bulk from California, followed by Florida. But in the end, these loans would cause
significant losses during the crisis.
Mentioning Countrywide and WaMu as tough, “in our face” competitors, John
Stumpf, the CEO, chairman, and president of Wells Fargo, recalled Wells’s decision
not to write option ARMs, even as it originated many other high-risk mortgages.
These were “hard decisions to make at the time,” he said, noting “we did lose revenue,
and we did lose volume.”
Across the market, the volume of option ARMs had risen nearly fourfold from
 to , from approximately  billion to  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  in  to  in  and
then to more than  by . At WaMu, it was  in ,  in , and 
in . Declines in house prices added to borrowers’ problems: any equity remain-
ing after the negative amortization would simply be eroded. Increasingly, borrowers
would owe more on their mortgages than their homes were worth on the market, giv-
ing them an incentive to walk away from both home and mortgage.
Kevin Stein, from the California Reinvestment Coalition, testified to the FCIC
that option ARMs were sold inappropriately: “Nowhere was this dynamic more
clearly on display than in the summer of  when the Federal Reserve convened
 T H E MORTG AG E M AC H I N E 

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 sig-
nificantly 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, de-
scribed the borrowers she was assisting as “people who got steered or defrauded into
entering option ARMs with teaser rates or pick-a-pay loans forcing them to pay
into—pay loans that they could never pay off. Prevalent among these clients are
seniors, people of color, people with disabilities, and limited English speakers and
seniors who are African American and Latino.”

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  (in other words, the loan-to-value ratio (LTV) had
been ). As prices continued to rise, finding the cash to put  down became
harder, and from  on, lenders began accepting smaller down payments.
There had always been a place for borrowers with down payments below .
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  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 , 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 stan-
dards, 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 consequences.”
In , 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  that lacked mortgage insurance or some other protection; they also
reminded the banks and thrifts that they should establish internal guidelines to man-
age the risk of these loans.
High LTV lending soon became even more common, thanks to the so-called
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

piggyback mortgage. The lender offered a first mortgage for perhaps  of the
home’s value and a second mortgage for another  or even . Borrowers liked
these because their monthly payments were often cheaper than a traditional mort-
gage plus the required mortgage insurance, and the interest payments were tax de-
ductible. 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 com-
bined 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. How-
ever, 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 , by September  those with piggybacks were four times as likely as other
mortgage holders to be  or more days delinquent. When senior management at
New Century heard these numbers, the head of the Secondary Marketing Depart-
ment asked for “thoughts on what to do with this . . . pretty compelling” information.
Nonetheless, New Century increased mortgages with piggybacks to  of loan pro-
duction by the end of , up from only  in . They were not alone. Across
securitized subprime mortgages, the average combined LTV rose from  to 
between  and .
Another way to get people into mortgages—and quickly—was to require less in-
formation of the borrower. “Stated income” or “low-documentation” (or sometimes
“no-documentation”) loans had emerged years earlier for people with fluctuating or
hard-to-verify incomes, such as the self-employed, or to serve longtime customers
with strong credit. Or lenders might waive information requirements if the loan
looked safe in other respects. “If I’m making a , ,  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 , however, low- and no-documentation loans took on an entirely dif-
ferent character. Nonprime lenders now boasted they could offer borrowers the con-
venience of quicker decisions and not having to provide tons of paperwork. In
return, they charged a higher interest rate. The idea caught on: from  to ,
low- and no-doc loans skyrocketed from less than  to roughly  of all outstand-
ing loans. Among Alt-A securitizations,  of loans issued in  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
 T H E MORTG AG E M AC H I N E 

loans as “an open ‘invitation to fraud’ that justified the industry term ‘liar’s loans.’”
Speaking of lending up to  at Citigroup, Richard Bowen, a veteran banker in the
consumer lending group, told the FCIC, “A decision was made that ‘We’re going to
have to hold our nose and start buying the stated product if we want to stay in busi-
ness.’” 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 for-
ever 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 ev-
idence is present in our case study mortgage-backed security, CMLTI -NC,
whose loans have many of the characteristics just described.
The , loans bundled in this deal were adjustable-rate and fixed-rate residen-
tial mortgages originated by New Century. They had an average principal balance of
,—just under the median home price of , in . The vast major-
ity had a -year maturity, and more than  were originated in May, June, and July
, just after national home prices had peaked. More than  were reportedly for
primary residences, with  for home purchases and  for cash-out refinancings.
The loans were from all  states and the District of Columbia, but more than a fifth
came from California and more than a tenth from Florida.
About  of the loans were ARMs, and most of these were /s or /s. In a
twist, many of these hybrid ARMs had other “affordability features” as well. For ex-
ample, more than  of the ARMs were interest-only—during the first two or three
years, not only would borrowers pay a lower fixed rate, they would not have to pay
any principal. In addition, more than  of the ARMs were “/ hybrid balloon”
loans, in which the principal would amortize over  years—lowering the monthly
payments even further, but as a result leaving the borrower with a final principal pay-
ment at the end of the -year term.
The great majority of the pool was secured by first mortgages; of these,  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  and .
Raising the risk a bit more,  of the mortgages were no-doc loans. The rest were
“full-doc,” 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 reg-
ulators were not on the same page.

FEDERAL REGULATORS: “IMMUNITY FROM

MANY STATE LAWS IS A SIGNIFICANT BENEFIT”
For years, some states had tried to regulate the mortgage business, especially to clamp
down on the predatory mortgages proliferating in the subprime market. The national
thrifts and banks and their federal regulators—the Office of Thrift Supervision (OTS)
and the Office of the Comptroller of the Currency (OCC), respectively—resisted the
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 , 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.
Back in  the OTS had issued rules saying federal law preempted state preda-
tory lending laws for federally regulated thrifts. In , 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
 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 pre-
serve.” In an interview that year, Hawke explained that the potential loss of regula-
tory market share for the OCC “was a matter of concern.”
In August  the OCC issued its first preemptive order, aimed at Georgia’s
mini-HOEPA statute, and in January  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  trillion said they would convert from state charters to national charters,
which increased OCC’s annual budget .
State-chartered operating subsidiaries were another point of contention in the
preemption battle. In  the OCC had adopted a regulation preempting state law
regarding state-chartered operating subsidiaries of national banks. In response, sev-
eral 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
.
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 suc-
ceeded Hawke, defended preemption, noting that “ 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 attor-
ney general of Illinois, flipped the argument around, noting that national banks and
thrifts, and their subsidiaries, were heavily involved in subprime lending. Using dif-
ferent data, she contended: “National banks and federal thrifts and . . . their sub-
 T H E MORTG AG E M AC H I N E 

sidiaries . . . were responsible for almost  percent of subprime mortgage loans, .
percent of the Alt-A loans, and  percent of the pay-option and interest-only ARMs
that were sold.” Madigan told the FCIC:

Even as the Fed was doing little to protect consumers and our financial
system from the effects of predatory lending, the OCC and OTS were
actively engaged in a campaign to thwart state efforts to avert the com-
ing 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.

Comptroller Hawke offered the FCIC a different interpretation: “While some crit-
ics 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.”

MORTGAGE SECURITIES PLAYERS:

“WALL STREET WAS VERY HUNGRY FOR OUR PRODUCT”
Subprime and Alt-A mortgage–backed securities depended on a complex supply
chain, largely funded through short-term lending in the commercial paper and repo
market—which would become critical as the financial crisis began to unfold in .
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 de-
posits—typically relied on financing to originate mortgages from warehouse lines of
credit extended by banks, from their own commercial paper programs, or from
money borrowed in the repo market.
For commercial banks such as Citigroup, warehouse lending was a multibillion-
dollar business. From  to , Citigroup made available at any one time as much
as  billion in warehouse lines of credit to mortgage originators, including  mil-
lion to New Century and more than . 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 , 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  and .
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

In , only five mortgage companies borrowed a total of  billion through as-
set-backed commercial paper; in ,  entities borrowed  billion. For in-
stance, Countrywide launched the commercial paper programs Park Granada in
 and Park Sienna in . By May , it was borrowing  billion through
Park Granada and . 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  in capital to protect against loss. When banks put mortgages into off-bal-
ance-sheet entities such as commercial paper programs, there was no capital charge
(in , a small charge was imposed). But to make the deals work for investors,
banks had to provide liquidity support to these programs, for which they earned a
fee. This liquidity support meant that the bank would purchase, at a previously set
price, any commercial paper that investors were unwilling to buy when it came up for
renewal. During the financial crisis these promises had to be kept, eventually putting
substantial pressure on banks’ balance sheets.
When the Financial Accounting Standards Board, the private group that estab-
lishes 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 fa-
vorable 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 , bank regulators responded by
proposing to let banks remove these assets from their balance sheets when calculat-
ing regulatory capital. The proposal would have also introduced for the first time a
capital charge amounting to at most . 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  announced a final rule
setting the charge at up to ., 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 ,
repo lenders had clear and immediate rights to their collateral following the bor-
rower’s bankruptcy only if that collateral was Treasury or GSE securities. In the
Bankruptcy Abuse Prevention and Consumer Protection Act of , Congress ex-
panded that provision to include many other assets, including mortgage loans, mort-
gage-backed securities, collateralized debt obligations, and certain derivatives. The
result was a short-term repo market increasingly reliant on highly rated non-agency
mortgage-backed securities; but beginning in mid-, when banks and investors
became skittish about the mortgage market, they would prove to be an unstable
funding source (see figure .). Once the crisis hit, these “illiquid, hard-to-value se-
curities 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.
 T H E MORTG AG E M AC H I N E 

Repo Borrowing
Broker-dealers’ use of repo borrowing rose sharply before the crisis.
IN BILLIONS OF DOLLARS

$1,500

1,200

900
600

300
$396
0

–300
1980 1985 1990 1995 2000 2005 2010

NOTE: Net borrowing by broker-dealers.

SOURCE: Federal Reserve Flow of Funds Report

Figure .

Our sample deal, CMLTI -NC, 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 , mortgages it would sell to Citigroup.
Most of the funds came through repo agreements from a set of banks—including
Morgan Stanley ( million); Barclays Capital, a division of a U.K.-based bank
( million); Bank of America ( million); and Bear Stearns ( million). The
financing was provided when New Century originated these mortgages; so for about
two months, New Century owed these banks approximately  million secured by
the mortgages. Another  million in funding came from New Century itself, includ-
ing million through its own commercial paper program. On August , , Citi-
group paid New Century  million for the mortgages (and accrued interest), and
New Century repaid the repo lenders after keeping a  million (.) premium.

The investors in the deal

Investors for mortgage-backed securities came from all over the globe; what made se-
curitization work were the customized tranches catering to every one of them.
CMLTI -NC had  tranches, whose investors are shown in figure .. Fannie
Mae bought the entire  million triple-A-rated A tranche, which paid a better
return than super-safe U.S. Treasuries. The other triple-A-rated tranches, worth
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Selected Investors in CMLTI 2006-NC2

A wide variety of investors throughout the world purchased the securities in this
deal, including Fannie Mae, many international banks, SIVs and many CDOs.

Tranche Original Balance Original Spread2 Selected Investors

(MILLIONS) Rating1

A1 $154.6 AAA 0.14% Fannie Mae

A2-A $281.7 AAA 0.04% Chase Security Lendings Asset
Management; 1 investment fund
in China; 6 investment funds
SENIOR
78%

A2-B $282.4 AAA 0.06% Federal Home Loan Bank of

Chicago; 3 banks in Germany,
Italy and France; 11 investment
funds; 3 retail investors
A2-C $18.3 AAA 0.24% 2 banks in the U.S. and Germany
M-1 $39.3 AA+ 0.29% 1 investment fund and 2
banks in Italy; Cheyne Finance
Limited; 3 asset managers
M-2 $44 .0 AA 0.31% Parvest ABS Euribor; 4 asset
managers; 1 bank in China;
1 CDO
M-3 $14.2 AA- 0.34% 2 CDOs; 1 asset manager
MEZZANINE

M-4 $16.1 A+ 0.39% 1 CDO; 1 hedge fund

21%

M-5 $16.6 A 0.40% 2 CDOs

M-6 $10.9 A- 0.46% 3 CDOs
M-7 $9.9 BBB+ 0.70% 3 CDOs
M-8 $8.5 BBB 0.80% 2 CDOs; 1 bank
M-9 $11.8 BBB- 1.50% 5 CDOs; 2 asset managers
M-10 $13.7 BB+ 2.50% 3 CDOs; 1 asset manager
M-11 $10.9 BB 2.50% NA
EQUITY

CE $13.3 NR Citi and Capmark Fin Grp

1%

P, R, Rx: Additional tranches entitled to specific payments

1
Standard & Poor’s.
2
The yield is the rate on the one-month London Interbank Offered Rate (LIBOR), an interbank lending
interest rate, plus the spread listed. For example, when the deal was issued, Fannie Mae would have
received the LIBOR rate of 5.32% plus 0.14% to give a total yield of 5.46%.

SOURCES: Citigroup; Standard & Poor’s; FCIC calculations

Figure .
 T H E MORTG AG E M AC H I N E 

 million, went to more than  institutional investors around the world, spread-
ing the risk globally. These triple-A tranches represented  of the deal. Among
the buyers were foreign banks and funds in China, Italy, France, and Germany; the
Federal Home Loan Bank of Chicago; the Kentucky Retirement Systems; a hospital;
and JP Morgan, which purchased part of the tranche using 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  of the total
value of the security. If losses rose above  to  (by design the threshold would in-
crease over time), investors in the residual tranches would be wiped out, and the
mezzanine investors would start to lose money. Creators of collateralized debt obliga-
tions, 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 Fi-
nance Limited purchased  million of the top mezzanine tranche. Cheyne—a struc-
tured investment vehicle (SIV)—would be one of the first casualties of the crisis,
sparking panic during the summer of . Parvest ABS Euribor, which purchased
 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 eq-
uity tranches of mortgage-backed securities; they would be the first to lose if there
were problems. These investors anticipated returns of , , or even . Citi-
group retained part of the residual or “first-loss” tranches, sharing the rest with Cap-
mark Financial Group.

“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  million premium received by New Century for the deal we ana-
lyzed 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  Incentive Plan by volume. As WaMu
showed in a  plan, “Home Loans Product Strategy,” the goals were also product-
specific: to drive “growth in higher margin products (Option ARM, Alt A, Home Equity,
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 be-
tween . and .) as discounts, concessions, or commissions. For a  billion
deal like CMLTI -NC, a  fee would earn Citigroup  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, exam-
ined the mortgage-backed securities sales and trading desks at  commercial and in-
vestment banks from  to . It found that associates had average annual base
salaries of , to , from  through , but received bonuses that could
well exceed their salaries. On the next rung, vice presidents averaged base salaries and
bonuses from , to ,,. Directors averaged , to ,,. At
the top was the head of the unit. For example, in , Dow Kim, the head of Merrill’s
Global Markets and Investment Banking segment, received a base salary of ,
plus a  million bonus, a package second only to Merrill Lynch’s CEO.

MOODY’S: “GIVEN A BLANK CHECK”

The rating agencies were essential to the smooth functioning of the mortgage-backed
securities market. Issuers needed them to approve the structure of their deals; banks
needed their ratings to determine the amount of capital to hold; repo markets needed
their ratings to determine loan terms; some investors could buy only securities with a
triple-A rating; and the rating agencies’ judgment was baked into collateral agreements
and other financial contracts. To examine the rating process, the Commission focused
on Moody’s Investors Service, the largest and oldest of the three rating agencies.
The rating of structured finance products such as mortgage-backed securities
made up close to half of Moody’s rating revenues in , , and . From
 to , revenues from rating such financial instruments increased more than
fourfold. But the rating process involved many conflicts, which would come into fo-
cus 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 ac-
count the layered risks of subprime securities until late , after it had already
rated nearly , subprime securities.

“In the business forevermore”

Credit ratings have been linked to government regulations for three-quarters of a
century. In , 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
 T H E MORTG AG E M AC H I N E 

they paid for the bonds); lower-rated bonds had to be reported at current market
prices, which might be lower. In , the National Association of Insurance Com-
missioners adopted higher capital requirements on lower-rated bonds held by insur-
ers. But the watershed event in federal regulation occurred in , when the
Securities and Exchange Commission modified its minimum capital requirements
for broker-dealers to base them on credit ratings by a “nationally recognized statisti-
cal rating organization” (NRSRO); at the time, that was Moody’s, S&P, or Fitch. Rat-
ings are also built into banking capital regulations under the Recourse Rule, which,
since , has permitted banks to hold less capital for higher-rated securities. For
example, BBB rated securities require five times as much capital as AAA and AA
rated securities, and BB securities require ten times more capital. Banks in some
countries were subject to similar requirements under the Basel II international capi-
tal agreement, signed in June , 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 re-
ceived credit ratings from any two NRSROs . . . in one of the two highest short-term
rating categories or comparable unrated securities.” The Department of Labor re-
stricts 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. Trig-
gers played an important role in the financial crisis and helped cripple AIG.
Importantly for the mortgage market, the Secondary Mortgage Market Enhance-
ment Act of  permitted federal- and state-chartered financial institutions to in-
vest in mortgage-related securities if the securities had high ratings from at least one
rating agency. “Look at the language of the original bill,” Lewis Ranieri told the FCIC.
“It requires a rating. . . . It put them in the business forevermore. It became one of the
biggest, if not the biggest, business.” As Eric Kolchinsky, a former Moody’s manag-
ing 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
, the SEC had to approve a company’s application to become an NRSRO—but if
approved, a company faced no further regulation. More than  years later, the SEC
got limited authority to oversee NRSROs in the Credit Rating Agency Reform Act of
. That law, taking effect in June , 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 agen-
cies 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

financial institutions, relied on the ratings. Still, some investors who did their home-
work were skeptical of these products despite their ratings. Arnold Cattani, chairman
of Mission Bank in Bakersfield, California, described deciding to sell the bank’s hold-
ings of mortgage-backed securities and CDOs:

At one meeting, when things started getting difficult, maybe in , 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 mort-
gage. But as a package security, what happens? And he couldn’t answer
the question. And I told him to sell them, sell all of them, then, because
we didn’t understand it, and I don’t know that we had the capability to
understand the financial complexities; didn’t want any part of it.

Notably, rating agencies were not liable for misstatements in securities registra-
tions because courts ruled that their ratings were opinions, protected by the First
Amendment. Moody’s standard disclaimer reads “The ratings . . . are, and must be
construed solely as, statements of opinion and not statements of fact or recommen-
dations 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 . . . invest-
ment decisions should always be based on much more than just a rating.”

“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-s, Moody’s has rated tranches of mortgage-backed securities
using three models. The first, developed in , rated residential mortgage–backed
securities. In , Moody’s created a new model, M Prime, to rate prime, jumbo,
and Alt-A deals. Only in the fall of , when the housing market had already
peaked, did it develop its model for rating subprime deals, called M Subprime.
The models incorporated firm- and security-specific factors, market factors, regu-
latory and legal factors, and macroeconomic trends. The M 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 ,
scenarios, including variations in interest rates and state-level unemployment as well
as home price changes. On average, across the scenarios, home prices trended up-
ward at approximately  per year. The model put little weight on the possibility
prices would fall sharply nationwide. Jay Siegel, a former Moody’s team managing di-
rector 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
 T H E MORTG AG E M AC H I N E 

the  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 lev-
els, Moody’s never adjusted the scenarios to put greater weight on the possibility of a
decline. According to Siegel, in , “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 deter-
mine the overall ratings for the securities. Siegel told the FCIC that qualitative
analysis was also integral: “One common misperception is that Moody’s credit rat-
ings 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. Ulti-
mately, ratings are subjective opinions that reflect the majority view of the commit-
tee’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  model for years, in  Moody’s intro-
duced a parallel model for rating subprime mortgage–backed securities. Like M
Prime, the subprime model ran the mortgages through , scenarios. Moody’s
officials told the FCIC they recognized that stress scenarios were not sufficiently se-
vere, so they applied additional weight to the most stressful scenario, which reduced
the portion of each deal rated triple-A. Stein, who helped develop the subprime
model, said the output was manually “calibrated” to be more conservative to ensure
predicted losses were consistent with analysts’ “expert views.” Stein also noted
Moody’s concern about a suitably negative stress scenario; for example, as one step,
analysts took the “single worst case” from the M 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 is-
sues [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 -NC, our sample deal, Moody’s first used its model to simu-
late losses in the mortgage pool. Those estimates, in turn, determined how big the jun-
ior 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, in-
cluding interest-only mortgages. For its efforts, Moody’s was paid an estimated
,. (S&P also rated this deal and received ,.)
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 , , when
housing prices had declined by only . In October , the M–M tranches
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

were downgraded and by , all the tranches had been downgraded. Of all mort-
gage-backed securities it had rated triple-A in , Moody’s downgraded  to
junk. The consequences would reverberate throughout the financial system.

FANNIE MAE AND FREDDIE MAC:

“LESS COMPETITIVE IN THE MARKETPLACE”
In , Fannie and Freddie faced problems on multiple fronts. They had violated ac-
counting rules and now faced corrections and fines. They were losing market share
to Wall Street, which was beginning to dominate the securitization market. Strug-
gling 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 in-
creasing investments in risky mortgages and securities.
In , 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  billion from  through the third quarter of , 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 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 ,
Freddie agreed with OFHEO to pay a  million penalty and correct governance,
internal controls, accounting, and risk management. In January , OFHEO di-
rected Freddie to maintain  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  million and pay  million
in penalties to the SEC.
Fannie was next. In September , OFHEO discovered violations of accounting
rules that called into question previous filings. In , OFHEO reported that Fannie
had overstated earnings from  through  by  billion and that it, too, had
manipulated accounting in ways influenced by compensation plans. OFHEO made
Fannie improve accounting controls, maintain the same  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  through mid-. Fannie settled SEC and OFHEO enforcement actions for
 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 atten-
tion and probably led to us being less aggressive or less competitive in the market-
place [than] we otherwise might have been.”
 T H E MORTG AG E M AC H I N E 

As the scandals unfolded, subprime private label mortgage–backed securities

(PLS) issued by Wall Street increased from  billion in  to  billion in 
(shown in figure .); the value of Alt-A mortgage–backed securities increased from
 billion to  billion. Starting in  for Freddie and  for Fannie, the
GSEs—particularly Freddie—became buyers in this market. While private investors
always bought the most, the GSEs purchased . of the private-issued subprime
mortgage–backed securities in . The share peaked at  in  and then fell
back to  in . The share for Alt-A mortgage–backed securities was always
lower. The GSEs almost always bought the safest, triple-A-rated tranches. From
 through , the GSEs’ purchases declined, both in dollar amount and as a
percentage.
These investments were profitable at first, but as delinquencies increased in 
and , 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 , total impairments on securities totaled  billion at the
two companies—enough to wipe out nearly  of their pre-crisis capital.
OFHEO knew about the GSEs’ purchases of subprime and Alt-A mortgage–
backed securities. In its  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 capabil-
ities,” 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 securi-
ties and riskier mortgages were not a “significant supervisory concern,” and the ex-
amination 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 reasons for the GSEs’ purchases of subprime and Alt-A mortgage–backed se-
curities 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 pa-
per 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  and , Fannie Mae’s
single- and multifamily purchases alone met each of the goals; in other words, the en-
terprise would have met its obligations without buying subprime or Alt-A mortgage–
backed securities. In fact, none of Fannie Mae’s  purchases of subprime or Alt-A
securities were ever submitted to HUD to be counted toward the goals.
Before ,  or less of the GSEs’ loan purchases had to satisfy the affordable
housing goals. In  the goals were increased above ; but even then, single-
and multifamily purchases alone met the overall goals. Securities purchases did, in
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Buyers of Non-GSE Mortgage-Backed Securities

The GSEs purchased subprime and Alt-A nonagency securities during the 2000s.
These purchases peaked in 2004.
IN BILLIONS OF DOLLARS
Subprime Securities Purchases Alt-A Securities Purchases

$500
Freddie Mac
Fannie Mae
Other purchasers
400

300

200

100

’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08

SOURCES: Inside Mortgage Finance, Fannie Mae, Freddie Mac

Figure .

several cases, help Fannie meet its subgoals—specific targets requiring the GSEs to
purchase or guarantee loans to purchase homes. In , Fannie missed one of these
subgoals and would have missed a second without the securities purchases; in ,
the securities purchases helped Fannie meet those two subgoals.
The pattern is the same at Freddie Mac, a larger purchaser of non-agency mort-
gage–backed securities. Estimates by the FCIC show that from  through ,
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 Busi-
ness, 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
 T H E MORTG AG E M AC H I N E 

housing goals, and that the goals became a factor in the decision to increase pur-
chases of private label securities. 
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 gener-
ally extended to lower-income borrowers, and the regulations prohibited mortgages
to borrowers with unstated income levels—a hallmark of Alt-A loans—from count-
ing toward affordability goals. Levin told the FCIC that they believed that the pur-
chase of Alt-A 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  to  and also bought and securitized greater numbers of
riskier mortgages. The results would be disastrous for the companies, their share-
holders, and American taxpayers.

COMMISSION CONCLUSIONS ON CHAPTER 7

The Commission concludes that the monetary policy of the Federal Reserve,
along with capital flows from abroad, created conditions in which a housing bub-
ble could develop. However, these conditions need not have led to a crisis. The
Federal Reserve and other regulators did not take actions necessary to constrain
the credit bubble. In addition, the Federal Reserve’s policies and pronouncements
encouraged rather than inhibited the growth of mortgage debt and the housing
bubble.
Lending standards collapsed, and there was a significant failure of accounta-
bility and responsibility throughout each level of the lending system. This in-
cluded borrowers, mortgage brokers, appraisers, originators, securitizers, credit
rating agencies, and investors, and ranged from corporate boardrooms to individ-
uals. Loans were often premised on ever-rising home prices and were made re-
gardless of ability to pay.
The nonprime mortgage securitization process created a pipeline through
which risky mortgages were conveyed and sold throughout the financial system.
This pipeline was essential to the origination of the burgeoning numbers of high-
risk mortgages. The originate-to-distribute model undermined responsibility and
accountability for the long-term viability of mortgages and mortgage-related se-
curities and contributed to the poor quality of mortgage loans.
(continues)
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

(continued)
Federal and state rules required or encouraged financial firms and some insti-
tutional investors to make investments based on the ratings of credit rating agen-
cies, leading to undue reliance on those ratings. However, the rating agencies
were not adequately regulated by the Securities and Exchange Commission or any
other regulator to ensure the quality and accuracy of their ratings. Moody’s, the
Commission’s case study in this area, relied on flawed and outdated models to is-
sue erroneous ratings on mortgage-related securities, failed to perform meaning-
ful due diligence on the assets underlying the securities, and continued to rely on
those models even after it became obvious that the models were wrong.
Not only did the federal banking supervisors fail to rein in risky mortgage-
lending practices, but the Office of the Comptroller of the Currency and the Of-
fice of Thrift Supervision preempted the applicability of state laws and regulatory
efforts to national banks and thrifts, thus preventing adequate protection for bor-
rowers and weakening constraints on this segment of the mortgage market.
 8
THE CDO MACHINE

CONTENTS
CDOs: “We created the investor” .......................................................................
Bear Stearns’s hedge funds: “It functioned fine up until one day
it just didn’t function”.....................................................................................
Citigroup’s liquidity puts: “A potential conflict of interest” ..................................
AIG: “Golden goose for the entire Street” ...........................................................
Goldman Sachs: “Multiplied the effects of the collapse in subprime”..................
Moody’s: “Achieved through some alchemy” .......................................................
SEC: “It’s going to be an awfully big mess”..........................................................

In the first decade of the st 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 be-
come 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  of these CDO tranches would be rated
triple-A despite the fact that they generally comprised the lower-rated tranches of
mortgage-backed securities. CDO securities would be sold with their own waterfalls,
with the risk-averse 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 (see figure .).
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.

*Throughout this book, unless otherwise noted, we use the term “CDOs” to refer to cash CDOs backed
by asset-backed securities (such as mortgage-backed securities), also known as ABS CDOs.


 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Collateralized Debt Obligations

Collateralized debt obligations (CDOs) are structured 3. CDO tranches
financial instruments that purchase and pool Similar to
financial assets such as the riskier tranches of various mortgage-backed
mortgage-backed securities. securities, the CDO
issues securities in
tranches that vary
based on their place in
the cash flow waterfall.
1. Purchase
Low risk, low yield
The CDO manager and securities
firm select and purchase assets,
such as some of the lower-rated
tranches of mortgage-backed
securities.
First claim to cash flow from
principal & interest payments…

New pool AAA

of RMBS
and other
securities
next
AAA claim…
2. Pool
The CDO manager
and securities firm AA
pool various assets next…
etc.
in an attempt to A
BBB
AA get diversification BB
A
benefits. EQUITY
BBB High risk, high yield
BB

Figure .

The securities firms argued—and the rating agencies agreed—that if they pooled
many BBB-rated mortgage-backed securities, they would create additional diversifi-
cation 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
 T H E C D O M AC H I N E 

tranches of mortgage-backed securities, growing from a bit player to a multi-hundred-

billion-dollar industry. Between  and , as house prices rose  nationally
and  trillion in mortgage-backed securities were created, Wall Street issued nearly
 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 ef-
fect, the CDO became the engine that powered the mortgage supply chain. “There is a
machine going,” Scott Eichel, a senior managing director at Bear Stearns, told a finan-
cial journalist in May . “There is a lot of brain power to keep this going.”
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.
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 cor-
related—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.

CDO S : “WE CREATED THE INVESTOR”

Michael Milken’s Drexel Burnham Lambert assembled the first rated collateralized
debt obligation in  out of different companies’ junk bonds. The strategy made
sense—pooling many bonds reduced investors’ exposure to the failure of any one
bond, and putting the securities into tranches enabled investors to pick their pre-
ferred level of risk and return.
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 s, CDO managers generally purchased corporate and emerging market bonds
and bank loans. When the liquidity crisis of  drove up returns on asset-backed
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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, mu-
tual 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 se-
curities in which they invested started to perform poorly in —particularly those
backed by mobile home loans (after borrowers defaulted in large numbers), aircraft
leases (after /), and mutual fund fees (after the dot-com bust). The accepted wis-
dom 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. “Everyone looked at the sector and said, the CDO construct works, but
we just need to find more stable collateral,” said Wing Chau, who ran two firms,
Maxim Group and Harding Advisory, that managed CDOs mostly underwritten by
Merrill Lynch. “And the industry looked at residential mortgage–backed securities,
Alt-A, subprime, and non-agency mortgages, and saw the relative stability.”
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. “We told you these [BBB-rated
securities] were a great deal, and priced at great spreads, but nobody stepped up,” the
Credit Suisse banker Joe Donovan told a Phoenix conference of securitization
bankers in February . “So we created the investor.”
By , 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 , they were buying “virtually all” of the BBB
tranches. Just as mortgage-backed securities provided the cash to originate mort-
gages, now CDOs would provide the cash to fund mortgage-backed securities. Also
by , mortgage-backed securities accounted for more than half of the collateral in
CDOs, up from  in . Sales of these CDOs more than doubled every year,
jumping from  billion in  to  billion in . Filling this pipeline would
require hundreds of billions of dollars of subprime and Alt-A mortgages.

“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 vary-
ing degrees of risk and, for a time, profited handsomely.
Securities firms underwrote the CDOs: that is, they approved the selection of col-
 T H E C D O M AC H I N E 

lateral, 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  of CDOs structured from  to .
Deutsche Bank and UBS were also major participants. “We had sales representa-
tives in all those [global] locations, and their jobs were to sell structured products,”
Nestor Dominguez, the co-head of Citigroup’s CDO desk, told the FCIC. “We spent a
lot of effort to have people in place to educate, to pitch structured products. So, it was
a lot of effort, about  people. And I presume our competitors did the same.”
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. “Our business was to make new issue fees,
[and to] make sure that if the market did have a downturn, we were somehow
hedged,” Michael Lamont, the former co-head for CDOs at Deutsche Bank, told the
FCIC. Chris Ricciardi, formerly head of the CDO desk at Merrill Lynch, likewise
told the FCIC that he did not track the performance of CDOs after underwriting
them. Moreover, Lamont said it was not his job to decide whether the rating agen-
cies’ models had the correct underlying assumptions. That “was not what we brought
to the table,” he said. In many cases, though, underwriters helped CDO managers
select collateral, leading to potential conflicts (more on that later).
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. Man-
agers 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 , to a million dollars per year for a  billion dollar deal. For CDOs
that focused on the more junior tranches, which were often smaller, fees would be
, to . million per year for a  million deal. As managers did more
deals, they generated more fees without much additional cost. “You’d hear statements
like, ‘Everybody and his uncle now wants to be a CDO manager,’” Mark Adelson,
then a structured finance analyst at Nomura Securities and currently chief credit offi-
cer at S&P, told the FCIC. “That was an observation voiced repeatedly at several of
the industry conferences around those times—the enormous proliferation of CDO
managers— . . . because it was very lucrative.” CDO managers industry-wide earned
at least . billion in management fees between  and .
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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

triple-A rating made those products appropriate investments. Rating agency fees
were typically between , and , 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 dif-
ferent 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 pro-
grams that invested in CDOs and other highly rated assets. Hedge funds often
bought the equity tranches.
Eventually, other CDOs became the most important class of investor for the mez-
zanine tranches of CDOs. By , CDO underwriters were selling most of the mez-
zanine tranches—including those rated A—and, especially, those rated BBB, the
lowest and riskiest investment-grade rating—to other CDO managers, to be pack-
aged into other CDOs. It was common for CDOs to be structured with  or 
of their cash invested in other CDOs; CDOs with as much as  to  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 virtu-
ally risk free, but it created huge exposures for the credit default swap issuers if signif-
icant 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 st century, pretax profit for the five
largest investment banks doubled between  and , from  billion to 
billion; total compensation at these investment banks for their employees across the
world rose from  billion to  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. “Credit derivatives
traders as well as mortgage and asset-backed securities salespeople should especially
enjoy bonus season,” a firm that compiles compensation figures for investment banks
reported in .
To see in more detail how the CDO pipeline worked, we revisit our illustrative
Citigroup mortgage-backed security, CMLTI -NC. Earlier, we described how
most of the below-triple-A bonds issued in this deal went into CDOs. One such CDO
was Kleros Real Estate Funding III, which was underwritten by UBS, a Swiss bank.
The CDO manager was Strategos Capital Management, a subsidiary of Cohen &
Company; that investment company was headed by Chris Ricciardi, who had earlier
built Merrill’s CDO business. Kleros III, launched in , purchased and held .
million in securities from the A-rated M tranche of Citigroup’s security, along with
 junior tranches of other mortgage-backed securities. In total, it owned  mil-
 T H E C D O M AC H I N E 

lion of mortgage-related securities, of which  were rated BBB or lower,  A,
and the rest higher than A. To fund those purchases, Kleros III issued  billion of
bonds to investors. As was typical for this type of CDO at the time, roughly  of
the Kleros III bonds were triple-A-rated. At least half of the below-triple-A tranches
issued by Kleros III went into other CDOs.

“Mother’s milk to the . . . market”

The growth of CDOs had important impacts on the mortgage market itself. CDO man-
agers who were eager to expand the assets that they were managing—on which their in-
come 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 securities.
Informed institutional investors such as insurance companies had purchased the
private-label mortgage–backed securities issued in the s. These securities were
typically protected from losses by bond insurers, who had analyzed the deals as well.
Beginning in the late s, 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 pro-
tect investors. By , the earlier forms of mortgage-backed securities had essen-
tially 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. “The CDO manager and the CDO investor are not
the same kind of folks [as the monoline bond insurers], who just backed away,” Adel-
son said. “They’re mostly not mortgage professionals, not real estate professionals.
They are derivatives folks.”
Indeed, Chau, the CDO manager, portrayed his job as creating structures that rat-
ing agencies would approve and investors would buy, and making sure the mortgage-
backed securities that he bought “met industry standards.” He said that he relied on
the rating agencies. “Unfortunately, what lulled a lot of investors, and I’m in that
camp as well, what lulled us into that sense of comfort was that the rating stability
was so solid and that it was so consistent. I mean, the rating agencies did a very good
job of making everything consistent.” CDO production was effectively on autopilot.
“Mortgage traders speak lovingly of ‘the CDO bid.’ It is mother’s milk to the . . .
market,” James Grant, a market commentator, wrote in . “Without it, fewer as-
set-backed structures could be built, and those that were would have to meet a much
more conservative standard of design. The resulting pangs of credit withdrawal
would certainly be felt in the residential real-estate market.”
UBS’s Global CDO Group agreed, noting that CDOs “have now become bullies in
their respective collateral markets.” By promoting an increase in both the volume and
the price of mortgage-backed securities, bids from CDOs had “an impact on the
overall U.S. economy that goes well beyond the CDO market.” Without the demand
for mortgage-backed securities from CDOs, lenders would have been able to sell
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

fewer mortgages, and thus they would have had less reason to push so hard to make
the loans in the first place.

“Leverage is inherent in CDOs”

The mortgage pipeline also introduced leverage at every step. Most financial institu-
tions 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 cre-
ates 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 collat-
eral by those creating other CDOs with yet another round of debt. Synthetic CDOs
consisting of credit default swaps, described below, amplified the leverage. The CDO,
backed by securities that were themselves backed by mortgages, created leverage on
leverage, as Dan 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 invest-
ment vehicles—a type of commercial paper program that invested mostly in triple-A-
rated securities—were leveraged an average of just under -to-: in other words,
these SIVs would hold  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, as we will see. 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 , when the homeownership rate was peaking, and when new mort-
gages were increasingly being driven by serial refinancings, by investors and specula-
tors, 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 pay-
ments 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 under-
stood all along by some market participants. “Leverage is inherent in [asset-backed
securities] CDOs,” Mark Klipsch, a banker with Orix Capital Markets, an asset man-
agement firm, told a Boca Raton conference of securitization bankers in October
. While it was good for short-term profits, losses could be large later on. Klipsch
said, “We’ll see some problems down the road.”

BEAR STEARNS’S HEDGE FUNDS: “IT FUNCTIONED FINE

UP UNTIL ONE DAY IT JUST DIDN’ T FUNCTION”
Bear Stearns, the smallest of the five large investment banks, started its asset manage-
ment business in  when it established Bear Stearns Asset Management (BSAM).
 T H E C D O M AC H I N E 

Asset management brought in steady fee income, allowed banks to offer new prod-
ucts to customers and required little capital.
BSAM played a prominent role in the CDO business as both a CDO manager and
a hedge fund that invested in mortgage-backed securities and CDOs. At BSAM, by
the end of  Ralph Cioffi was managing  CDOs with . billion in assets and
 hedge funds with  billion in assets. Although Bear Stearns owned BSAM,
Bear’s management exercised little supervision over its business. The eventual fail-
ure of Cioffi’s two large mortgage-focused hedge funds would be an important event
in , early in the financial crisis.
In , Cioffi launched his first fund at BSAM, the High-Grade Structured
Credit Strategies Fund, and in  he added the High-Grade Structured Credit
Strategies Enhanced Leverage Fund. The funds purchased mostly mortgage-backed
securities or CDOs, and used leverage to enhance their returns. The target was for
 of assets to be rated either AAA or AA. As Cioffi told the FCIC, “The thesis be-
hind the fund was that the structured credit markets offered yield over and above
what their ratings suggested they should offer.” Cioffi targeted a leverage ratio of 
to  for the first High-Grade fund. For Enhanced Leverage, Cioffi upped the ante,
touting the Enhanced Leverage fund as “a levered version of the [High Grade] fund”
that targeted leverage of  to . At the end of , the High-Grade fund contained
. billion in assets (using . billion of his hedge fund investors’ money and .
billion in borrowed money). The Enhanced Leverage Fund had . billion (using
. billion from investors and . billion in borrowed money).
BSAM financed these asset purchases by borrowing in the repo markets, which
was typical for hedge funds. A survey conducted by the FCIC identified at least 
billion of repo borrowing as of June  by the approximately  hedge funds that
responded. The respondents invested at least  billion in mortgage-backed securi-
ties or CDOs as of June . The ability to borrow using the AAA and AA
tranches of CDOs as repo collateral facilitated demand for those securities.
But repo borrowing carried risks: it created significant leverage and it had to be
renewed frequently. For example, an investor buying a stock on margin—meaning
with borrowed money—might have to put up  cents on the dollar, with the other
 cents loaned by his or her stockbroker, for a leverage ratio of  to . A home-
owner buying a house might make a  down payment and take out a mortgage
for the rest, a leverage ratio of  to . By contrast, repo lending allowed an investor
to buy a security for much less out of pocket—in the case of a Treasury security, an
investor may have to put in only ., borrowing . from a securities firm
( to ). In the case of a mortgage-backed security, an investor might pay 
( to ).
With this amount of leverage, a  change in the value of that mortgage-backed
security can double the investor’s money—or lose all of the initial investment.
Another inherent fallacy in the structure was the assumption that the underlying
collateral could be sold easily. But when it came to selling them in times of distress,
private-label mortgage-backed securities would prove to be very different from U.S.
Treasuries.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

The short-term nature of repo money also makes it inherently risky and unreli-
able: funding that is offered at certain terms today could be gone tomorrow. Cioffi’s
funds, for example, took the risk that its repo lenders would decide not to extend, or
“roll,” the repo lines on any given day. Yet more and more, repo lenders were loaning
money to funds like Cioffi’s, rolling the debt nightly, and not worrying very much
about the real quality of the collateral.
The firms loaning money to Cioffi’s hedge funds were often also selling them
mortgage-related securities, and the hedge funds pledged those same securities to se-
cure the loans. If the market value of the collateral fell, the repo lenders could and
would demand more collateral from the hedge fund to back the repo loan. This dy-
namic would play a pivotal role in the fate of many hedge funds in —most spec-
tacularly in the case of Cioffi’s funds. “The repo market, I mean it functioned fine up
until one day it just didn’t function,” Cioffi told the FCIC. Up to that point, his hedge
funds could buy billions of dollars of CDOs on borrowed money because of the mar-
ket’s bullishness about mortgage assets, he said. “It became . . . a more and more ac-
ceptable asset class, [with] more traders, more repo lenders, more investors
obviously. [It had a] much broader footprint domestically as well as internationally.
So the market just really exploded.”
BSAM touted its CDO holdings to investors, telling them that CDOs were a mar-
ket opportunity because they were complex and therefore undervalued in the general
marketplace. In , this was a promising market with seemingly manageable risks.
Cioffi and his team not only bought CDOs, they also created and managed other
CDOs. Cioffi would purchase mortgage-backed securities, CDOs, and other securi-
ties for his hedge funds. When he had reached his firm’s internal investment limits,
he would repackage those securities and sell CDO securities to other customers.
With the proceeds, Cioffi would pay off his repo lenders, and at the same time he
would acquire the equity tranche of a new CDO.
Because Cioffi managed these newly created CDOs that selected collateral from
his own hedge funds, he was positioned on both sides of the transaction. The struc-
ture created a conflict of interest between Cioffi’s obligation to his hedge fund in-
vestors and his obligation to his CDO investors; this was not unique on Wall Street,
and BSAM disclosed the structure, and the conflict of interest, to potential in-
vestors. For example, a critical question was at what price the CDO should purchase
assets from the hedge fund: if the CDO paid above-market prices for a security, that
would advantage the hedge fund investors and disadvantage the CDO investors.
BSAM’s flagship CDOs—dubbed Klio I, II, and III—were created in rapid succes-
sion over  and , with Citigroup as their underwriter. All three deals were
mainly composed of mortgage- and asset-backed securities that BSAM already
owned, and BSAM retained the equity position in all three; all three were primarily
funded with asset-backed commercial paper. Typical for the industry at the time,
the expected return for the CDO manager, who was managing assets and holding the
equity tranche, was between  and  annually, assuming no defaults on the un-
derlying collateral. Thanks to the combination of mortgage-backed securities,
 T H E C D O M AC H I N E 

CDOs, and leverage, Cioffi’s funds earned healthy returns for a time: the High-Grade
fund had returns of  in ,  in , and  in  after fees. Cioffi and
Tannin made millions before the hedge funds collapsed in . Cioffi was rewarded
with total compensation worth more than  million from  to . In ,
the year the two hedge funds filed for bankruptcy, Cioffi made more than . mil-
lion in total compensation. Matt Tannin, his lead manager, was awarded compensa-
tion of more than . million from  to . Both managers invested some of
their own money in the funds, and used this as a selling point when pitching the
funds to others.
But when house prices fell and investors started to question the value of mort-
gage-backed securities in , the same short-term leverage that had inflated Cioffi’s
returns would amplify losses and quickly put his two hedge funds out of business.

CITIGROUP’S LIQUIDITY PUTS:

“A POTENTIAL CONFLICT OF INTEREST”
By the 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  million fine related to subprime mort-
gage lending, Citigroup again got into trouble, charged with helping Enron—before
that company filed for bankruptcy in —use structured finance transactions to
manipulate its financial statements. In July , Citigroup agreed to pay the SEC
 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 , the Fed had seen enough: it banned Citigroup from making any
more major acquisitions until it improved its governance and legal compliance. Ac-
cording to Prince, he had already decided to turn “the company’s focus from an ac-
quisition-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 direc-
tors, 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 pur-
sued by investment banks affiliated with commercial banks. One opportunity among
many was the CDO business, which was just then taking off amid the booming mort-
gage market.
In , 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Thomas Maheras, co-CEO of the investment bank, had become a leader in the nas-
cent market for CDOs, creating more than  billion in  and —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
long-term 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 asset-backed 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) pro-
vided 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 com-
mercial paper if there were no buyers when it matured or if the cost of funding rose
by a predetermined amount.
The CDO team at Citigroup had jumped into the market in July  with a .
billion CDO named Grenadier Funding that included a . billion tranche backed by
a liquidity put from Citibank. Over the next three years, Citi would write liquidity
puts on  billion of commercial paper issued by CDOs, more than any other com-
pany. BSAM’s three Klio CDOs, which Citigroup had underwritten, accounted for just
over  billion of this total, a large number that would not bode well for the bank.
But initially, this “strategic initiative,” as Dominguez called it, was very profitable for
Citigroup. The CDO desk earned roughly  of the total deal value in structuring fees
for Citigroup’s investment banking arm, or about  million for a  billion deal. In
addition, Citigroup would generally charge buyers . to . in premiums annu-
ally for the liquidity puts. In other words, for a typical  billion deal, Citibank would
receive  to  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 lia-
bility that would be triggered in some circumstances. Prior to the  change in the
capital rules regarding liquidity puts (discussed earlier), 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. Follow-
ing the  rule change, Citibank was required to hold . in capital against the
amount of commercial paper supported by the liquidity put, or . million for a 
billion liquidity put. Given a  to  million annual fee for the put, the annual return
on that capital could still exceed . 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
 would reveal the fallacy of those assumptions and catapult the entire  billion
 T H E C D O M AC H I N E 

in commercial paper straight onto the bank’s balance sheet, requiring it to come up
with  billion in cash as well as more capital to satisfy bank regulators.
The liquidity puts were approved by Citigroup’s Capital Markets Approval Com-
mittee, which was charged with reviewing all new financial products. Deeming
them to be low risk, the company based its opinions on the credit risk of the underly-
ing collateral, but failed to consider the liquidity risk posed by a general market
disruption. The OCC, the supervisor of Citigroup’s largest commercial bank sub-
sidiary, was aware that the bank had issued the liquidity puts. However, the terms of
the OCC’s post-Enron enforcement action focused only on whether Citibank had a
process in place to review the product, and not on the risks of the puts to Citibank’s
balance sheet.
Besides Citigroup, only a few large financial institutions, such as AIG Financial
Products, BNP, WestLB of Germany, and Société Générale of France, wrote signifi-
cant 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  but did  billion worth in , just before the market crashed.
When asked why other market participants were not writing liquidity puts,
Dominguez stated that Société Générale and BNP were big players in that market.
“You needed to be a bank with a strong balance sheet, access to collateral, and exist-
ing relationships with collateral managers,” he said.
The CDO desk stopped writing liquidity puts in early , when it reached its
internal limits. Citibank’s treasury function had set a  billion cap on liquidity
puts; it granted one final exception, bringing the total to  billion. Risk manage-
ment had also set a  billion risk limit on top-rated asset-backed securities, which
included the liquidity puts. Later, in an October  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  billion cash demand on Citibank. An
undated and unattributed internal document (believed to have been drafted in )
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 to be generated.” The re-
sult would be losses so severe that they would help bring the huge financial conglom-
erate to the brink of failure, as we will see.

AIG: “GOLDEN GOOSE FOR THE ENTIRE STREET”

In , American International Group was the largest insurance company in the
world as measured by stock market value: a massive conglomerate with  billion
in assets, , employees in  countries, and  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 , AAA by S&P since
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

—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  carried those ratings.
Starting in , AIG Financial Products, a Connecticut-based unit with major op-
erations 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 . trillion in notional
amount. Among other derivatives activities, the unit issued credit default swaps guar-
anteeing 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 de-
fault swaps were not regulated insurance contracts, no such requirement was applica-
ble. In this case, the unit predicted with . 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 .
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  to .. By , AIG had written
 billion in CDS for such regulatory capital benefits; most were with European
banks for a variety of asset types. That total would rise to  billion by .
The same advantages could be enjoyed by banks in the United States, where regu-
lators had introduced similar capital standards for banks’ holdings of mortgage-
backed securities and other investments under the Recourse Rule in . So a credit
default swap with AIG could also lower American banks’ capital requirements.
In  and , AIG sold protection on super-senior CDO tranches valued at
 billion, up from just  billion in . 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.”
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, Société Générale, 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.”
 T H E C D O M AC H I N E 

AIG also bestowed the imprimatur of its pristine credit rating on commercial pa-
per 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 ; by , it had written more than
 billion of liquidity puts on commercial paper issued by CDOs. AIG also wrote
more than  billion in CDS to protect Société Générale 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 vir-
tually riskless, and get paid a small premium,” Gene Park, who was a managing direc-
tor 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
mortgage-backed securities and CDOs, grew from  billion in  to  billion
in  and  billion in . This business was a small part of the AIG Finan-
cial Services business unit, which included AIG Financial Products; AIG Financial
Services generated operating income of . billion in , or  of AIG’s total.
AIG did not post any collateral when it wrote these contracts; but unlike mono-
line insurers, AIG Financial Products agreed to post collateral if the value of the un-
derlying securities dropped, or if the rating agencies downgraded AIG’s long-term
debt ratings. Its competitors, the monoline financial guarantors—insurance compa-
nies 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 . 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  of new
earnings. Financial Products CEO Joseph J. Cassano made the allocations at the end
of the year. Between  and , the least amount Cassano paid himself in a year
was  million. In the later years, his compensation was sometimes double that of
the parent company’s CEO.
In the spring of , disaster struck: AIG lost its triple-A rating when auditors
discovered that it had manipulated earnings. By November , the company had
reduced its reported earnings over the five-year period by . billion. The board
forced out Maurice “Hank” Greenberg, who had been CEO for  years. New York
Attorney General Eliot Spitzer prepared to bring fraud charges against him.
Greenberg told the FCIC, “When the AAA credit rating disappeared in spring
, 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 Prod-
ucts wrote another  billion in credit default swaps on super-senior tranches of
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

CDOs in . The company wouldn’t make the decision to stop writing these con-
tracts until .

GOLDMAN SACHS: “MULTIPLIED THE EFFECTS

OF THE COLLAPSE IN SUBPRIME”
Henry Paulson, the CEO of Goldman Sachs from  until he became secretary of
the Treasury in , testified to the FCIC that by the time he became secretary many
bad loans already had been issued—“most of the toothpaste was out of the tube”—
and that “there really wasn’t the proper regulatory apparatus to deal with it.” Paul-
son provided examples: “Subprime mortgages went from accounting for  percent of
total mortgages in  to  percent by . . . . Securitization separated origina-
tors 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 cre-
ation and sale of mortgage securities. From  through , the company pro-
vided 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, Gold-
man acquired  billion of loans from these and other subprime loan originators,
which it securitized and sold to investors. From  to , Goldman issued 
mortgage securitizations totaling  billion (about a quarter were subprime), and
 CDOs totaling  billion; Goldman also issued  synthetic or hybrid CDOs
with a face value of  billion between  and June .
Synthetic CDOs were complex paper transactions involving credit default swaps.
Unlike the traditional cash CDO, synthetic CDOs contained no actual tranches of
mortgage-backed 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 se-
curities failed. While funded investors received interest if the reference securities per-
formed, they could lose all of their investment if the reference securities defaulted.
Unfunded investors, which were highest in the payment waterfall, received pre-
mium-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 tra-
 T H E C D O M AC H I N E 

ditional CDOs at the same time as the supply of mortgages was beginning to dry up.
Because there were no mortgage assets to collect and finance, creating synthetic
CDOs took a fraction of 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. Figure .
provides an example of how such a deal worked.
In , Goldman launched its first major synthetic CDO, Abacus -—a deal
worth  billion. About one-third of the swaps referenced residential mortgage-
backed securities, another third referenced existing CDOs, and the rest, commercial
mortgage–backed securities (made up of bundled commercial real estate loans) and
other securities.
Goldman was the short investor for the entire  billion deal: it purchased credit
default swap protection on these reference securities from the CDO. The funded in-
vestors—IKB (a German bank), the TCW Group, and Wachovia—put up a total of
 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 re-
ceive the  million. In this sense, IKB, TCW, and Wachovia were “long” in-
vestors, 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 re-
ceived 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 origi-
nated, retaining the . billion super-senior tranche. Goldman’s  billion short po-
sition 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 an-
nual payment of . million. As a result, by , AIG was effectively the largest
unfunded investor in the super-senior tranches of the Abacus deal.
All told, long investors in Abacus - 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  billion if the assets
failed.
In the end, Goldman, the short investor in the Abacus - CDO, has received
about  million while the long investors have lost just about all of their investments.
In April , GSC paid Goldman . million as a result of CDS protection sold by
GSC to Goldman on the first and second loss tranches. In June , Goldman received
 million from AIG Financial Products as a result of the CDS protection it had pur-
chased against the super-senior tranche. The same month it received  million from
TCW as a result of the CDS purchased against the junior mezzanine tranches, and 
million from IKB because of the CDS it purchased against the C tranche. In April ,
IKB paid Goldman another  million as a result of the CDS against the B tranche.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Synthetic CDO
Synthetic CDOs, such as Goldman Sachs’s Abacus 2004-1 deal, were complex
paper transactions involving credit default swaps.

1. Short investors CDO 2. Unfunded investors

Short investors enter into credit Unfunded investors, who typically
default swaps with the CDO, buy the super senior tranche, are
referencing assets such as effectively in a swap with the CDO
mortgage-backed securities. The and receive premiums. If the
CDO receives swap premiums. If reference securities do not
the reference securities do not perform and there are not enough
perform, the CDO pays out to the SUPER SENIOR funds within the CDO, the
short investors. investors pay.

Premiums
Unfunded
CREDIT DEFAULT
Investors
SWAPS Credit
Protection
Premiums
Short
Investors
Credit
Protection
3. Funded investors
Funded investors (bond holders)
invest cash and expect interest
AAA
Reference and principal payments. They
Securities typically incur losses before the
unfunded investors.
Interest and
Principal
Payments Bond
AA
Holders
Cash
A Invested
AAA BBB
BB
EQUITY
AA

A
BBB
BB
4. Cash Pool
The CDO would invest cash
Cash Pool received from the bond holders
in presumably safe assets.

Figure .
 T H E C D O M AC H I N E 

Through May , Goldman received  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 - found their way into other funds and CDOs; for example,
TCW put tranches of Abacus - into three of its own CDOs.
In total, between July , , and May , , Goldman packaged and sold 
synthetic CDOs, with an aggregate face value of  billion. Its underwriting fee
was . to . 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 in-
vestors 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 -NC. Credit default swaps made it possible for new
market participants to bet for or against the performance of these securities. Syn-
thetic CDOs significantly increased the demand for such bets. For example, there
were about  million worth of bonds in the M (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 M tranche was ref-
erenced. As long as the M 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
M bonds defaulted, then the long investors would make large payments to the short
investors. That is the bet—and there were more than  million in such bets in early
 on the M tranche of this deal. Thus, on the basis of the performance of 
million in bonds, more than  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 M tranche was not unique. A  million tranche of the
Glacier Funding CDO -A, rated A, was referenced in  million worth of syn-
thetic CDOs. A  million tranche of the Soundview Home Equity Loan Trust
-EQ, also rated A, was referenced in  million worth of synthetic CDOs. A
 million tranche of the Soundview Home Equity Loan Trust -EQ, rated
BBB, was referenced in  million worth of synthetic CDOs.
In total, synthetic CDOs created by Goldman referenced , mortgage securities,
some of them multiple times. For example,  securities were referenced twice. In-
deed, one single mortgage-backed security was referenced in nine different synthetic
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 mag-
nified overall risk, they also maintained that their creation had “social utility” be-
cause 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 dif-
ferent 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.”
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 Fu-
tures 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.”

MOODY’S: “ACHIEVED THROUGH SOME ALCHEMY”

The machine churning out CDOs would not have worked without the stamp of ap-
proval 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 half-million dollars for a “standard” CDO in  and  and as much as
, 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 securi-
 T H E C D O M AC H I N E 

ties] 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 disinte-
grated below us and we didn’t react and we should have. . . . We had to be looking for
a problem. And we weren’t looking.”
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 se-
curities in the portfolio—always tricky, but particularly so in the case of CDOs con-
sisting of subprime and Alt-A mortgage-backed securities that had only a short
performance 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 acknowl-
edged in one early explanation of its process.
In plainer English, Witt said, Moody’s didn’t have a good model on which to esti-
mate 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 ex-
plicitly 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-, he developed a new rating methodology that directly incorpo-
rated 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
 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 [mort-
gage-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 , Moody’s updated its approach for estimating default correlation, but
it based the new model on trends from the previous  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 mod-
ified 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 mort-
gage-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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

choices that lowered the estimated correlation of default, which would improve the
ratings for these securities. Using these methods, Moody’s estimated that two mort-
gage-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, in-
cluding some who worked at regulatory agencies, cautioned investors that assump-
tion-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 re-
sult in unanticipated concentrations of risk in institutions’ portfolios,” a report from
the Bank for International Settlements, an international financial organization spon-
sored by the world’s regulators and central banks, warned in June .
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 in-
vestors 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. With-
out exception, every pitch book examined by the FCIC staff cited an analysis from ei-
ther 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  and ,  of these new products did not experience
any rating changes over a twelve-month period while only  of corporate bonds
maintained their ratings. Over a longer time period, however, structured finance rat-
ings were not so stable. Between  and , only  of triple-A-rated struc-
tured finance securities retained their original rating after five years. Underwriters
continued to sell CDOs using these statistics in their pitch books during  and
, 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 diligence.
As Kyle Bass of Dallas-based Hayman Capital Advisors testified before the House
Financial Services Committee, CDOs that purchased lower-rated tranches of mort-
gage-backed securities “are arcane structured finance products that were designed
specifically to make dangerous, lowly rated tranches of subprime debt deceptively at-
tractive to investors. This was achieved through some alchemy and some negligence
in adapting unrealistic correlation assumptions on behalf of the ratings agencies.
They convinced investors that  of a collection of toxic subprime tranches were
the ratings equivalent of U.S. Government bonds.”
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 ,  of U.S. CDO securities would be downgraded. In ,  would.
 T H E C D O M AC H I N E 

In late , 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.
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 diversi-
fying 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.”
Second, the agencies based their CDO ratings on ratings they themselves had as-
signed 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 man-
agement process, and a mean and static expectation of security loss.”
Of course, rating CDOs was a profitable business for the rating agencies. Includ-
ing all types of CDOs—not just those that were mortgage-related—Moody’s rated
 deals in ,  in ,  in , and  in ; the value of those deals
rose from  billion in  to  billion in ,  billion in , and 
billion in . The reported revenues of Moody’s Investors Service from struc-
tured products—which included mortgage-backed securities and CDOs—grew from
 million in , or  of Moody’s Corporation’s revenues, to  million in
 or  of overall corporate revenue. The rating of asset-backed CDOs alone
contributed more than  of the revenue from structured finance. The boom
years of structured finance coincided with a company-wide surge in revenue and
profits. From  to , the corporation’s revenues surged from  million to
 billion and its profit margin climbed from  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
catch-up,” Witt said. Moody’s “penny-pinching” and “stingy” management was re-
luctant to pay up for experienced employees. “The problem of recruiting and retain-
ing 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 for-
mer team managing director at Moody’s, told the FCIC that from  to , the
increase in the number of deals rated was “huge . . . but our personnel did not go up
accordingly.” By , Kolchinsky recalled, “My role as a team leader was crisis man-
agement. Each deal was a crisis.” When personnel worked to create a new method-
ology, 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  billion of CDO deals between  and .
The ratings agencies’ correlation assumptions had a direct and critical impact on
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

how CDOs were structured: assumptions of a lower correlation made possible larger
easy-to-sell 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. More-
over, because issuers could choose which rating agencies to do business with, and be-
cause 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 , was presented with an organization
chart from July . She identified  out of  analysts—about  of the staff—
who had left Moody’s to work for investment or commercial banks.
Brian Clarkson, who oversaw the structured finance group before becoming the
president of Moody’s Investors Service, explained to FCIC investigators that retaining
employees was always a challenge, for the simple reason that the banks paid more. As
a precaution, Moody’s employees were prohibited from rating deals by a bank or is-
suer while they were interviewing for a job with that particular institution, but the re-
sponsibility for notifying management of the interview rested on the employee. After
leaving Moody’s, former employees were barred from interacting with Moody’s on
the same series of deals they had rated while in its employ, but there were no bans
against working on other deals with Moody’s.

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 st century with little formal govern-
ment regulation beyond their broker-dealer subsidiaries. In , the European
Union told U.S. financial firms that to continue to do business in Europe, they would
need a “consolidated” supervisor by —that is, one regulator that had responsibil-
ity 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 invest-
ment banks, however, did not meet the standard: the SEC was supervising their secu-
rities arms, but 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 , the combined assets at the five firms totaled . trillion, more than half
of the . 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 . 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
 T H E C D O M AC H I N E 

dealing, investments, securitization, and similar activities on top of their traditional

investment banking functions. Recall that at Bear Stearns, trading and investments ac-
counted for more than  of pretax earnings in some years after .
The investment banks also owned depository institutions through which they
could provide FDIC-insured accounts to their brokerage customers; the deposits pro-
vided cheap but limited funding. These depositories took the form of a thrift (super-
vised 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 origina-
tion activities.
The investment banks’ possession of depository subsidiaries suggested two obvi-
ous 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 regu-
lation 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 fo-
cus was on investor protection.
In November , 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 leg-
islative authority to require the investment banks to submit to consolidated regula-
tion, 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 in-
vestment 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 Mor-
gan 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
 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  had
required straightforward calculations based on asset classes and credit ratings, a
bright-line approach that gave firms little discretion in calculating their capital. The
new rules would allow the investment banks to create their own proprietary Value at
Risk (VaR) models to calculate their regulatory capital—that is, the capital each firm
would have to hold to protect its customers’ assets should it experience losses on its
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

securities and derivatives. All in all, the SEC estimated that the proposed new re-
liance on proprietary VaR models would allow broker-dealers to reduce average cap-
ital charges by . 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
 billion at any time.
Meanwhile, the OTS was already supervising the thrifts owned by several securi-
ties 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 pro-
posal, 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 Gramm-Leach-Bliley Act, “carefully kept the responsibility for supervision of
the holding company itself with the OTS or the Federal Reserve Board, depending
upon whether the holding company was a [thrift holding company] or a bank hold-
ing 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 fed-
eral deposit insurance funds by depository institution holding companies and their
affiliates.” The OTS declared: “We believe that the SEC’s proposed assertion of au-
thority over [savings and loan holding companies] is unfounded and could pose sig-
nificant 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 con-
sistency with modern comprehensive risk management practices.” In FCIC inter-
views, 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  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, al-
though 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.
Harvey Goldschmid, SEC commissioner from  to , told FCIC staff that
before the CSE program was created, SEC staff members were concerned about how
little authority they had over the Wall Street firms, including their hedge funds and
overseas subsidiaries. Once the CSE program was in place, the SEC had “the author-
ity to look at everything.” SEC commissioners discussed at the time the risks they
were taking by allowing firms to reduce their capital. “If anything goes wrong it’s go-
 T H E C D O M AC H I N E 

ing to be an awfully big mess,” Goldschmid said at a  meeting. “Do we feel secure
if these drops in capital and other things [occur] we really will have investor protec-
tion?” In response, Annette Nazareth, the SEC official who would be in charge of the
program, assured the commissioners that her division was up to the challenge.
The new program was housed primarily in the SEC’s Office of Prudential Supervi-
sion and Risk Analysis, an office with a staff of  to  within the Division of Market
Regulation. In the beginning, it was supported by the SEC’s much larger examina-
tion staff; by  the staff dedicated to the CSE program had grown to . Still,
only  “monitors” were responsible for the five investment banks;  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 OCC alone assigned more than  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 en-
trance exam, in , showed several deficiencies. For example, examiners were con-
cerned that there were no firmwide 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 reor-
ganization, Bear did not have its next annual exam, during which the SEC was sup-
posed 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 , 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 se-
cured repo lending. Unfortunately, tens of billions of dollars of that repo lending
was overnight funding that could disappear with no warning. Ironically, in the sec-
ond week of March , 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  to , 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 irrespon-
sible.” In fact, leverage had been higher at the five investment banks in the late
s, then dropped before increasing over the life of the CSE program—a history
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

that suggests that the program was not solely responsible for the changes. In ,
Sirri noted that under the CSE program the investment banks’ net capital levels “re-
mained relatively stable . . . and, in some cases, increased significantly” over the pro-
gram. Still, Goldschmid, who left the SEC in , 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  until the fi-
nancial 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 , in the midst
of the financial crisis, the CSE program was discontinued after all five of the largest
independent investment banks had either closed down (Lehman Brothers), merged
into other entities (Bear Stearns and Merrill Lynch), or converted to bank holding
companies to be supervised by the Federal Reserve (Goldman Sachs and Morgan
Stanley).
For the Fed, there would be a certain irony in that last development concerning
Goldman and Morgan Stanley. Fed officials had seen their agency’s regulatory
purview shrinking over the course of the decade, as JP Morgan switched the charter
of its banking subsidiary to the OCC and as the OTS and SEC promoted their al-
ternatives for consolidated supervision. “The OTS and SEC were very aggressive in
trying to promote themselves as a regulator in that environment and wanted to be the
consolidated supervisor . . . to meet the requirements in Europe for a consolidated
supervisor,” said Mark Olson, a Fed governor from  to . “There was a lot of
competitiveness among the regulators.” In January , Fed staff had prepared an
internal study to find out why none of the investment banks had chosen the Fed as its
consolidated supervisor. The staff interviewed five firms that already were supervised
by the Fed and four that had chosen the SEC. According to the report, the biggest
reason firms opted not to be supervised by the Fed was the “comprehensiveness” of
the Fed’s supervisory approach, “particularly when compared to alternatives such as
Office of Thrift Supervision (OTS) or Securities & Exchange Commission (SEC)
holding company supervision.”
 T H E C D O M AC H I N E 

COMMISSION CONCLUSIONS ON CHAPTER 8

The Commission concludes declining demand for riskier portions (or tranches)
of mortgage-related securities led to the creation of an enormous volume of col-
lateralized debt obligations (CDOs). These CDOs—composed of the riskier
tranches—fueled demand for nonprime mortgage securitization and contributed
to the housing bubble. Certain products also played an important role in doing
so, including CDOs squared, credit default swaps, synthetic CDOs, and asset-
backed commercial paper programs that invested in mortgage-backed securities
and CDOs. Many of these risky assets ended up on the balance sheets of systemi-
cally important institutions and contributed to their failure or near failure in the
financial crisis.
Credit default swaps, sold to provide protection against default to purchasers
of the top-rated tranches of CDOs, facilitated the sale of those tranches by con-
vincing investors of their low risk, but greatly increased the exposure of the sellers
of the credit default swap protection to the housing bubble’s collapse.
Synthetic CDOs, which consisted in whole or in part of credit default swaps,
enabled securitization to continue and expand even as the mortgage market dried
up and provided speculators with a means of betting on the housing market. By
layering on correlated risk, they spread and amplified exposure to losses when the
housing market collapsed.
The high ratings erroneously given CDOs by credit rating agencies encour-
aged investors and financial institutions to purchase them and enabled the con-
tinuing securitization of nonprime mortgages. There was a clear failure of
corporate governance at Moody’s, which did not ensure the quality of its ratings
on tens of thousands of mortgage-backed securities and CDOs.
The Securities and Exchange Commission’s poor oversight of the five largest
investment banks failed to restrict their risky activities and did not require them
to hold adequate capital and liquidity for their activities, contributing to the fail-
ure or need for government bailouts of all five of the supervised investment banks
during the financial crisis.
 9
ALL IN

CONTENTS
The bubble: “A credit-induced boom”.................................................................
Mortgage fraud: “Crime-facilitative environments” ...........................................
Disclosure and due diligence: “A quality control issue in the factory” .................
Regulators: “Markets will always self-correct”....................................................
Leveraged loans and commercial real estate:
“You’ve got to get up and dance” ....................................................................
Lehman: From “moving” to “storage” .................................................................
Fannie Mae and Freddie Mac: “Two stark choices”............................................

In , the Bakersfield, California, homebuilder Warren Peterson was paying as lit-
tle as , for a ,-square-foot lot, about the size of three tennis courts. The
next year the cost more than tripled to ,, as real estate boomed. Over the pre-
vious quarter century, Peterson had built between  and  custom and semi-custom
homes a year. For a while, he was building as many as . And then came the crash.
“I have built exactly one new home since late ,” he told the FCIC five years
later.
In , the average price was , for a new house in Bakersfield, at the
southern end of California’s agricultural center, the San Joaquin Valley. That jumped
to almost , by June . “By , 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. Some-
times they would flip the house while it was still in escrow, and would still make 
to .”
Nationally, housing prices jumped  between  and their peak in ,
more than in any decade since at least . It would be catastrophically downhill
from there—yet the mortgage machine kept churning well into , apparently in-
different to the fact that housing prices were starting to fall and lending standards 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


 ALL IN 

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 ap-
peared 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.

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  presentation, the Quality Assurance staff reported they had found severe
underwriting errors, including evidence of predatory lending, legal and state viola-
tions, and credit issues, in  of the loans they audited in November and December
. In , Chief Operating Officer and later CEO Brad Morrice recommended
these results be removed from the statistical tools used to track loan performance,
and in , 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 , it gave the company’s loan production depart-
ment “unsatisfactory” ratings seven times. Patrick Flanagan, president of New Cen-
tury’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 in-
stead of audit.”
This happened as the company struggled with increasing requests that it buy
back soured loans from investors. By December , almost  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.
In September —seven months before the housing market peaked—thou-
sands of originators, securitizers, and investors met at the ABS East  conference
in Boca Raton, Florida, to play golf, do deals, and talk about the market. The asset-
backed security business was still good, but even the most optimistic could read the
signs. Panelists had three concerns: Were housing prices overheated, or just driven by
“fundamentals” such as increased demand? Would rising interest rates halt the
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

market? And was the CDO, because of its ratings-driven investors, distorting the
mortgage market?
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 de-
clines—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  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 na-
tion as a whole does not appear likely.”
Globally, prices jumped in many countries around the world during the s. 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  to , price in-
creases 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 Mon-
etary Fund study from , more than one half of the  developed countries ana-
lyzed had greater home price appreciation than the United States from late 
through the third quarter of , 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 . 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 in-
creases. The good news was the economy was growing and unemployment was low.
But, a Federal Reserve study in May  presented evidence that the cost of owning
rather than renting was much higher than had been the case historically: home prices
had risen from  times the annual cost of renting to  times. In some cities, the
change was particularly dramatic. From  to , the ratio of house prices to
rents rose in Los Angeles, Miami, and New York City by , , and , re-
spectively. In , the National Association of Realtors’ affordability index—which
measures whether a typical family could qualify for a mortgage on a typical home—
had reached a record low. But that was based on the cost of a traditional mortgage
with a  down payment, which was no longer required. Perhaps such measures
were no longer relevant, when Americans could make lower down payments and ob-
tain loans such as payment-option adjustable-rate mortgages and interest-only mort-
gages, with reduced initial mortgage payments. Or perhaps buying a home continued
to make financial sense, given homeowners’ expectations of further price gains.
During a June meeting, the Federal Open Market Committee (FOMC), com-
posed of Federal Reserve governors, four regional Federal Reserve Bank presidents,
and the Federal Reserve Bank of New York president, heard five presentations on
 ALL IN 

mortgage risks and the housing market. Members and staff had difficulty develop-
ing a consensus on whether housing prices were overvalued and “it was hard for
many 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 ar-
gued, according to the letter. In discussions about nontraditional mortgage prod-
ucts, 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 on a portion
of interest-only loans, the ratios for most remained around . Another presenta-
tion suggested that housing market activity could be the result of “solid fundamen-
tals.” 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 s stock
bubble.” Most FOMC participants agreed “the probability of spillovers to financial
institutions seemed moderate.”
As one recent study argues, many economists were “agnostics” on housing, un-
willing to risk their reputations or spook markets by alleging a bubble without find-
ing support in economic theory. Fed Vice Chairman Donald Kohn was one.
“Identification [of a bubble] is a tricky proposition because not all the fundamental
factors driving asset prices are directly observable,” Kohn said in a  speech, cit-
ing research by the European Central Bank. “For this reason, any judgment by a cen-
tral bank that stocks or homes are overpriced is inherently highly uncertain.”
But not all economists hesitated to sound a louder alarm. “The situation is begin-
ning to look like a credit-induced boom in housing that could very well result in a
systemic bust if credit conditions or economic conditions should deteriorate,” Federal
Deposit Insurance Corporation Chief Economist Richard Brown wrote in a March
 report. “During the past five years, the average U.S. home has risen in value by
, while homes in the fastest-growing markets have approximately doubled in
value.” While this increase might have been explained by strong market fundamen-
tals, “the dramatic broadening of the housing boom in  strongly suggests the in-
fluence of systemic factors, including the low cost and wide availability of mortgage
credit.”
A couple of months later, Fed economists in an internal memo acknowledged the
possibility that housing prices were overvalued, but downplayed the potential im-
pacts 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.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

MORTGAGE FRAUD:
“CRIMEFACILITATIVE ENVIRONMENTS”
New Century—where  of the mortgages were loans with little or no documenta-
tion—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 depart-
ments and concerned employees were ignored. These conditions created an environ-
ment 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-s, at least . 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 informa-
tion on a loan application. Fraud for profit typically involves a deception to gain fi-
nancially 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 borrowers.”
In  of cases, according to the FBI, fraud involves industry insiders. For ex-
ample, property flipping can involve buyers, real estate agents, appraisers, and com-
plicit 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 buy-
ers” 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  for placing
ads between  and  in Haitian community newspapers offering assistance
with immigration problems; they were accused of then stealing the identities of hun-
dreds 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.
Estimates vary on the extent of fraud, as it is seldom investigated unless proper-
ties go into foreclosure. Ann Fulmer, vice president of business relations at Inter-
thinx, a fraud detection service, told the FCIC that her firm analyzed a large
sample of all loans from  to  and found  contained lies or omissions
significant enough to rescind the loan or demand a buyback if it had been securi-
tized. The firm’s analysis indicated that about  trillion of the loans made during
the period were fraudulent. Fulmer further estimated  billion worth of fraudu-
lent loans from  to  resulted in foreclosures, leading to losses of  bil-
lion 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 
of originations. Such loans could stay comfortably under the radar, because many
borrowers made payments on time.
 ALL IN 

Ed Parker, the head of mortgage fraud investigation at Ameriquest, the largest

subprime lender in , , and , told the FCIC that fraudulent loans were
very common at the company. “No one was watching. The volume was up and now
you see the fallout behind the loan origination process,” he told the FCIC. David
Gussmann, the former vice president of Enterprise Management Capital Markets at
Fannie Mae, told the Commission that in one package of  securitized loans his an-
alysts found one purchaser who had bought  properties, falsely identifying himself
each time as the owner of only one property, while another had bought five proper-
ties. Fannie Mae’s detection of fraud increased steadily during the housing bubble
and accelerated in late , according to William Brewster, the current director of
the company’s mortgage fraud program. He said that, seeing evidence of fraud, Fan-
nie demanded that lenders such as Bank of America, Countrywide, Citigroup, and
JP Morgan Chase repurchase about  million in mortgages in  and  mil-
lion in . “Lax or practically non-existent government oversight created what
criminologists have labeled ‘crime-facilitative environments,’ where crime could
thrive,” said Henry N. Pontell, a professor of criminology at the University of Califor-
nia, Irvine, in testimony to the Commission.
The responsibility to investigate and prosecute mortgage fraud violations falls to
local, state and federal law enforcement officials. On the federal level, the Federal Bu-
reau of Investigation investigates and refers cases for prosecution to U.S. Attorneys,
who are part of the Department of Justice. Cases may also involve other agencies, in-
cluding the U.S. Postal Inspection Service, the Department of Housing and Urban
Development, and the Internal Revenue Service. The FBI, which has the broadest ju-
risdiction of any federal law enforcement agency, was aware of the extent of the
fraudulent mortgage problem. FBI Assistant Director Chris Swecker began noticing
a rise in mortgage fraud while he was the special agent in charge of the Charlotte,
North Carolina, office from  to . In , that office investigated First Bene-
ficial Mortgage for selling fraudulent loans to Fannie Mae, leading to the successful
criminal prosecution of the company’s owner, James Edward McLean Jr., and others.
First Beneficial repurchased the mortgages after Fannie discovered evidence of fraud,
but then—without any interference from Fannie—resold them to Ginnie Mae. For
not alerting Ginnie, Fannie paid . million of restitution to the government.
McLean came to the attention of the FBI after buying a luxury yacht for , in
cash. Soon after Swecker was promoted to assistant FBI director for investigations
in , he turned a spotlight on mortgage fraud. “The potential impact of mortgage
fraud is clear,” Swecker told a congressional committee in . “If fraudulent prac-
tices become systemic within the mortgage industry and mortgage fraud is allowed
to become unrestrained, it will ultimately place financial institutions at risk and have
adverse effects on the stock market.”
In that testimony, Swecker pointed out the inadequacies of data regarding fraud
and recommended that Congress mandate a reporting system and other remedies
and require all lenders to participate, whether federally regulated or not. For exam-
ple, suspicious activity reports, also known as SARs, are reports filed by FDIC-in-
sured banks and their affiliates to the Financial Crimes Enforcement Network
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

(FinCEN), a bureau within the Treasury Department that administers money-laun-

dering laws and works closely with law enforcement to combat financial crimes.
SARs are filed by financial institutions when they suspect criminal activity in a finan-
cial transaction. But many mortgage originators, such as Ameriquest, New Century,
and Option One, were outside FinCEN’s jurisdiction—and thus the loans they gener-
ated, which were then placed into securitized pools by larger lenders or investment
banks, were not subject to FinCEN review. William Black testified to the Commis-
sion that an estimated  of nonprime mortgage loans were made by noninsured
lenders not required to file SARs. And as for those institutions required to do so, he
believed he saw evidence of underreporting in that, he said, only about  of feder-
ally insured mortgage lenders filed even a single criminal referral for alleged mort-
gage fraud in the first half of .
Countrywide, the nation’s largest mortgage lender at the time, had about , in-
ternal referrals of potentially fraudulent activity in its mortgage business in ,
, in , and , in , according to Francisco San Pedro, the former
senior vice president of special investigations at the company. But it filed only 
SARs in , , in , and , in .
Similarly, in examining Bank of America in , its lead bank regulator, the Of-
fice of the Comptroller of the Currency (OCC), sampled  mortgages and found 
with “quality assurance referrals” for suspicious activity for which no report had been
filed with FinCEN. All  met the legal requirement for a filing. The OCC conse-
quently required management to refine its processes to ensure that SARs were consis-
tently filed.
Darcy Parmer, a former quality assurance and fraud analyst at Wells Fargo, the
second largest mortgage lender from  through  and the largest in , told
the Commission that “hundreds and hundreds and hundreds of fraud cases” that she
knew were identified within Wells Fargo’s home equity loan division were not re-
ported to FinCEN. And, she added, at least half the loans she flagged for fraud were
nevertheless funded, over her objections.
Despite the underreporting, the jump in mortgage fraud drew attention. FinCEN
in November  reported a -fold increase in SARs related to mortgage fraud be-
tween  and . It noted that two-thirds of the loans being created were origi-
nated by mortgage brokers who were not subject to any federal standard or
oversight. Swecker unsuccessfully asked legislators to compel all lenders to forward
information about criminal fraud to regulators and law enforcement agencies.
Swecker attempted to gain more funding to combat mortgage fraud but was resis-
ted. Swecker told the FCIC his funding requests were cut at either the director level at
the FBI, at the Justice Department, or at the Office of Management and Budget. He
called his struggle for more resources an “uphill slog.”
In , , SARs related to mortgage fraud were filed; in  there were
,. The number kept climbing, to , in , , in , and , in
. At the same time, top FBI officials, focusing on terrorist threats, reduced the
agents assigned to white-collar crime from , in the  fiscal year to fewer than
, by . That year, its mortgage fraud program had only  agents at any one
 ALL IN 

time to review more than , SARs filed with FinCEN. In response to inquiries
from the FCIC, the FBI said that to compensate for a lack of manpower, it had devel-
oped “new and innovative methods to detect and combat mortgage fraud,” such as a
computer application, created in , to detect property flipping.
Robert Mueller, the FBI’s director since , said mortgage fraud needed to be
considered “in context of other priorities,” such as terrorism. He told the Commis-
sion 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 addi-
tional 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 inves-
tigate fraud, and Mueller suggested that some prosecutions may be still to come.
Alberto Gonzales, the nation’s attorney general from February  to Septem-
ber , 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 , the Office of Federal Housing Enterprise Oversight, the regulator of the
GSEs, released a report showing a “significant rise in the incidence of fraud in mort-
gage lending in  and the first half of .” OFHEO stated it had been working
closely with law enforcement and was an active member of the Department of Justice
Mortgage Fraud Working Group. “The concern about mortgage fraud and fraud in
general was an issue,” Richard Spillenkothen, head of banking supervision and regu-
lation at the Fed from  to , told the FCIC. “And we understood there was an
increasing incidence of [mortgage fraud].”
Michael B. Mukasey, who served as U.S. attorney general from November 
to the end of , told the Commission that he recalled “receiving reports of mort-
gage failures and of there being fraudulent activity in connection with flipping
houses, overvaluation, and the like. . . . I have a dim recollection of outside people
commenting that additional resources should be devoted, and there being specula-
tion about whether resources that were being diverted to national security investiga-
tions, and in particular the terrorism investigations were somehow impeding fraud
investigations, which I thought was a bogus issue.” He said that the department had
other pressing priorities, such as terrorism, gang violence, and southwestern border
issues.
In letters to the FCIC, the Department of Justice outlined actions it undertook
along with the FBI to combat mortgage fraud. For example, in , the FBI
launched Operation Continued Action, targeting a variety of financial crimes, in-
cluding 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 an-
nounced a joint effort combating mortgage fraud. From July to October , this
program, Operation Quick Flip, produced  indictments,  arrests, and 
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

convictions for mortgage fraud. In , the FBI started specifically tracking mort-
gage fraud cases and increased personnel dedicated to those efforts. And in ,
Operation Malicious Mortgage resulted in  mortgage fraud cases in which 
defendants were charged by U.S. Attorneys offices throughout the country.
William Black told the Commission that Washington essentially ignored the issue
and allowed it to worsen. “The FBI did have severe limits,” because of the need to re-
spond to the / attacks, Black said, and the problem was compounded by the lack
of cooperation: “The terrible thing that happened was that the FBI got virtually no
assistance from the regulators, the banking regulators and the thrift regulators.”
Swecker, the former FBI official, told the Commission he had no contact with bank-
ing regulators during his tenure.
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 ,  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 in-
volved some  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- 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 , 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 disap-
pear 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  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 , although Argent, and the company’s loan-servicing
arm, were bought by Citigroup that same year.
 ALL IN 

DISCLOSURE AND DUE DILIGENCE:

“A QUALITY CONTROL ISSUE IN THE FACTORY”
In addition to the rising fraud and egregious lending practices, lending standards de-
teriorated in the final years of the bubble. After growing for years, Alt-A lending in-
creased another  from  to . In particular, option ARMs grew  during
that period, interest-only mortgages grew , and no-documentation or low-docu-
mentation loans (measured for borrowers with fixed-rate mortgages) grew .
Overall, by  no-doc or low-doc loans made up  of all mortgages originated.
Many of these products would perform only if prices continued to rise and the bor-
rower 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 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 securities.
In theory, the rating agencies were 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 pur-
chasing and securitizing the mortgages would conduct due diligence reviews of the
mortgage pools, either using third-party firms or doing the reviews in-house. Sec-
ond, following Securities and Exchange Commission rules, parties in the securitiza-
tion process were expected to disclose what they were selling to investors. Neither of
these checks performed as they should have.

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 dili-
gence investigation. While the percentage of the pool examined could be as high as
, 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  to . Some secu-
ritizers 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.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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, some-
times 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 prop-
erty 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.
Because of the volume of loans examined by Clayton during the housing boom,
the firm had a unique inside view of the underwriting standards that originators were
actually applying—and that securitizers were willing to accept. Loans were classified
into three groups: loans that met guidelines (a Grade  Event), those that failed to
meet guidelines but were approved because of compensating factors (a Grade 
Event), and those that failed to meet guidelines and were not approved (a Grade 
Event). Overall, for the  months that ended June , , Clayton rated  of the
, loans it analyzed as Grade , and another  as Grade —for a total of 
that met the guidelines outright or with compensating factors. The remaining  of
the loans were Grade . In theory, the banks could have refused to buy a loan pool,
or, indeed, they could have used the findings of the due diligence firm to probe the
loans’ quality more deeply. Over the -month period,  of the loans that Clayton
found to be deficient—Grade —were “waived in” by the banks. Thus  of the
loans sampled by Clayton were accepted even though the company had found a basis
for rejecting them (see figure .).
Referring to the data, Keith Johnson, the president of Clayton from May  to
May , told the Commission, “That  to me says there [was] a quality control
issue in the factory” for mortgage-backed securities. Johnson concluded that his
clients often waived in loans to preserve their business relationship with the loan
originator—a high number of rejections might lead the originator to sell the loans to
a competitor. Simply put, it was a sellers’ market. “Probably the seller had more
power than the Wall Street issuer,” Johnson told the FCIC.
The high rate of waivers following rejections may not itself be evidence of some-
thing wrong in the process, Beal testified. She said that as originators’ lending guide-
lines were declining, she saw the securitizing firms introduce additional credit
 ALL IN 

Rejected Loans Waived in by Selected Banks

From January 2006 through June 2007, Clayton rejected 28% of the mortgages
it reviewed. Of these, 39% were waived in anyway.
A B C D E
ACCEPTED REJECTED REJECTED REJECTED FINANCIAL
LOANS LOANS LOANS LOANS AFTER INSTITUTION
(Event 1 & 2)/ (Event 3)/ WAIVED IN BY WAIVERS WAIVER RATE
Total pool of Total pool of FINANCIAL (B–C) (C/B)
loans loans INSTITUTIONS
Financial Institution
Citigroup 58% 42% 13% 29% 31%
Credit Suisse 68 32 11 21 33
Deutsche 65 35 17 17 50
Goldman 77 23 7 16 29
JP Morgan 73 27 14 13 51
Lehman 74 26 10 16 37
Merrill 77 23 7 16 32
UBS 80 20 6 13 33
WaMu 73 27 8 19 29
Total Bank Sample 72% 28% 11% 17% 39%

NOTES: From Clayton Trending Reports. Numbers may not add due to rounding.
SOURCE: Clayton Holdings

Figure .

guidelines. “As you know, there was stated income, they were telling us look for rea-
sonableness of that income, things like that.” With stricter guidelines, one would ex-
pect more rejections, and, after the securitizer looks more closely at the rejected
loans, possibly more waivers. As Moody’s Investors Service explained in a letter to
the FCIC, “A high rate of waivers from an institution with extremely tight underwrit-
ing standards could result in a pool that is less risky than a pool with no waivers from
an institution with extremely loose underwriting standards.” Nonetheless, many
prospectuses indicated that the loans in the pools either met guidelines outright or
had compensating factors, even though Clayton’s records show that only a portion of
the loans were sampled, and that of those that were sampled, a substantial percentage
of Grade  Event loans were waived in.
Johnson said he approached the rating agencies in  and  to gauge their
interest in the exception-tracking product that Clayton was developing. He said he
shared some of their company’s results, attempting to convince the agencies that the
data would benefit the ratings process. “We went to the rating agencies and said,
‘Wouldn’t this information be great for you to have as you assign tranche levels of
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

risk?’” Johnson recalled. The agencies thought the due diligence firm’s data were
“great,” but they did not want the information, Johnson said, because it would pre-
sumably produce lower ratings for the securitizations and cost the agency business—
even in , as the private securitization market was winding down.
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 bank-
ruptcy describes such a practice. Similarly, Fremont Investment & Loan had a pol-
icy 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 per-
sonnel 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 -plus professional underwriters, testified that his team con-
ducted 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.
For subprime purchases, Bowen’s team would review the physical credit file of the
loans they were purchasing. “During  and , I witnessed many changes to the
way the credit risk was being evaluated for these pools during the purchase
processes,” Bowen said. For example, he said, the chief risk officer in Citigroup’s Con-
sumer Lending business reversed large numbers of underwriting decisions from
“turn down” to “approved.”
Another part of Bowen’s charge was to supervise the purchase of roughly  bil-
lion annually in prime loan pools, a high percentage of which were sold to Fannie
Mae and Freddie Mac for securitization. The sampling provided to Bowen’s staff for
quality control was supposed to include at least  of the loan pool for a given secu-
ritization, but “this corporate mandate was usually ignored.” Samples of  were
more likely, and the loan samples that Bowen’s group did examine showed extremely
high rates of noncompliance. “At the time that I became involved, which was early to
mid-, we identified that  to  percent of the files either had a ‘disagree’ deci-
sion, or they were missing critical documents.”
Bowen repeatedly expressed concerns to his direct supervisor and company exec-
utives about the quality and underwriting of mortgages that CitiMortgage purchased
and then sold to the GSEs. As discussed in a later chapter, the GSEs would later re-
 ALL IN 

quire Citigroup to buy back . billion in loans as of November , finding that
the loans Citigroup had sold them did not conform to GSE standards.

SEC: “The elephant in the room is that

we didn’t review the prospectus supplements”
By the time the financial crisis hit, investors held more than  trillion of non-GSE
mortgage-backed securities and close to  billion of CDOs that held mortgage-
backed securities. These securities were issued with practically no SEC oversight.
And only a minority were subject to the SEC’s ongoing public reporting require-
ments. 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 securi-
ties 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 de-
scribing 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 fi-
nance, Shelley Parratt, told the FCIC. To improve disclosures pertaining to mort-
gage-backed securities and other asset-backed securities, the SEC issued Regulation
AB in late . The regulation required that every prospectus include “a description
of the solicitation, credit-granting or underwriting criteria used to originate or pur-
chase 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.”
With essentially no review or oversight, how good were disclosures about mort-
gage-backed 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.” Citi-
group’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 mort-
gages they were buying actually did meet. Only a small portion—as little as  to
—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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

the loans in the remainder of the mortgage pool that were not sampled (as much as
), Clayton and the securitizers had no information, but one could reasonably ex-
pect 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 ap-
plied 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
A, which allows the unregistered resale of certain securities to so-called qualified
institutional buyers (QIBs); these included investors as diverse as insurance compa-
nies like MetLife, pension funds like the California State Teachers’ Retirement Sys-
tem, and investment banks like Goldman Sachs.
The SEC created Rule A in , making securities markets more attractive to
borrowers and U.S. investment banks more competitive with their foreign counter-
parts; at the time, market participants viewed U.S. disclosure requirements as more
onerous than those in other countries. The new rule significantly expanded the mar-
ket 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 , 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 Com-
mission “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 A. This market was liquid, since qualified
investors could freely trade Rule A debt securities. But debt securities when Rule
A 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.

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 dis-
agreements among the agencies and their traditional preference for minimal interfer-
ence delayed action.
Supervisors had, since the s, 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 dupli-
 ALL IN 

cating 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 . Across agencies, there was a “his-
toric vision, historic approach, that a lighter hand at regulation was the appropriate
way to regulate,” Eugene Ludwig, comptroller of the currency from  to , told
the FCIC, referring to the Gramm-Leach-Bliley Act in . The New York Fed, in a
“lessons-learned” analysis after the crisis, pointed to the mistaken belief that “markets
will always self-correct.” “A deference to the self-correcting property of markets inhib-
ited 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  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, in-
troduced the Basel II capital regime in June , which would allow banks to lower
their capital charges if they could show they had sophisticated internal models for es-
timating 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 super-
visors’ risk-focused approach. Spillenkothen said that one of the regulators’ biggest
mistakes was their “acceptance of Basel II premises,” which he described as display-
ing “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 re-
turn 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 , 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.’”
Indeed, in the same June  Federal Open Market Committee meeting de-
scribed 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 hap-
pen.” 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 securities.
In the spring of , 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 per-
nicious 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 prices.
John Snow, then treasury secretary, told the FCIC that he called a meeting in late
 or early  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 -degree view. The basic reaction from finan-
cial 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 de-
fault 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 , 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 , examiners from the Fed and other agencies conducted a confidential
“peer group” study of mortgage practices at six companies that together had origi-
nated . trillion in mortgages in , 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 prod-
ucts had deteriorated.
Once the Fed and other supervisors had identified the mortgage problems, they
agreed to express those concerns to the industry in the form of nonbinding guidance.
“There was among the Board of Governors folks, you know, some who felt that if we
just put out 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 . The draft guidance
directed lenders to consider a borrower’s ability to make the loan payment when rates
 ALL IN 

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 mar-
ket 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 pay-
ment 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 evi-
dence 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, in-
ternally,” the Fed’s Siddique told the FCIC. “Because it was stifling innovation, poten-
tially, 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 mort-
gage 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 un-
level playing field . . . [for] stand-alone mortgage lenders whom the [Fed] did not reg-
ulate.” Another challenge to regulating the mortgage market was Congress. She
recalled an occasion when she testified about a proposed rule and “members of Con-
gress [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 , regulators policed their guidance
through bank examinations and informal measures such as “voluntary agreements”
with supervised institutions.
It also appeared some institutions switched regulators in search of more lenient
treatment. In December , 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 pro-
moted by the OTS itself over the course of an “outreach effort” initiated in mid-
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.
However, other factors came into play as well. The OCC’s top Countrywide exam-
iner 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  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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

less sophisticated regulator than the Federal Reserve.” In August , 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 ,
.

LEVERAGED LOANS AND COMMERCIAL REAL ESTATE:

“YOU’VE GOT TO GET UP AND DANCE”
The credit bubble was not confined to the residential mortgage market. The markets
for commercial real estate and leveraged loans (typically loans to below-investment-
grade companies to aid their business or to finance buyouts) also experienced similar
bubble-and-bust dynamics, although the effects were not as large and damaging as in
residential real estate. From  to , these other two markets grew tremen-
dously, spurred by structured finance products—commercial mortgage–backed se-
curities and collateralized loan obligations (CLOs), respectively—which were in
many ways similar to residential mortgage-backed securities and CDOs. And just as
in the residential mortgage market, underwriting standards loosened, even as the
cost of borrowing decreased, and trading in these securities was bolstered by the
development of new credit derivatives products.
Historically, leveraged loans had been made by commercial banks; but a market
for institutional investors developed and grew in the mid- to late s. An “agent”
bank would originate a package of loans to only one company and then sell or syndi-
cate the loans in the package to other banks and large nonbank investors. The pack-
age generally included loans with different maturities. Some were short-term lines of
credit, which would be syndicated to banks; the rest were longer-term loans syndi-
cated to nonbank, institutional investors. Leveraged loan issuance more than dou-
bled from  to , but the rapid growth was in the longer-term institutional
loans rather than in short-term lending. By , the longer-term leveraged loans
rose to  billion, up from  billion in .
Starting in , the longer-term leveraged loans were packaged in CLOs, which
were rated according to methodologies similar to those the rating agencies used for
CDOs. Like CDOs, CLOs had tranches, underwriters, and collateral managers. The
market was less than  billion annually from  to , but then it started grow-
ing dramatically. Annual issuance exceeded  billion in  and peaked above
 billion in . From  through the third quarter of , more than  of
leveraged loans were packaged into CLOs.
As the market for leveraged loans grew, credit became looser and leverage in-
creased as well. The deals became larger and costs of borrowing declined. Loans that
in  had paid interest of  percentage points over an interbank lending rate were
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refinanced in early  into loans paying just  percentage points over that same
rate. During the peak of the recent leveraged buyout boom, leveraged loans were fre-
quently issued with interest-only, “payment-in-kind,” and “covenant-lite” terms.
Payment-in-kind loans allowed borrowers to defer paying interest by issuing new
debt to cover accrued interest. Covenant-lite loans exempted borrowers from stan-
dard loan covenants that usually require corporate firms to limit their other debts
and to maintain minimum levels of cash. Private equity firms, those that specialized
in investing directly in companies, found it easier and cheaper to finance their lever-
aged buyouts. Just as home prices rose, so too did the prices of the target companies.
One of the largest deals ever made involving leveraged loans was announced on
April , , by KKR, a private equity firm. KKR said it intended to purchase First
Data Corporation, a processor of electronic data including credit and debit card pay-
ments, for about  billion. As part of this transaction, KKR would issue  billion
in junk bonds and take out another  billion in leveraged loans from a consortium
of banks including Citigroup, Deutsche Bank, Goldman Sachs, HSBC Securities,
Lehman Brothers, and Merrill Lynch.
As late as July , Citigroup and others were still increasing their leveraged loan
business. Citigroup CEO Charles Prince then said of the business, “When the mu-
sic stops, in terms of liquidity, things will be complicated. But as long as the music is
playing, you’ve got to get up and dance. We’re still dancing.” Prince later explained to
the FCIC, “At that point in time, because interest rates had been so low for so long,
the private equity firms were driving very hard bargains with the banks. And at that
point in time the banks individually had no credibility to stop participating in this
lending business. It was not credible for one institution to unilaterally back away
from this leveraged lending business. It was in that context that I suggested that all of
us, we were all regulated entities, that the regulators had an interest in tightening up
lending standards in the leveraged lending area.”
The CLO market would seize up in the summer of  during the financial cri-
sis, just as the much-larger mortgage-related CDO market seized. At the time this
would be roughly  billion in outstanding commitments for new loans; as de-
mand in the secondary market dried up, these loans ended up on the banks’ balance
sheets.
Commercial real estate—multifamily apartment buildings, office buildings, ho-
tels, retail establishments, and industrial properties—went through a bubble similar
to that in the housing market. Investment banks created commercial mortgage–
backed securities and even CDOs out of commercial real estate loans, just as they did
with residential mortgages. And, just as houses appreciated from  on, so too did
commercial real estate values. Office prices rose by nearly  between  and
 in the central business districts of the  markets for which data are available.
The increase was  in Phoenix,  in Tampa,  in Manhattan, and  in
Los Angeles.
Issuance of commercial mortgage–backed securities rose from  billion in 
to  billion in , reaching  billion in . When securitization markets
contracted, issuance fell to  billion in  and  billion in . When about
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one-fourth of commercial real estate mortgages were securitized in , securitizers

issued  billion of commercial mortgage CDOs, a number that again dropped pre-
cipitously in .
Leveraged loans and the commercial real estate sector came together on July ,
, when the Blackstone Group announced its plan to buy Hilton—a hotel chain
with , properties—for  billion, a  premium over the share price. A year
later, one author described this deal as “the apogee of the early-millennial megabuy-
out frenzy, where cheap and readily available credit, coupled with a relentless one-up-
manship, spurred private equity firms to buy out companies at often absurd
overvaluations, saddle them with massive debt, and then pay themselves hefty fees
for the trouble.” Twenty billion dollars in financing came from the top five invest-
ment banks and large commercial banks such as Bank of America and Deutsche
Bank.
Bear Stearns was increasingly active in these markets. While Bear topped the 
market in residential securitizations, it ranked in the bottom half in commercial se-
curitizations. But it was racing to catch up, and in a  presentation boasted: “In
, we firmly established Bear Stearns as a global presence in commercial real es-
tate finance.” The firm’s commercial real estate mortgage originations more than dou-
bled between  and .
And then the market came crashing to a halt. Although the commercial real estate
mortgage market was much smaller than the residential real estate market—in ,
commercial real estate debt was less than  trillion, compared to  trillion for res-
idential mortgages—it declined even more steeply. From its peak, commercial real
estate fell roughly  in value, and prices have remained close to their lows. Losses
on commercial real estate would be an issue across Wall Street, particularly for
Lehman and Bear. And potentially for the taxpayer. When the Federal Reserve would
assume  billion of Bear’s illiquid assets in , that would include roughly  bil-
lion in loans from the unsold portion of the Hilton financing package. And the
commercial real estate market would continue to decline long after the housing mar-
ket had begun to stabilize.

LEHMAN: FROM “MOVING” TO “STORAGE”

Even as the market was nearing its peak, Lehman took on more risk.
On October , , when commercial real estate already made up . of its as-
sets, Lehman Brothers acquired a major stake in Archstone Smith, a publicly traded
real estate investment trust, for . billion. Archstone owned more than ,
apartments, including units still under construction, in over  communities in the
United States. It was the bank’s largest commercial real estate investment.
Lehman initially projected that Archstone would generate more than . billion
in profits over  years—projections based on optimistic assumptions, given the state
of the market at that point. Both Lehman and Archstone were highly leveraged:
Archstone had little cushion if its rent receipts should go down, and Lehman had lit-
tle cushion if investments such as Archstone should lose value. Although the firm
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had proclaimed that “Risk Management is at the very core of Lehman’s business
model,” the Executive Committee simply left its risk officer, Madelyn Antoncic, out of
the loop when it made this investment.
Since the late s, Lehman had also built a large mortgage origination arm, a
formidable securities issuance business, and a powerful underwriting division as
well. Then, in its March  “Global Strategy Offsite,” CEO Richard Fuld and other
executives explained to their colleagues a new move toward an aggressive growth
strategy, including greater risk and more leverage. They described the change as a
shift from a “moving” or securitization business to a “storage” business, in which
Lehman would make and hold longer-term investments.
By summer , the housing market faced ballooning inventories, sharply re-
duced sales volumes, and wavering prices. Senior management regularly disregarded
the firm’s risk policies and limits—and warnings from risk managers—and pursued
its “countercyclical growth strategy.” It had worked well during prior market disloca-
tions, and Lehman’s management assumed that it would work again. Lehman’s Au-
rora unit continued to originate Alt-A loans after the housing market had begun to
show signs of weakening. Lehman also continued to securitize mortgage assets for
sale but was now holding more of them as investments. Across both the commercial
and residential real estate sectors, the mortgage-related assets on Lehman’s books in-
creased from  billion in  to  billion in . This increase would be part
of Lehman’s undoing a year later.
Lehman’s regulators did not restrain its rapid growth. The SEC, Lehman’s main
regulator, knew of the firm’s disregard of risk management. The SEC knew that
Lehman continued to increase its holding of mortgage securities, and that it had in-
creased and exceeded risk limits—facts noted almost monthly in official SEC reports
obtained by the FCIC. Nonetheless, Erik Sirri, who led the SEC’s supervision pro-
gram, told the FCIC that it would not have mattered if the agency had fully recog-
nized the risks associated with commercial real estate. To avoid serious losses, Sirri
maintained, Lehman would have had to start selling real estate assets in . In-
stead, it kept buying, well into the first quarter of .
In addition, according to the bankruptcy examiner, Lehman understated its lever-
age through “Repo ” transactions—an accounting maneuver to temporarily re-
move assets from the balance sheet before each reporting period. Martin Kelly,
Lehman’s global financial controller, stated that the transactions had “no sub-
stance”—their “only purpose or motive . . . was reduction in the balance sheet.” Other
Lehman executives described Repo  transactions as an “accounting gimmick” and
a “lazy way of managing the balance sheet as opposed to legitimately meeting balance
sheet targets at quarter-end.” Bart McDade, who became Lehman’s president and
chief operating officer in June , in an email called Repo  transactions “an-
other drug we R on.”
Ernst & Young (E&Y), Lehman’s auditor, was aware of the Repo  practice but
did not question Lehman’s failure to publicly disclose it, despite being informed in
May  by Lehman Senior Vice President Matthew Lee that the practice was im-
proper. The Lehman bankruptcy examiner concluded that E&Y took “virtually no
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action to investigate the Repo  allegations, . . . took no steps to question or chal-
lenge the non-disclosure by Lehman,” and that “colorable claims exist that E&Y did
not meet professional standards, both in investigating Lee’s allegations and in con-
nection with its audit and review of Lehman’s financial statements.” New York At-
torney General Andrew Cuomo sued E&Y in December , accusing the firm of
facilitating a “massive accounting fraud” by helping Lehman to deceive the public
about its financial condition.
The Office of Thrift Supervision had also regulated Lehman since  through
its jurisdiction over Lehman’s thrift subsidiary. Although “the SEC was regarded as
the primary regulator,” the OTS examiner told the FCIC, “we in no way just assumed
that [the SEC] would do the right thing, so we regulated and supervised the holding
company.” Still, not until July —just a few months before Lehman failed—
would the OTS issue a report warning that Lehman had made an “outsized bet” on
commercial real estate—larger than that by its peer firms, despite Lehman’s smaller
size; that Lehman was “materially overexposed” to the commercial real estate sector;
and that Lehman had “major failings in its risk management process.”

FANNIE MAE AND FREDDIE MAC: “TWO STARK CHOICES”

In , while Countrywide, Citigroup, Lehman, and many others in the mortgage
and CDO businesses were going into overdrive, executives at the two behemoth
GSEs, Fannie and Freddie, worried they were being left behind. One sign of the
times: Fannie’s biggest source of mortgages, Countrywide, expanded—that is, loos-
ened—its underwriting criteria, and Fannie would not buy the new mortgages,
Countrywide President and COO Sambol told the FCIC. Typical of the market as a
whole, Countrywide sold  of its loans to Fannie in  but only  in  and
 in .
“The risk in the environment has accelerated dramatically,” Thomas Lund, Fan-
nie’s head of single-family lending, told fellow senior officers at a strategic planning
meeting on June , . In a bulleted list, he ticked off changes in the market: the
“proliferation of higher risk alternative mortgage products, growing concern about
housing bubbles, growing concerns about borrowers taking on increased risks and
higher debt, [and] aggressive risk layering.”
“We face two stark choices: stay the course [or] meet the market where the market
is,” Lund said. If Fannie Mae stayed the course, it would maintain its credit discipline,
protect the quality of its book, preserve capital, and intensify the company’s public
voice on concerns. However, it would also face lower volumes and revenues, contin-
ued declines in market share, lower earnings, and a weakening of key customer rela-
tionships. It was simply a matter of relevance, former CEO Dan Mudd told the
FCIC: “If you’re not relevant, you’re unprofitable, and you’re not serving the mission.
And there was danger to profitability. I’m speaking more long term than in any given
quarter or any given year. So this was a real strategic rethinking.”
Lund saw significant obstacles to meeting the market. He noted Fannie’s lack of
capability and infrastructure to structure the types of riskier mortgage-backed secu-
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rities offered by Wall Street, its unfamiliarity with the new credit risks, worries that
the price of the mortgages wouldn’t be worth the risk, and regulatory concerns sur-
rounding certain products. At this and other meetings, Lund recommended study-
ing whether the current market changes were cyclical or more permanent, but he also
recommended that Fannie “dedicate significant resources to develop capabilities to
compete in any mortgage environment.” Citibank executives also made a presenta-
tion to Fannie’s board in July , warning that Fannie was increasingly at risk of
being marginalized, and that “stay the course” was not an option. Citibank proposed
that Fannie expand its guarantee business to cover nontraditional products such as
Alt-A and subprime mortgages. Of course, as the second-largest seller of mort-
gages to Fannie, Citibank would benefit from such a move. Over the next two years,
Citibank would increase its sales to Fannie by more than a quarter, to  billion in
the  fiscal year, while more than tripling its sales of interest-only mortgages, to
 billion.
Lund told the FCIC that in , the board would adopt his recommendation: for
the time being, Fannie would “stay the course,” while developing capabilities to com-
pete with Wall Street in nonprime mortgages. In fact, however, internal reports
show that by September , the company had already begun to increase its acquisi-
tions of riskier loans. By the end of , its Alt-A loans were  billion, up from
 billion in  and  billion in ; its loans without full documentation
were  billion, up from  billion in ; and its interest-only mortgages were
 billion in , up from  billion in . (Note that these categories can over-
lap. For example, Alt-A loans may also lack full documentation.) To cover potential
losses from all of its business activities, Fannie had a total of  billion in capital at
the end of . “Plans to meet market share targets resulted in strategies to increase
purchases of higher risk products, creating a conflict between prudent credit risk
management and corporate business objectives,” the Federal Housing Finance
Agency (the successor to the Office of Federal Housing Enterprise Oversight) would
write in September  on the eve of the government takeover of Fannie Mae.
“Since , Fannie Mae has grown its Alt-A portfolio and other higher risk products
rapidly without adequate controls in place.”
In its financial statements, Fannie Mae’s disclosures about key loan characteristics
changed over time, making it difficult to discern the company’s exposure to subprime
and Alt-A mortgages. For example, from  until , the company’s definition of
a “subprime” loan was one originated by a company or a part of a company that spe-
cialized in subprime loans. Using that definition, Fannie Mae stated that subprime
loans accounted for less than  of its business volume during those years even while
it reported that  of its conventional, single-family loans in ,  and 
loans were to borrowers with FICO scores less than .
Similarly, Freddie had enlarged its portfolios quickly with limited capital. In
, CEO Richard Syron fired David Andrukonis, Freddie’s longtime chief risk offi-
cer. Syron said one of the reasons that Andrukonis was fired was that Andrukonis
was concerned about relaxing underwriting standards to meet mission goals. He told
the FCIC, “I had a legitimate difference of opinion on how dangerous it was. Now, as
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it turns out . . . he was able to foresee the market better than a lot of the rest of us
could.” The new risk officer, Anurag Saksena, recounted to the FCIC staff that he
repeatedly made the case for increasing capital to compensate for the increasing
risk, although Donald Bisenius, Freddie’s executive vice president for single-family
housing, told FCIC staff that he did not recall such discussions. Syron never made
Saksena part of the senior management team.
OFHEO, the GSEs’ regulator, noted their increasing purchases of riskier loans and
securities in every examination report. But OFHEO never told the GSEs to stop.
Rather, year after year, the regulator said that both companies had adequate capital,
strong asset quality, prudent credit risk management, and qualified and active officers
and directors.
In May , at the same time as it paid a  million penalty related to deficien-
cies in its accounting practices, Fannie agreed to limit its on-balance-sheet mortgage
portfolio to  billion, the level on December , . Two months later, Fred-
die agreed to limit the growth of its portfolio to  per year. In examination re-
ports for the year , issued to both companies in May , OFHEO noted the
growth in purchases of risky loans and non-GSE securities but concluded that each
GSE had “strong” asset quality and was adequately capitalized. OFHEO reported that
management at Freddie was committed to resolving weaknesses and its Board was
“qualified and active.” The  examination of Fannie was limited in scope—focus-
ing primarily on the company’s efforts to fix accounting and internal control defi-
ciencies—because of the extensive resources needed to complete a three-year special
examination initiated in the wake of Fannie’s accounting scandal.
In that special examination, OFHEO pinned many of the GSEs’ problems on their
corporate cultures. Its May  special examination report on Fannie Mae detailed the
“arrogant and unethical corporate culture where Fannie Mae employees manipulated
accounting and earnings to trigger bonuses for senior executives from  to .”
OFHEO Director James Lockhart (who had assumed that position the month the re-
port was issued) recalled discovering during the special examination an email from
Mudd, then Fannie’s chief operating officer, to CEO Franklin Raines. Mudd wrote,
“The old political reality [at Fannie] was that we always won, we took no prisoners . . .
we used to . . . be able to write, or have written rules that worked for us.”
Soon after his arrival, Lockhart began advocating for reform. “The need for legis-
lation was obvious as OFHEO was regulating two of the largest and most systemati-
cally important US financial institutions,” he told the FCIC. But no reform
legislation would be passed until July , , and by then it would be too late.

: “Increase our penetration into subprime”

After several years during which Fannie Mae purchased riskier loans and securities,
then-Chief Financial Officer Robert Levin proposed a strategic initiative to “increase
our penetration into subprime” at Fannie’s January  board meeting. In the
next month the board gave its approval. Fannie would become more and more ag-
gressive in its purchases. During a summer retreat for Fannie’s senior officers, as
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Stephen Ashley, the chairman of the board, introduced Fannie’s new chief risk officer,
Enrico Dallavecchia, he declared that the new CRO would not stand in the way of
risk taking: “We have to think differently and creatively about risk, about compliance,
and about controls. Historically these have not been strong suits of Fannie Mae. . . .
Today’s thinking requires that these areas become active partners with the business
units and be viewed as tools that enable us to develop product and address market
needs. Enrico Dallavecchia was not brought on-board to be a business dampener.”
In , Fannie acquired  billion of loans; of those (including some overlap),
 billion, or about , had combined loan-to-value ratios above ;  were
interest-only; and  did not have full documentation. Fannie also purchased 
billion of subprime and  billion of Alt-A non-GSE mortgage-backed securities.
The total amount of riskier loans represented larger multiples of capital than before.
At least initially, while house prices were still increasing, the strategic plan to in-
crease risk and market share appeared to be successful. Fannie reported net income
of  billion in  and then  billion in . In those two years, CEO Mudd’s
compensation totaled . million and Levin, who was interim CFO and then chief
business officer, received . million.
In , Freddie Mac also continued to increase risk, “expand[ing] the purchase
and guarantee of higher-risk mortgages . . . to increase market share, meet mission
goals, stay competitive, and be responsive to sellers’ needs.” It lowered its under-
writing standards, increasing the use of credit policy waivers and exceptions. Newer
alternative products, offered to a broader range of customers than ever before, ac-
counted for about  of that year’s purchases. Freddie Mac’s plan also seemed to be
successful. The company increased risk and market share while maintaining the
same net income for  and ,  billion. CEO Richard Syron’s compensation
totaled . million for  and  combined, while Chief Operating Officer
Eugene McQuade received . million.
Again, OFHEO was aware of these developments. Its March  report noted
that Fannie’s new initiative to purchase higher-risk products included a plan to cap-
ture  of the subprime market by . And OFHEO reported that credit risk in-
creased “slightly” because of growth in subprime and other nontraditional products.
But overall asset quality in its single-family business was found to be “strong,” and the
board members were “qualified and active.” And, of course, Fannie was “adequately
capitalized.”
Similarly, OFHEO told Freddie in  that it had weaknesses that raised some
possibility of failure, but that overall, Freddie’s strength and financial capacity made
failure unlikely. Freddie did remain a “significant supervisory concern,” and
OFHEO noted the significant shift toward higher-risk mortgages. But again, as in
previous years, the regulator concluded that Freddie had “adequate capital,” and its
asset quality and credit risk management were “strong.”
The GSEs charged a fee for guaranteeing payments on GSE mortgage–backed secu-
rities, and OFHEO was silent about Fannie’s practice of charging less to guarantee secu-
rities than their models indicated was appropriate. Mark Winer, the head of Fannie’s
Business, Analysis and Decisions Group since May  and the person responsible for
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

modeling pricing fees, raised concerns that Fannie Mae was not charging fees for Alt-A
mortgages that adequately compensated for the risk. Winer recalled that Levin was crit-
ical of his models, asking, “Can you show me why you think you’re right and everyone
else is wrong?” Undercharging for the guarantee fees was intended to increase market
share, according to Todd Hempstead, the senior vice president at Fannie in charge of
the western region. Mudd acknowledged the difference between the model fee and
the fee actually charged and also told the FCIC that the scarcity of historical data for
many loans caused the model fee to be unreliable.
In the September , , memo that would recommend that Fannie be placed
into conservatorship, OFHEO would expressly cite this practice as unsafe and un-
sound: “During  and , modeled loan fees were higher than actual fees
charged, due to an emphasis on growing market share and competing with Wall
Street and the other GSE.”

: “Moving deeper into the credit pool”

By the time housing prices had peaked in the second quarter of , delinquencies
had started to rise. During the board meeting held in April , Lund said that dis-
location in the housing market was an opportunity for Fannie to reclaim market
share. At the same time, Fannie would support the housing market by increasing liq-
uidity. At the next month’s meeting, Lund reported that Fannie’s market share
could increase to  from about  in . Indeed, in  Fannie Mae forged
ahead, purchasing more high-risk loans. Fannie also purchased  billion of sub-
prime non-GSE securities, and  billion of Alt-A.
In June, Fannie prepared its  five-year strategic plan, titled “Deepen Seg-
ments—Develop Breadth.” The plan, which mentioned Fannie’s “tough new chal-
lenges—a weakening housing market” and “slower-growing mortgage debt
market”—included taking and managing “more mortgage credit risk, moving deeper
into the credit pool to serve a large and growing part of the mortgage market.” Over-
all, revenues and earnings were projected to increase in each of the following five
years.
Management told the board that Fannie’s risk management function had all the
necessary means and budget to act on the plan. Chief Risk Officer Dallavecchia did
not agree, especially in light of a planned  cut in his budget. In a July , ,
email to CEO Mudd, Dallavecchia wrote that he was very upset that he had to hear at
the board meeting that Fannie had the “will and the money to change our culture and
support taking more credit risk,” given the proposed budget cut for his department in
 after a  reduction in headcount in . In an earlier email, Dallavecchia
had written to Chief Operating Officer Michael Williams that Fannie had “one of the
weakest control processes” that he “ever witnessed in [his] career, . . . was not even
close to having proper control processes for credit, market and operational risk,” and
was “already back to the old days of scraping on controls . . . to reduce expenses.”
These deficiencies indicated that “people don’t care about the [risk] function or they
don’t get it.”
 ALL IN 

Mudd responded, “My experience is that email is not a very good venue for con-
versation, venting or negotiating.” If Dallavecchia felt that he had been dealt with in
bad faith, he should “address it man to man,” unless he wanted Mudd “to be the one
to carry messages for you to your peers.” Mudd concluded, “Please come and see me
today face to face.” Dallavecchia told the FCIC that when he wrote this email he
was tired and upset, and that the view it expressed was more extreme than what he
thought at the time. Fannie, after continuing to purchase and guarantee higher-risk
mortgages in , would report a . billion net loss for the year, caused by credit
losses. In , Mudd’s compensation totaled . million and Levin’s totaled
 million.
In , Freddie Mac also persisted in increasing purchases of riskier loans. A
strategic plan from March highlighted “pressure on the franchise” and the “risk of
falling below our return aspirations.” The company would try to improve earnings
by entering adjacent markets: “Freddie Mac has competitive advantages over non-
GSE participants in nonprime,” the strategy document explained. “We have an op-
portunity to expand into markets we have missed—Subprime and Alt-A.” It took
that opportunity. As OFHEO would note in its  examination report, Freddie
purchased and guaranteed loans originated in  and  with higher-risk char-
acteristics, including interest-only loans, loans with FICO scores less than , loans
with higher loan-to-value ratios, loans with high debt-to-income ratios, and loans
without full documentation. Financial results in  were poor: a . billion net
loss driven by credit losses. The value of the  billion subprime and Alt-A private-
label securities book suffered a  billion decline in market value. In , Syron’s
compensation totaled . million and McQuade’s totaled . million.

Affordable housing goals: “GSEs cried bloody murder forever”

As discussed earlier, beginning in , the Department of Housing and Urban Devel-
opment (HUD) periodically set goals for the GSEs related to increasing homeowner-
ship among low- and moderate-income borrowers and borrowers in underserved
areas. Until , these goals were based on the fraction of the total mortgage market
made up of low- and moderate-income families. The goals were intended to be only a
modest reach beyond the mortgages that the GSEs would normally purchase.
From  to ,  of GSE purchases were required to meet goals for low-
and moderate-income borrowers. In , the goal was raised to . Mudd said
that as long as the goals remained below half of the GSEs’ lending, loans made in the
normal course of business would satisfy the goals: “What comes in the door through
the natural course of business will tend to match the market, and therefore will tend
to meet the goals.” Levin told the FCIC that “there was a great deal of business that
came through normal channels that met goals” and that most of the loans that satis-
fied the goals “would have been made anyway.”
In  HUD announced that starting in ,  of the GSEs’ purchases would
need to satisfy the low- and moderate-income goals. The targets would reach  in
 and  in . Given the dramatic growth in the number of riskier loans
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

originated in the market, the new goals were closer to where the market really was.
But, as Mudd noted, “When  became [] ultimately, then you have to work
harder, pay more attention, and create a preference for those loans.” Targeted goals
loans (loans made specifically to meet the targets), while always a small share of the
GSEs’ purchases, rose in importance.
Mudd testified that by , when the housing market was in turmoil, Fannie
Mae could no longer balance its obligations to shareholders with its affordable hous-
ing goals and other mission-related demands: “There may have been no way to sat-
isfy  of the myriad demands for Fannie Mae to support all manner of projects
[or] housing goals which were set above the origination levels in the marketplace.”
As the combined size of the GSEs rose steadily from . trillion in  to . tril-
lion in , the number of mortgage borrowers that the GSEs needed to serve in
order to fulfill the affordable housing goals also rose. By , Fannie and Freddie
were stretching to meet the higher goals, according to a number of GSE executives,
OFHEO officials, and market observers.
Yet all but two of the dozens of current and former Fannie Mae employees and
regulators interviewed on the subject told the FCIC that reaching the goals was not
the primary driver of the GSEs’ purchases of riskier mortgages and of subprime and
Alt-A non-GSE mortgage–backed securities. Executives from Fannie, including
Mudd, pointed to a “mix” of reasons for the purchases, such as reversing the declines
in market share, responding to originators’ demands, and responding to shareholder
demands to increase market share and profits, in addition to fulfilling the mission of
meeting affordable housing goals and providing liquidity to the market.
For example, Levin told the FCIC that while Fannie, to meet its housing goals, did
purchase some subprime mortgages and mortgage-backed securities it would other-
wise have passed up, Fannie was driven to “meet the market” and to reverse declining
market share. On the other hand, he said that most Alt-A loans were high-income-
oriented and would not have counted toward the goals, so those were purchased
solely to increase profits. Similarly, Lund told the FCIC that the desire for market
share was the main driver behind Fannie’s strategy in . Housing goals had been a
factor, but not the primary one. And Dallavecchia likewise told the FCIC that Fan-
nie increased its purchases of Alt-A loans to regain relevance in the market and meet
customer needs.
Hempstead, Fannie’s principal contact with Countrywide, told the FCIC that
while housing goals were one reason for Fannie’s strategy, the main reason Fannie en-
tered the riskier mortgage market was that those were the types of loans being origi-
nated in the primary market. If Fannie wanted to continue purchasing large
quantities of loans, the company would need to buy riskier loans. Kenneth Bacon,
Fannie’s executive vice president of multifamily lending, said much the same thing,
and added that shareholders also wanted to see market share and returns rise. For-
mer Fannie chairman Stephen Ashley told the FCIC that the change in strategy in
 and  was owed to a “mix of reasons,” including the desire to regain market
share and the need to respond to pressures from originators as well as to pressures
from real estate industry advocates to be more engaged in the marketplace.
 ALL IN 

To ensure an adequate supply of mortgages in case the goals were not met in the
normal course of business, Fannie and Freddie instituted outreach programs in un-
derserved geographic areas and conducted educational programs for originators and
brokers. In addition, as explained by Mike Quinn, the Fannie executive responsible
for the goals, Fannie set lower fees on loans that met the goals, although it would not
purchase mortgages that fell outside its predetermined risk targets. Ashley also
maintained that Fannie did not shift eligibility or underwriting standards to meet
goals but instead directed its resources to marketing and promotional efforts, hous-
ing fairs, and outreach programs run by the company’s partnership offices. “The ef-
fort was really in the outreach as opposed to reduced or diminished or loosened
standards,” Ashley told the FCIC.
Former OFHEO Director Armando Falcon Jr. testified that the GSEs invested in
subprime and Alt-A mortgages in order to increase profits and regain market share
and that any impact on meeting affordable housing goals was simply a by-product of
this activity. Lockhart, a subsequent OFHEO director, attributed the GSEs’ change
in strategy to their drive for profit and market share, as well as the need to meet hous-
ing goals. Noting that the affordable housing goals increased markedly in , he
said in an FCIC interview that the “goals were just one reason, certainly not the ex-
clusive reason” for the change. These views were corroborated by numerous other
officials from the agency.
The former HUD official Mike Price told the FCIC that while the “GSEs cried
bloody murder forever” when it came to the goals, they touted their contribution to
increasing homeownership. In addition, Price and other HUD officials told the FCIC
that the GSEs never claimed that meeting the goals would leave them in an unsafe or
unsound condition.
Indeed, the law allowed both Fannie Mae and Freddie Mac to fall short of meeting
housing goals that were “infeasible” or that would affect the companies’ safety and
soundness. And while the GSEs often exceeded the goals, in some cases those tar-
gets were adjusted downward by HUD or, in rare cases, were simply missed by the
GSEs. For example, on December , , Mudd wrote to HUD: “Fannie Mae be-
lieves that the low- and moderate-income and special affordable subgoals are infeasi-
ble for .” Fannie Mae’s  strategic plan had already anticipated such a
communication, stating, “In the event we reach a viewpoint that achieving the goals
this year is ‘infeasible,’ we will determine how best to address the matter with HUD
and will continue to keep the Board apprised accordingly.” In fact, both Fannie and
Freddie appealed to HUD to lower two components of the goals for affordable hous-
ing. HUD complied and allowed the GSEs to fall short without any consequences.

The impact of the goals

At least until HUD set new affordable housing goals for , the GSEs only supple-
mented their routine purchases with a small volume of loans and non-GSE mort-
gage–backed securities needed to meet their requirements. The GSEs knew that they
might not earn as much on these targeted goal loans as they would earn on both
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

goal-qualifying and non-goal-qualifying loans purchased in the usual course of busi-

ness; on some of these loans, they might even lose money. The organizations also had
administrative and other costs related to the housing goals.
In June  Freddie Mac staff made a presentation to the Business and Risk
Committee of the Board of Directors on the costs of meeting its goals. From  to
, the cost of the targeted goal loans was effectively zero, as the goals were
reached through “profitable expansion” of the company’s multifamily business. Dur-
ing the refinance boom, the goals became more challenging and cost Freddie money
in the multifamily business; thus, only after  did meeting the multifamily and
single-family goals cost the GSE money. Still, only about  of all loans purchased by
Freddie between  and  were bought “specifically because they contribute to
the goals”—loans it labeled as “targeted affordable.” These loans did have higher than
average expected default rates, although Freddie also charged a higher fee to guaran-
tee them. From  through , Freddie’s costs of complying with the housing
goals averaged  million annually. The costs of complying with these goals took
into account three components: expected revenues, expected defaults, and foregone
revenues (based on an assumption of what they might have earned elsewhere). These
costs were only computed on the narrow set of loans specifically purchased to
achieve the goals, as opposed to goal-qualifying loans purchased in the normal
course of business. For comparison, the company’s net earnings averaged just un-
der  billion per year from  to .
In , Fannie Mae retained McKinsey and Citigroup to determine whether it
would be worthwhile to give up the company’s charter as a GSE, which—while af-
fording the company enormous benefits—imposed regulations and put constraints
on business practices, including its mission goals. The final report to Fannie Mae’s
top management, called Project Phineas, found that the explicit cost of compliance
with the goals from  to  was close to zero: “it is hard to discern a fundamen-
tal marginal cost to meeting the housing goals on the single family business side.”
The report came to this conclusion despite the slightly greater difficulty of meeting
the goals in the  refinancing boom: the large numbers of homeowners refinanc-
ing, in particular those who were middle and upper income, necessarily reduced the
percentage of the pool that would qualify for the goals.
In calculating these costs, the consultants computed the difference between fees
charged on goal-qualifying loans and the higher fees suggested by Fannie’s own mod-
els. But this cost was not unique to goal qualifying loans. Across its portfolio, Fannie
charged lower fees than its models computed for goals loans as well as for non-goals
loans. As a result, goals loans, even targeted goals loans, were not solely responsible
for this cost. In fact, Fannie’s discount was actually smaller for many goal-qualifying
loans than for the others from  to .
Facing more aggressive goals in  and , Fannie Mae expanded initiatives
to purchase targeted goals loans. These included mortgages acquired under the My
Community Mortgage program, mortgages underwritten with looser standards, and
manufactured housing loans. For these loans, Fannie explicitly calculated the oppor-
tunity cost (foregone revenues based on an assumption of what they might have
 ALL IN 

earned elsewhere) along with the so-called cash flow cost, or the difference between
their expected losses and expected revenue on these loans. For , as the market
was peaking, Fannie Mae estimated the cash flow cost of the loans to be  million
and the opportunity cost of the targeted goals loans  million, compared to net
income that year to Fannie of . billion—a figure that includes returns on the goal-
qualifying loans made during the normal course of business. The targeted goals
loans amounted to  billion, or ., of Fannie Mae’s  billion of single-family
mortgage purchases in . As the markets tightened in the middle of , the
opportunity cost for that year was forecast to be roughly  billion.
Looking back at how the targeted affordable portfolio performed in comparison
with overall losses, the  presentation at Freddie Mac took the analysis of the
goals’ costs one step further. While the outstanding  billion of these targeted af-
fordable loans was only  of the total portfolio, these were relatively high-risk loans
and were expected to account for  of total projected losses. In fact, as of late ,
they had accounted for only  of losses—meaning that they had performed better
than expected in relation to the whole portfolio. The company’s major losses came
from loans acquired in the normal course of business. The presentation noted that
many of these defaulted loans were Alt-A.

COMMISSION CONCLUSIONS ON CHAPTER 9

The Commission concludes that firms securitizing mortgages failed to perform
adequate due diligence on the mortgages they purchased and at times knowingly
waived compliance with underwriting standards. Potential investors were not
fully informed or were misled about the poor quality of the mortgages contained
in some mortgage-related securities. These problems appear to have been signifi-
cant. The Securities and Exchange Commission failed to adequately enforce its
disclosure requirements governing mortgage securities, exempted some sales of
such securities from its review, and preempted states from applying state law to
them, thereby failing in its core mission to protect investors.
The Federal Reserve failed to recognize the cataclysmic danger posed by the
housing bubble to the financial system and refused to take timely action to con-
strain its growth, believing that it could contain the damage from the bubble’s
collapse.
Lax mortgage regulation and collapsing mortgage-lending standards and
practices created conditions that were ripe for mortgage fraud.
 10
THE MADNESS

CONTENTS
CDO managers: “We are not a rent-a-manager” ..............................................
Credit default swaps: “Dumb question”..............................................................
Citigroup: “I do not believe we were powerless”..................................................
AIG: “I’m not getting paid enough to stand on these tracks” ..............................
Merrill: “Whatever it takes”...............................................................................
Regulators: “Are undue concentrations of risk developing?” ...............................
Moody’s: “It was all about revenue”....................................................................

The collateralized debt obligation machine could have sputtered to a natural end by
the spring of . 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 
and into . “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 expo-
sures 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


 THE MADNESS 

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 de-
pended 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 bet-
ting against the collateral, as a high-profile case launched by the Securities and Ex-
change Commission against Goldman Sachs would eventually illustrate.
Regulators reacted weakly. As early as , 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 guid-
ance in late  warning banks of the risks of complex structured finance transac-
tions—but excluded mortgage-backed securities and CDOs, because they saw the
risks of those products as relatively straightforward and well understood.
Disaster was fast approaching.

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. 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  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 in-
vestors—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 particu-
lar 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 mort-
gage-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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

funds in the country, whose CDO management unit was one of the nation’s largest in
. Early in , it announced that it would not manage any new deals, in part be-
cause 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 . “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 strin-
gent, 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 confer-
ence. “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 cri-
sis, 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—in-
cluding 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
triple-A.
Another development also changed the CDOs: in  and , 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 Man-
agement, a unit of the financial guarantor ACA Capital, provides a good illustration
of this trend. ACA held  of the equity in the CDOs it originated in  and
,  and  of two deals it originated in , between  and  of deals
in , and between  and  of deals in .
And synthetic CDOs, as we will see, had no fail-safe at all with regard to the man-
agers’ 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.

CREDIT DEFAULT SWAPS: “DUMB QUESTION”

In June , 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 : the first index based on the prices of credit default swaps on mortgage-
backed 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
 THE MADNESS 

consortium of securities firms would select  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 protec-
tion rose, the index would fall. The index was therefore a barometer recording the
confidence of the market.
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 , while the equity tranche of a
typical cash CDO could pay .
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  and  he brokered deals for at least  and maybe as many as
 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 [syn-
thetic] 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  billion in  to  billion just
one year later. (We include all CDOs with  or more synthetic collateral; again,
unless otherwise noted, our data refers to CDOs that include mortgage-backed secu-
rities.) Even CDOs that were labeled as “cash CDOs” increasingly held some credit
derivatives. A total of  billion in CDOs were issued in , including those la-
beled as cash, “hybrid,” or synthetic; the FCIC estimates that  of the collateral was
derivatives, compared with  in  and  in .
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 com-
plex 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,
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 
hedge funds encompassing over . trillion in assets as of early  found this to
be a common strategy among medium-size hedge funds: of all the CDOs issued in
the second half of , 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
, the largest hedge funds held  billion in equity and other lower-rated
tranches of mortgage-backed securities. These were more than offset by  billion
in short positions.
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 ad-
vent of credit default swaps, it was no longer clear who—if anyone—had that incentive.
For one example, consider Merrill Lynch’s . billion Norma CDO, issued in
. 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 . million re-
lated to this transaction and NIR Capital Management, the CDO manager, was paid a
fee of , plus additional fees. Magnetar’s counsel told the FCIC that the .
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
good or services. Court documents indicate that Magnetar was involved in select-
ing collateral, and that NIR abdicated its asset selection duties to Magnetar with Mer-
rill’s knowledge. In addition, they show that when one Merrill employee learned that
Magnetar had executed approximately  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 . 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.
Federal regulators have identified abuses that involved short investors influencing
the choice of the instruments inside synthetic CDOs. In April , 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 selec-
tion. The SEC alleged that those misrepresentations were in Goldman’s marketing
materials for Abacus -AC, one of Goldman’s  Abacus deals.
 THE MADNESS 

Ira Wagner, the head of Bear Stearns’s CDO Group in , 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 neces-
sarily 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 re-
sponsible 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 Paul-
son 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 protec-
tion. 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 , Goldman Sachs settled the case, paying a record  million fine.
Goldman “acknowledge[d] that the marketing materials for the ABACUS -AC
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 port-
folio selection process and that Paulson’s economic interests were adverse to CDO
investors.”
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 Capi-
tal, told the FCIC that they had warned the SEC in  that the agencies were dan-
gerously overoptimistic in their assessment of mortgage-backed CDOs. Mai and
Hockett saw the rating agencies as “the root of the mess,” because their ratings re-
moved the need for buyers to study prices and perform due diligence, even as “there
was a massive amount of gaming going on.”
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  that initially focused only on shorting BBB-rated
tranches. By the end of , Paulson & Co.’s Credit Opportunities fund, set up less
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

than a year earlier to bet exclusively against the subprime housing market, was up
. “Each MBS tranche typically would be  mortgages in California,  in
Florida,  in New York, and when you aggregate  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 mortgage-backed securities would be at risk for downgrades. Should
prices drop , CDO losses would increase -fold.
And if a relatively small number of the underlying loans were to go into fore-
closure, the losses would render virtually all of the riskier BBB-rated tranches worth-
less. “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 , about half [the mortgages
sold] were no-doc or low-doc. You were at max underwriting weakness at max hous-
ing prices. And so the system imploded. Everyone was so levered there was no ability
to take any pain.” On October , , 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 es-
timated that even the triple-A tranches of CDOs would experience some losses if na-
tional home prices were to fall just  or less within two years; and if prices were to
fall , investors of tranches rated AA- or below would be completely wiped out.
In , 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 , 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 certifi-
able lunatics.”
Michael Burry, another short who became well-known after the crisis hit, was a
doctor-turned-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 . But the closer he
looked, the more he wondered about the financing that supported this booming mar-
ket. 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 , Burry had bought credit default swaps on billions of dollars of mortgage-
backed securities and the bonds of financial companies in the housing market, in-
cluding Fannie Mae, Freddie Mac, and AIG.
Eisman, Cornwall, Paulson, and Burry were not alone in shorting the housing mar-
 THE MADNESS 

ket. In fact, on one side of tens of billions of dollars worth of synthetic CDOs were in-
vestors taking short positions. The purchasers of credit default swaps illustrate the im-
pact 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 insti-
tutions 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 ac-
cepting. “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 catas-
trophe and I think it was preventable.”
Credit default swaps greased the CDO machine in several ways. First, they al-
lowed 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 de-
fault 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 spec-
ulators 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 hous-
ing and mortgage-backed securities bubble. Because CDO arrangers could more eas-
ily 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 partic-
ipants 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  would be one of the first harbingers of market turmoil. “Once
[pessimists] can, in effect, sell short via the CDS, prices must reflect their views and
not just the views of the leveraged optimists,” John Geanakoplos, a Yale economics
professor and a partner in the hedge fund Ellington Capital Management, which
both invested in and managed CDOs, told the FCIC.

CITIGROUP: “I DO NOT BELIEVE WE WERE POWERLESS”

While the hedge funds were betting against the housing market in  and ,
Citigroup’s CDO desk was pushing more money to the center of the table.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

But after writing  billion in liquidity puts—protecting investors who bought
commercial paper issued by Citigroup’s CDOs—the bank’s treasury department had
put a stop to the practice. To keep doing deals, the CDO desk had to find another
market for the super-senior tranches of the CDOs it was underwriting—or it had to
find a way to get the company to support the CDO production line. The CDO desk
accumulated another  billion in super-senior exposures, most between early 
and August , which it otherwise would have been able to sell into the market
only for a loss. It was also increasingly financing securities that it was holding in its
CDO warehouse—that is, securities that were waiting to be put into new CDOs.
Historically, owning securities was not what securities firms did. The adage “We
are in the moving business, not the storage business” suggests that they were struc-
turing and selling securities, not buying or retaining them.
However, as the biggest commercial banks and investment banks competed in the
securities business in the late s and on into the new century, they often touted
the “balance sheet” that they could make available to support the sale of new securi-
ties. In this regard, Citigroup broke new ground in the CDO market. Citigroup re-
tained significant exposure to potential losses on its CDO business, particularly
within Citibank, the  trillion commercial bank whose deposits were insured by the
FDIC. While its competitors did the same, few did so as aggressively or, ultimately,
with such losses.
In , Citigroup retained the super-senior and triple-A tranches of most of the
CDOs it created. In many cases Citigroup would hedge the associated credit risk
from these tranches by obtaining credit protection from a monoline insurance com-
pany such as Ambac. Because these hedges were in place, Citigroup presumed that
the risk associated with the retained tranches had been neutralized.
Citigroup reported these tranches at values for which they could not be sold, rais-
ing questions about their accuracy and, therefore, the accuracy of reported earnings.
“As everybody in any business knows, if inventory is growing, that means you’re not
pricing it correctly,” Richard Bookstaber, who had been head of risk management at
Citigroup in the late s, told the FCIC. But keeping the tranches on the books at
these prices improved the finances for creating the deal. “It was a hidden subsidy of
the CDO business by mispricing,” Bookstaber said. The company would not begin
writing the securities down toward the market’s real valuations until the fall of .
Part of the reason for retaining exposures to super-senior positions in CDOs was
their favorable capital treatment. As we saw in an earlier chapter, under the  Re-
course Rule, one of the attractions of triple-A-rated securities was that banks were re-
quired to hold relatively less capital against them than against lower-rated securities.
And if the bank held those assets in their trading account (as opposed to holding
them as a long-term investment), it could get even better capital treatment under the
 Market Risk Amendment. That rule allowed banks to use their own models to
determine how much capital to hold, an amount that varied according to how much
market prices moved. Citigroup judged that the capital requirement for the super-se-
nior tranches of synthetic CDOs it held for trading purposes was effectively zero, be-
 THE MADNESS 

cause the prices didn’t move much. As a result, Citigroup held little regulatory capital
against the super-senior tranches.
Citibank also held “unfunded” positions in super-senior tranches of some syn-
thetic CDOs; that is, it sold protection to the CDO. If the referenced mortgage collat-
eral underperformed, the short investors would begin to get paid. Money to pay
them would come first from wiping out long investors who had bought tranches that
were below triple-A. Then, if the short investors were still owed money, Citibank
would have to pay. For taking on this risk, Citi typically received about . to
. in annual fees on the super-senior protection; on a billion-dollar transaction, it
would earn an annual fee of  million to  million.
Citigroup also had exposure to the mortgage-backed and other securities that
went into CDOs during the ramp-up period, which could be as long as six or nine
months, before it packaged and sold the CDO. Typically, Citigroup’s securities unit
would set up a warehouse funding line for the CDO manager. During the ramp-up
period, the collateral securities would pay interest; depending on the terms of the
agreement, that interest would either go exclusively to Citigroup or be split with the
manager. For the CDO desk, this frequently represented a substantial income stream.
The securities sitting in the warehouse facility had relatively attractive yields—often
. to . more than the typical bank borrowing rate—and it was not uncommon
for the CDO desk to earn  to  million in interest on a single transaction.
Traders on the desk would get credit for those revenues at bonus time. But Citigroup
would also be on the hook for any losses incurred on assets stuck in the warehouse.
When the financial crisis deepened, many CDO transactions could not be com-
pleted; Citigroup and other investment banks were forced to write down the value of
securities held in their warehouses. The result would be substantial losses across Wall
Street. In many cases, to offload assets underwriters placed collateral from CDO
warehouses into other CDOs.
A factor that made firm-wide hedging complicated was that different units of
Citigroup could have various and offsetting exposures to the same CDO. It was pos-
sible, even likely, that the CDO desk would structure a given CDO, a different divi-
sion would buy protection for the underlying collateral, and yet another division
would buy the unfunded super-senior tranche. If the collateral in this CDO ran into
trouble, the CDO immediately would have to pay the division that bought credit pro-
tection on the underlying collateral; if the CDO ran out of money to pay, it would
have to draw on the division that bought the unfunded tranche. In November ,
after Citigroup had reported substantial losses on its CDO portfolio, regulators
would note that the company did not have a good understanding of its firmwide
CDO exposures: “The nature, origin, and size of CDO exposure were surprising to
many in senior management and the board. The liquidity put exposure was not well
known. In particular, management did not consider or effectively manage the credit
risk inherent in CDO positions.”
Citigroup’s willingness to use its balance sheet to support the CDO business had
the desired effect. Its CDO desk created  billion in CDOs that included mortgage-
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

backed securities in their collateral in  and  billion in . Among CDO un-
derwriters, including all types of CDOs, Citigroup rose from fourteenth place in
 to second place in , according to FCIC analysis of Moody’s data.
What was good for Citigroup’s investment bank was also lucrative for its invest-
ment bankers. Thomas Maheras, the co-CEO of the investment bank who said he
spent less than  of his time thinking about CDOs, was a highly paid Citigroup ex-
ecutive, earning more than  million in salary and bonus compensation in .
Co-head of Global Fixed Income Randolph Barker made about  million in that
same year. Citigroup’s chief risk officer made . million. Others were also well re-
warded. The co-heads of the global CDO business, Nestor Dominguez and Janice
Warne, each made about  million in total compensation in .
Citi did have “clawback” provisions: under narrowly specified circumstances,
compensation would have to be returned to the firm. But despite Citigroup’s eventual
large losses, no compensation was ever clawed back under this policy. The Corporate
Library, which rates firms’ corporate governance, gave Citigroup a C. In early ,
the Corporate Library would downgrade Citigroup to a D, “reflecting a high degree
of governance risk.” Among the issues cited: executive compensation practices that
were poorly aligned with shareholder interests.
Where were Citigroup’s regulators while the company piled up tens of billions of
dollars of risk in the CDO business? Citigroup had a complex corporate structure
and, as a result, faced an array of supervisors. The Federal Reserve supervised the
holding company but, as the Gramm-Leach-Bliley legislation directed, relied on oth-
ers to monitor the most important subsidiaries: the Office of the Comptroller of the
Currency (OCC) supervised the largest bank subsidiary, Citibank, and the SEC su-
pervised the securities firm, Citigroup Global Markets. Moreover, Citigroup did not
really align its various businesses with the legal entities. An individual working on
the CDO desk on an intricate transaction could interact with various components of
the firm in complicated ways.
The SEC regularly examined the securities arm on a three-year examination cycle,
although it would also sometimes conduct other examinations to target specific con-
cerns. Unlike the Fed and OCC, which had risk management and safety and sound-
ness rules, the SEC used these exams to look for general weaknesses in risk
management. Unlike safety and soundness regulators, who concentrated on prevent-
ing firms from failing, the SEC always kept its focus on protecting investors. Its most
recent review of Citigroup’s securities arm preceding the crisis was in , and the
examiners completed their report in June . In that exam, they told the FCIC,
they saw nothing “earth shattering,” but they did note key weaknesses in risk man-
agement practices that would prove relevant—weaknesses in internal pricing and
valuation controls, for example, and a willingness to allow traders to exceed their risk
limits.
Unlike the SEC, the Fed and OCC did maintain a continuous on-site presence.
During the years that CDOs boomed, the OCC team regularly criticized the com-
pany for its weaknesses in risk management, including specific problems in the CDO
 THE MADNESS 

business. “Earnings and profitability growth have taken precedence over risk man-
agement and internal control,” the OCC told the company in January . An-
other document from that year stated, “The findings of this examination are
disappointing, in that the business grew far in excess of management’s underlying in-
frastructure and control processes.” In May , a review undertaken by peers at
the other Federal Reserve banks was critical of the New York Fed—then headed by
the current treasury secretary, Timothy Geithner—for its oversight of Citigroup. The
review concluded that the Fed’s on-site Citigroup team appeared to have “insufficient
resources to conduct continuous supervisory activities in a consistent manner. At
Citi, much of the limited team’s energy is absorbed by topical supervisory issues that
detract from the team’s continuous supervision objectives . . . the level of the staffing
within the Citi team has not kept pace with the magnitude of supervisory issues that
the institution has realized.” That the Fed’s  examination of Citigroup did not
raise the concerns expressed that same year by the OCC may illustrate these prob-
lems. Four years later, the next peer review would again find substantial weaknesses
in the New York Fed’s oversight of Citigroup.
In April , the Fed raised the holding company’s supervisory rating from the
previous year’s “fair” to “satisfactory.” It lifted the ban on new mergers imposed the
previous year in response to Citigroup’s many regulatory problems. The Fed and
OCC examiners concurred that the company had made “substantial progress” in im-
plementing CEO Charles Prince’s plan to overhaul risk management. The Fed de-
clared: “The company has  .  .  . completed improvements necessary to bring the
company into substantial compliance with two existing Federal Reserve enforcement
actions related to the execution of highly structured transactions and controls.” The
following year, Citigroup’s board would allude to Prince’s successful resolution of its
regulatory compliance problems in justifying his  compensation increase.
The OCC noted in retrospect that the lifting of supervisory constraints in 
had been a key turning point. “After regulatory restraints against significant acquisi-
tions were lifted, Citigroup embarked on an aggressive acquisition program,” the OCC
wrote to Vikram Pandit, Prince’s replacement, in early . “Additionally, with the re-
moval of formal and informal agreements, the previous focus on risk and compliance
gave way to business expansion and profits.” Meanwhile, risk managers granted excep-
tions to limits, and increased exposure limits, instead of keeping business units in
check as they had told the regulators. Well after Citigroup sustained large losses on
its CDOs, the Fed would criticize the firm for using its commercial bank to support its
investment banking activities. “Senior management allowed business lines largely un-
challenged access to the balance sheet to pursue revenue growth,” the Fed wrote in an
April  letter to Pandit. “Citigroup attained significant market share across numer-
ous products, including leveraged finance and structured credit trading, utilizing bal-
ance sheet for its ‘originate to distribute’ strategy. Senior management did not
appropriately consider the potential balance sheet implications of this strategy in the
case of market disruptions. Further, they did not adequately access the potential nega-
tive impact of earnings volatility of these businesses on the firm’s capital position.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Geithner told the Commission that he and others in leadership positions could
have done more to prevent the crisis, testifying, “I do not believe we were powerless.”

AIG: “I’M NOT GETTING PAID ENOUGH

TO STAND ON THESE TRACKS”
Unlike their peers at Citigroup, some senior executives at AIG’s Financial Products
subsidiary had figured out that the company was taking on too much risk. Nonethe-
less, they did not do enough about it. Doubts about all the credit default swaps that
they were originating emerged in  among AIG Financial Products executives,
including Andrew Forster and Gene Park. Park told the FCIC that he witnessed
Financial Products CEO Joseph Cassano berating a salesman over the large volume
of credit default swaps being written by AIG Financial Products, suggesting there was
already some high-level uneasiness with these deals. Told by a consultant, Gary Gor-
ton, that the “multisector” CDOs on which AIG was selling credit default swaps con-
sisted mainly of mortgage-backed securities with less than  subprime and Alt-A
mortgages, Park asked Adam Budnick, another AIG employee, for verification. Bud-
nick double checked and returned to say, according to Park, “‘I can’t believe it. You
know, it’s like  or .’” Reviewing the portfolio—and thinking about a friend who
had received  financing for his new home after losing his job—Park said, “This
is horrendous business. We should get out of it.”
In July , Park’s colleague Andrew Forster sent an email both to Alan Frost,
the AIG salesman primarily responsible for the company’s booming credit default
swap business, and to Gorton, who had engineered the formula to determine how
much risk AIG was taking on each CDS it wrote. “We are taking on a huge amount of
sub prime mortgage exposure here,” Forster wrote. “Everyone we have talked to says
they are worried about deals with huge amounts [of high-risk mortgage] exposure
yet I regularly see deals with  [high-risk mortgage] concentrations currently. Are
these really the same risk as other deals?”
Park and others studied the issue for weeks, talked to bank analysts and other ex-
perts, and considered whether it made sense for AIG to continue to write protection
on the subprime and Alt-A mortgage markets. The general view of others was that
some of the underlying mortgages “were structured to fail, [but] that all the borrow-
ers would basically be bailed out as long as real estate prices went up.”
The AIG consultant Gorton recalled a meeting that he and others from AIG had
with one Bear Stearns analyst. The analyst was so optimistic about the housing mar-
ket that they thought he was “out of his mind” and “must be on drugs or some-
thing.” Speaking of a potential decline in the housing market, Park related to the
FCIC the risks as he and some of his colleagues saw them, saying, “We weren’t getting
paid enough money to take that risk. . . . I’m not going to opine on whether there’s a
train on its way. I just know that I’m not getting paid enough to stand on these
tracks.”
By February , Park and others persuaded Cassano and Frost to stop writing
 THE MADNESS 

CDS protection on subprime mortgage–backed securities. In an email to Cassano on

February , Park wrote:

Joe,
Below summarizes the message we plan on delivering to dealers later
this week with regard to our approach to the CDO of ABS super senior
business going forward. We feel that the CDO of ABS market has in-
creasingly become less diverse over the last year or so and is currently at
a state where deals are almost totally reliant on subprime/non prime
residential mortgage collateral. Given current trends in the housing
market, our perception of deteriorating underwriting standards, and
the potential for higher rates we are no longer as comfortable taking
such concentrated exposure to certain parts of the non prime mortgage
securitizations. On the deals that we participate on we would like to see
significant change in the composition of these deals going forward—i.e.
more diversification into the non-correlated asset classes.
As a result of our ongoing due diligence we are not as comfortable
with the mezzanine layers (namely BBB and single A tranches) of this
asset class. . . . We realize that this is likely to take us out of the CDO of
ABS market for the time being given the arbitrage in subprime collat-
eral. However, we remain committed to working with underwriters and
managers in developing the CDO of ABS market to hopefully become
more diversified from a collateral perspective. With that in mind, we
will be open to including new asset classes to these structures or in-
creasing allocations to others such as [collateralized loan obligations]
and [emerging market] CDOs.

AIG’s counterparties responded with indifference. “The day that you [AIG] drop
out, we’re going to have  other people who are going to replace you,” Park says he
was told by an investment banker at another firm. In any event, counterparties had
some time to find new takers, because AIG Financial Products continued to write the
credit default swaps. While the bearish executives were researching the issue from
the summer of  onward, the team continued to work on deals that were in the
pipeline, even after February . Overall, they completed  deals between Sep-
tember  and July —one of them on a CDO backed by  subprime
assets.
By June , AIG had written swaps on  billion in multisector CDOs, five
times the  billion held at the end of . Park asserted that neither he nor most
others at AIG knew at the time that the swaps entailed collateral calls on AIG if the
market value of the referenced securities declined. Park said their concern was sim-
ply that AIG would be on the hook if subprime and Alt-A borrowers defaulted in
large numbers. Cassano, however, told the FCIC that he did know about the possible
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

calls, but AIG’s SEC filings to investors for  mentioned the risk of collateral
calls only if AIG were downgraded.
Still, AIG never hedged more than  million of its total subprime exposure.
Some of AIG’s counterparties not only used AIG’s swaps to hedge other positions but
also hedged AIG’s ability to make good on its contracts. As we will see later, Goldman
Sachs hedged aggressively by buying CDS protection on AIG and by shorting other
securities and indexes to counterbalance the risk that AIG would fail to pay up on its
swaps or that a collapsing subprime market would pull down the value of mortgage-
backed securities.

MERRILL: “WHATEVER IT TAKES”

When Dow Kim became co-president of Merrill Lynch’s Global Markets and Invest-
ment Banking Group in July , he was instructed to boost revenue, especially in
businesses in which Merrill lagged behind its competitors. Kim focused on the
CDO business; clients saw CDOs as an integral part of their trading strategy, CEO
Stanley O’Neal told the FCIC. Kim hired Chris Ricciardi from Credit Suisse, where
Ricciardi’s group had sold more CDOs than anyone else.
Ricciardi came through, lifting Merrill’s CDO business from fifteenth place in
 to second place behind only Citigroup in  and Goldman in . Then, in
February , he left the bank to become CEO of Cohen & Company, an asset man-
agement business; at Cohen he would manage several CDOs, often deals underwrit-
ten by Merrill.
After Ricciardi left, Kim instructed the rest of the team to do “whatever it takes”
not just to maintain market share but also to take over the number one ranking, for-
mer employees said in a complaint filed against Merrill Lynch. Kim told FCIC staff
that he couldn’t recall specific conversations but that after Ricciardi left, Merrill was
still trying to expand the CDO business globally and that he, Kim, wanted people to
know that Merrill was willing to commit its people, resources, and balance sheet to
achieve that goal.
It was indeed willing. Despite the loss of its rainmaker, Merrill swamped the com-
petition, originating a total . billion in mortgage-related CDOs in , while
the second-ranked firm, Morgan Stanley, did only . billion, and earning another
first-place ranking in , on the strength of the CDO machine Ricciardi had
built—a machine that brought in more than  billion in fees between  and
.
To keep its CDO business going, Merrill pursued three strategies, all of which in-
volved repackaging riskier mortgages more attractively or buying its own products
when no one else would. Like Citigroup, Merrill increasingly retained for its own
portfolio substantial portions of the CDOs it was creating, mainly the super-senior
tranches, and it increasingly repackaged the hard-to-sell BBB-rated and other low-
rated tranches of its CDOs into its other CDOs; it used the cash sitting in its synthetic
CDOs to purchase other CDO tranches.
 THE MADNESS 

It had long been standard practice for CDO underwriters to sell some mezzanine
tranches to other CDO managers. Even in the early days of ABS CDOs, these assets
often contained a small percentage of mezzanine tranches of other CDOs; the rating
agencies signed off on this practice when rating each deal. But reliance on them be-
came heavier as the demand from traditional investors waned, as it had for the riskier
tranches of mortgage-backed securities. The market came to call traditional investors
the “real money,” to distinguish them from CDO managers who were buying tranches
just to put them into their CDOs. Between  and , the typical amount a CDO
could include of the tranches of other CDOs and still maintain its ratings grew from
 to , according to the CDO manager Wing Chau. According to data compiled
by the FCIC, tranches from CDOs rose from an average of  of the collateral in
mortgage-backed CDOs in  to  by . CDO-squared deals—those engi-
neered primarily from the tranches of other CDOs—grew from  marketwide in
 to  in  and  in . Merrill created and sold  of them.
Still, there are clear signs that few “real money” investors remained in the CDO
market by late . Consider Merrill: for the  ABS CDOs that Merrill created and
sold from the fourth quarter of  through August , nearly  of the mezza-
nine tranches were purchased by CDO managers. The pattern was similar for Chau:
an FCIC analysis determined that  of the mezzanine tranches sold by the 
CDOs managed by Chau were sold for inclusion into other CDOs. An estimated 
different CDO managers purchased tranches in Merrill’s Norma CDO. In the most
extreme case found by the FCIC, CDO managers were the only purchasers of Mer-
rill’s Neo CDO.
Marketwide, in  CDOs took in about  of the A tranches,  of the Aa
tranches, and  of the Baa tranches issued by other CDOs, as rated by Moody’s.
(Moody’s rating of Aaa is equivalent to S&P’s AAA, Aa to AA, Baa to BBB, and Ba to
BB). In , those numbers were , , and , respectively. Merrill and
other investment banks simply created demand for CDOs by manufacturing new
ones to buy the harder-to-sell portions of the old ones.
As SEC attorneys told the FCIC, heading into  there was a Streetwide gentle-
man’s agreement: you buy my BBB tranche and I’ll buy yours.
Merrill and its CDO managers were the biggest buyers of their own products.
Merrill created and sold  CDOs from  to . All but  of these—
CDOs—sold at least one tranche into another Merrill CDO. In Merrill’s deals, on av-
erage,  of the collateral packed into the CDOs consisted of tranches of other
CDOs that Merrill itself had created and sold. This was a relatively high percentage,
but not the highest: for Citigroup, another big player in this market, the figure was
. For UBS, it was just .
Managers defended the practice. Chau, who managed  CDOs created and sold
by Merrill at Maxim Group and later Harding Advisory and had worked with Riccia-
rdi at Prudential Securities in the early days of multisector CDOs, told the FCIC that
plain mortgage-backed securities had become expensive in relation to their returns,
even as the real estate market sagged. Because CDOs paid better returns than did
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

similarly rated mortgage-backed securities, they were in demand, and that is why
CDO managers packed their securities with other CDOs.
And Merrill continued to push its CDO business despite signals that the market
was weakening. As late as the spring of , when AIG stopped insuring even the
very safest, super-senior CDO tranches for Merrill and others, it did not reconsider
its strategy. Cut off from AIG, which had already insured . billion of its CDO
bonds—Merrill was AIG’s third-largest counterparty, after Goldman and Société
Générale—Merrill switched to the monoline insurance companies for protection. In
the summer of , Merrill management noticed that Citigroup, its biggest com-
petitor in underwriting CDOs, was taking more super-senior tranches of CDOs onto
its own balance sheet at razor-thin margins, and thus in effect subsidizing returns for
investors in the BBB-rated and equity tranches. In response, Merrill continued to
ramp up its CDO warehouses and inventory; and in an effort to compete and get
deals done, it increasingly took on super-senior positions without insurance from
AIG or the monolines.
This would not be the end of Merrill’s all-in wager on the mortgage and CDO
businesses. Even though it did grab the first-place trophy in the mortgage-related
CDO business in , it had come late to the “vertical integration” mortgage model
that Lehman Brothers and Bear Stearns had pioneered, which required having a stake
in every step of the mortgage business—originating mortgages, bundling these loans
into securities, bundling these securities into other securities, and selling all of them
on Wall Street. In September , months after the housing bubble had started to
deflate and delinquencies had begun to rise, Merrill announced it would acquire a
subprime lender, First Franklin Financial Corp., from National City Corp. for .
billion. As a finance reporter later noted, this move “puzzled analysts because the
market for subprime loans was souring in a hurry.” And Merrill already had a 
million ownership position in Ownit Mortgage Solutions Inc., for which it provided a
warehouse line of credit; it also provided a line of credit to Mortgage Lenders Net-
work. Both of those companies would cease operations soon after the First Franklin
purchase.
Nor did Merrill cut back in September , when one of its own analysts issued a
report warning that this subprime exposure could lead to a sudden cut in earnings,
because demand for these mortgages assets could dry up quickly. That assessment
was not in line with the corporate strategy, and Merrill did nothing. Finally, at the
end of , Kim instructed his people to reduce credit risk across the board. As it
would turn out, they were too late. The pipeline was too large.

REGULATORS: “ARE UNDUE CONCENTRATIONS

OF RISK DEVELOPING?”
As had happened when they faced the question of guidance on nontraditional mort-
gages, in dealing with the rapidly changing structured finance market the regulators
failed to take timely action. They missed a crucial opportunity. On January , ,
one year after the collapse of Enron, the U.S. Senate Permanent Subcommittee on In-
 THE MADNESS 

vestigations called on the Fed, OCC, and SEC “to immediately initiate a one-time,
joint review of banks and securities firms participating in complex structured finance
products with U.S. public companies to identify those structured finance products,
transactions, or practices which facilitate a U.S. company’s use of deceptive account-
ing in its financial statements or reports.” The subcommittee recommended the agen-
cies issue joint guidance on “acceptable and unacceptable structured finance
products, transactions and practices” by June . Four years later, the banking
agencies and the SEC issued their “Interagency Statement on Sound Practices Con-
cerning Elevated Risk Complex Structured Finance Activities,” a document that was
all of nine pages long.
In the intervening years, from  to , the banking agencies and SEC issued
two draft statements for public comment. The  draft, issued the year after the
OCC, Fed, and SEC had brought enforcement actions against Citigroup and JP Mor-
gan for helping Enron to manipulate its financial statements, focused on the policies
and procedures that financial institutions should have for managing the structured fi-
nance business. The aim was to avoid another Enron—and for that reason, the
statement encouraged financial institutions to look out for customers that, like En-
ron, 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 bur-
densome. 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 transac-
tions] in the United States and abroad.”
Two years later, in May , the agencies issued an abbreviated draft that re-
flected 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  enforcement actions.
When the regulators issued the final guidance in January , 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 finan-
cial markets, have well-established track records, and typically would not be consid-
ered [complex structured finance transactions] for purposes of the Final
Statement.” Those exclusions had been added after the regulators received com-
ments on the  draft.
Regulators did take note of the potential risks of CDOs and credit default swaps.
In , the Basel Committee on Banking Supervision’s Joint Forum, which includes
banking, securities, and insurance regulators from around the world, issued a com-
prehensive 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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.
The regulators also said they had researched in some depth, for the CDO and de-
rivatives market, the question “Are undue concentrations of risk developing?” Their
answer: probably not. The credit risk was “quite modest,” the regulators concluded,
and the monoline financial guarantors appeared to know what they were doing.

The [Joint Forum’s Working Group on Risk Assessment and Capital]

has not found evidence of ‘hidden concentrations’ of credit risk. There
are some non-bank firms whose primary business model focuses on
taking on credit risk. Most important among these firms are the mono-
line financial guarantors. Other market participants seem to be fully
aware of the nature of these firms. In the case of the monolines, credit
risk has always been a primary business activity and they have invested
heavily in obtaining the relevant expertise. While obviously this does
not rule out the potential for one of these firms to experience unantici-
pated problems or to misjudge the risks, their risks are primarily at the
catastrophic or macroeconomic level. It is also clear that such firms are
subjected to regulatory, rating agency, and market scrutiny.

The 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 in-
volved 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.”

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 ac-
cording to guidelines set by the agencies; without their models and their generous al-
lotment of triple-A ratings, there would have been little investor interest and few
deals. Between  and , the volume of Moody’s business devoted to rating res-
idential mortgage–backed securities more than doubled; the dollar value of that busi-
ness increased from  million to  million; the number of staff rating these
deals doubled. But over the same period, while the volume of CDOs to be rated in-
creased sevenfold, staffing increased only . From  to , annual revenue
tied to CDOs grew from  million to  million.
When Moody’s Corporation went public in , the investor Warren Buffett’s
 THE MADNESS 

Berkshire Hathaway held  of the company. After share repurchases by Moody’s
Corporation, Berkshire Hathaway’s holdings of outstanding shares increased to over
 by . As of , Berkshire Hathaway and three other investors owned a com-
bined . of Moody’s. When asked whether he was satisfied with the internal con-
trols 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 man-
aging 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  as a senior analyst in the residential mortgage group, and after suc-
cessive promotions he became co-chief operating officer of the rating agency in ,
and then president in August . 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 di-
rector Jerome Fons, who was responsible for assembling an internal history of
Moody’s, agreed: “The main problem was . . . that the firm became so focused, partic-
ularly 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.”
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 cul-
ture” 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 com-
pany. “[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 con-
cerns 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 analyt-
ical 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 per-
spective, compliance is a very important function.”
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 , 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 mar-
ket share.” Clarkson denied having a “forceful” management style, and his supervi-
sor, 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 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 , a strong emphasis on market share was evident in em-
ployee performance evaluations. In July , Clarkson circulated a spreadsheet to
subordinates that listed  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
 THE MADNESS 

[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 , a derivatives manager listed his most important achievements in
a  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 , in the midst of significant downgrades in the structured fi-
nance market. Group Managing Director of U.S. Derivatives Yuri Yoshizawa asked her
team’s managing directors to explain a market share decrease from  to .
Despite this apparent emphasis on market share, Clarkson told the FCIC that “the
most important goal for any managing director would be credibility . . . and perform-
ance [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 pos-
sible 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  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 rat-
ings accuracy.” Witt recalled, “Moody’s reputation was just being absolutely lacer-
ated; 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  sent to McDaniel, in a section
titled “Conflict of Interest: Market Share,” Chief Credit Officer Andrew Kimball
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

explained that “Moody’s has erected safeguards to keep teams from too easily solv-
ing the market share problem by lowering standards.” But he observed that these
protections were far from fail-safe, as he detailed in two area. First, “Ratings are as-
signed by committee, not individuals. (However, entire committees, entire depart-
ments, 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 
years of success rating RMBS [residential mortgage–backed securities] may have in-
duced 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, testi-
fied 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 cap-
tive 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 rat-
ing, 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] knew that they were being bullied into cav-
ing in to bank pressure from the investment banks and originators of these things. . . .
Moody’s allow[ed] itself to be bullied. And, you know, they willingly played the
game. . . . They could have stood up and said, ‘I’m sorry, this is not—we’re not going
to sign off on this. We’re going to protect investors. We’re going to stop—you know,
we’re going to try to protect our reputation. We’re not going to rate these CDOs, we’re
not going to rate these subprime RMBS.’”
Kimball elaborated further in his October  memorandum:

Ideally, competition would be primarily on the basis of ratings quality,

with a second component of price and a third component of service.
 THE MADNESS 

Unfortunately, of the three competitive factors, rating quality is proving

the least powerful given the long tail in measuring performance. . . . The
real problem is not that the market does underweights [sic] ratings
quality but rather that, in some sectors, it actually penalizes quality by
awarding rating mandates based on the lowest credit enhancement
needed for the highest rating. Unchecked, competition on this basis can
place the entire financial system at risk. It turns out that ratings quality
has surprisingly few friends: issuers want high ratings; investors don’t
want rating downgrades; and bankers game the rating agencies for a few
extra basis points on execution.

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 an-
alyze 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 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
, 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 , Moody’s gave triple-A ratings to an average of
more than  mortgage securities each and every working day.
Such pressure can be seen in an April  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  memorandum:
“Analysts and [managing directors] are continually ‘pitched’ by bankers, issuers, in-
vestors—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 , reporting its findings to Moody’s in July . The SEC criticized
Moody’s for, among other things, failing to verify the accuracy of mortgage informa-
tion, leaving that work to due diligence firms and other parties; failing to retain doc-
umentation about how most deals were rated; allowing ratings quality to be
compromised by the complexity of CDO deals; not hiring sufficient staff to rate
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 decisions.
So matters stood in , when the machine that had been humming so smoothly
and so lucratively slipped a gear, and then another, and another—and then seized up
entirely.

COMMISSION CONCLUSIONS ON CHAPTER 10

The Commission concludes that the credit rating agencies abysmally failed in
their central mission to provide quality ratings on securities for the benefit of in-
vestors. They did not heed many warning signs indicating significant problems in
the housing and mortgage sector. Moody’s, the Commission’s case study in this
area, continued issuing ratings on mortgage-related securities, using its outdated
analytical models, rather than making the necessary adjustments. The business
model under which firms issuing securities paid for their ratings seriously under-
mined the quality and integrity of those ratings; the rating agencies placed market
share and profit considerations above the quality and integrity of their ratings.
Despite the leveling off and subsequent decline of the housing market begin-
ning in , securitization of collateralized debt obligations (CDOs), CDOs
squared, and synthetic CDOs continued unabated, greatly expanding the expo-
sure to losses when the housing market collapsed and exacerbating the impact of
the collapse on the financial system and the economy.
During this period, speculators fueled the market for synthetic CDOs to bet
on the future of the housing market. CDO managers of these synthetic products
had potential conflicts in trying to serve the interests of customers who were bet-
ting mortgage borrowers would continue to make their payments and of cus-
tomers who were betting the housing market would collapse.
There were also potential conflicts for underwriters of mortgage-related secu-
rities to the extent they shorted the products for their own accounts outside of
their roles as market makers.
 11
THE BUST

CONTENTS
Delinquencies: “The turn of the housing market” ..............................................
Rating downgrades: “Never before”....................................................................
CDOs: “Climbing the wall of subprime worry”..................................................
Legal remedies: “On the basis of the information”..............................................
Losses: “Who owns residential credit risk?” .......................................................

What happens when a bubble bursts? In early , 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 fi-
nancial 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 FCIC.
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 securi-
ties 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 in-
vestments were supposed to be super-safe.
As  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.


 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

The summer of  also saw a near halt in many securitization markets, includ-
ing the market for non-agency mortgage securitizations. For example, a total of 
billion in subprime securitizations were issued in the second quarter of  (already
down from prior quarters). That figure dropped precipitously to  billion in the
third quarter and to only  billion in the fourth quarter of . Alt-A issuance
topped  billion in the second quarter, but fell to  billion in the fourth quarter
of . Once-booming markets were now gone—only  billion in subprime or Alt-
A mortgage-backed securities were issued in the first half of , and almost none
after that.
CDOs followed suit. From a high of more than  billion in the first quarter of
, worldwide issuance of CDOs with mortgage-backed securities as collateral
plummeted to  billion in the third quarter of  and only  billion in the
fourth quarter. And as the CDO market ground to a halt, investors no longer trusted
other structured products. Over  billion of collateralized loan obligations
(CLOs), or securitized leveraged loans, were issued in ; only  billion were is-
sued in . The issuance of commercial real estate mortgage–backed securities
plummeted from  billion in  to  billion in .
Those securitization markets that held up during the turmoil in  eventually
suffered in  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 .

DELINQUENCIES: “THE TURN OF THE HOUSING MARKET”

Home prices rose  nationally in , their third year of double-digit growth. But
by the spring of , 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  years. Nationwide,
home prices peaked in April .
Members of the Federal Reserve’s Federal Open Market Committee (FOMC) dis-
cussed housing prices in the spring of . 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.
In October , with the housing market downturn under way, Moody’s Econ-
omy.com, a business unit separate from Moody’s Investors Service, issued a report
authored by Chief Economist Mark Zandi titled “Housing at the Tipping Point: The
Outlook for the U.S. Residential Real Estate Market.” He came to the following
conclusion:

Nearly  of the nation’s metro areas will experience a crash in house

prices; a double-digit peak-to-trough decline in house prices. . . . These
sharp declines in house prices are expected along the Southwest coast of
Florida, in the metro areas of Arizona and Nevada, in a number of Cali-
 THE BUST 

fornia areas, throughout the broad Washington, D.C. area, and in and
around Detroit. Many more metro areas are expected to experience only
house-price corrections in which peak-to-trough price declines remain
in the single digits. . . . It is important to note that price declines in vari-
ous markets are expected to extend into  and even .
With over  metro areas representing nearly one-half of the na-
tion’s housing stock experiencing or about to experience price declines,
national house prices are also set to decline. Indeed, odds are high that
national house prices will decline in .

For , the National Association of Realtors announced that the number of
sales of existing homes had experienced the sharpest fall in  years. That year, home
prices declined . In , they would drop a stunning . Overall, by the end of
, prices would drop  from their peak in . Some cities saw a particularly
large drop: in Las Vegas, as of August , home prices were down  from their
peak. And areas that never saw huge price gains have experienced losses as well:
home prices in Denver have fallen  since their peak.
In some areas, home prices started to fall as early as late . For example, in
Ocean City, New Jersey, where many properties are vacation homes, home prices had
risen  since ; they topped out in December  and fell  in the first half
of . By mid-, they would be  below their peak. Prices topped out in
Sacramento in October  and are today down nearly . In most places, prices
rose for a bit longer. For instance, in Tucson, Arizona, prices kept increasing for
much of , climbing  from  to their high point in August , and then
fell only  by the end of the year.
One of the first signs of the housing crash was an upswing in early payment de-
faults—usually defined as borrowers’ being  or more days delinquent within the first
year. Figures provided to the FCIC show that by the summer of , . of loans
less than a year old were in default. The figure would peak in late  at ., well
above the . peak in the  recession. Even more stunning, first payment de-
faults—that is, mortgages taken out by borrowers who never made a single payment—
went above . of loans in early . Responding to questions about that data,
CoreLogic Chief Economist Mark Fleming told the FCIC that the early payment de-
fault rate “certainly correlates with the increase in the Alt-A and subprime shares and
the turn of the housing market and the sensitivity of those loan products.”
Mortgages in serious delinquency, defined as those  or more days past due or in
foreclosure, had hovered around  during the early part of the decade, jumped in
, and kept climbing. By the end of , . of mortgage loans were seriously
delinquent. By comparison, serious delinquencies peaked at . in  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 delinquency rose to  in mid- and  by late , double
the rate in other areas of the country (see figure .).
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Mortgage Delinquencies by Region

Arizona, California, Florida, and Nevada—the “sand states”—had the most
problem loans.
IN PERCENT, BY REGION
16%
13.6%
Sand
states
12
8.7%
U.S.
total
8
7.0%
Non-sand
states
4

0
1998 2000 2002 2004 2006 2008 2010

NOTE: Serious delinquencies include mortgages 90 days or more past due and those in foreclosure.
SOURCE: Mortgage Bankers Association National Delinquency Survey

Figure .

Serious delinquency also varied by type of loan (see figure .). Subprime ad-
justable-rate mortgages began to show increases in serious delinquency in early ,
even as house prices were peaking; the rate rose rapidly to  in . By late ,
the delinquency rate for subprime ARMs was . Prime ARMs did not weaken un-
til , 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 se-
rious delinquency that coincided with the increasing severity of the recession and of
unemployment in .
The FCIC undertook an extensive examination of the relative performance of
mortgages purchased or guaranteed by the GSEs, those securitized in the private
market, and those insured by the Federal Housing Administration or Veterans Ad-
ministration (see figure .). The analysis was conducted using roughly  million
mortgages outstanding at the end of each year from  through . The data
contained mortgages in four groups—loans that were sold into private label securiti-
zations labeled subprime by issuers (labeled SUB), loans sold into private label Alt-A
securitizations (ALT), loans either purchased or guaranteed by the GSEs (GSE), and
loans guaranteed by the Federal Housing Administration or Veterans Administration
(FHA). The GSE group, in addition to the more traditional conforming GSE loans,
 THE BUST 

Mortgage Delinquencies by Loan Type

Serious delinquencies started earlier and were substantially higher among
subprime adjustable-rate loans, compared with other loan types.
IN PERCENT, BY TYPE
50%
Subprime
adjustable
40 rate

30
Subprime

20 rate
Prime
adjustable
10 rate

Prime
0 
rate
1998 2000 2002 2004 2006 2008 2010

NOTE: Serious delinquencies include mortgages 90 days or more past due and those in foreclosure.
SOURCE: Mortgage Bankers Association National Delinquency Survey

Figure .

also includes mortgages that the GSEs identified as subprime and Alt-A loans owing
to their higher-risk characteristics, as discussed in earlier chapters.
Within each of the four groups, the FCIC created subgroups based on characteris-
tics that could affect loan performance: FICO credit scores, loan-to-value ratios
(LTVs), and mortgage size. For example, one subgroup would be GSE loans with a
balance below , (conforming to GSE loan size limits), a FICO score between
 and  (a borrower with below-average credit history), and LTV between 
and . Another group would be Alt-A loans with the same characteristics. In
each year, the loans were broken into  different subgroups— each for GSE,
SUB, ALT, and FHA.
Figure . graphically demonstrates the results of the examination. The various
bars show the range of average delinquencies for each of the four groups examined,
based on the distribution of delinquency rates within the  subgroups for each
loan category. The black portion of each bar represents the middle  ( on ei-
ther side of the median) of the distribution of average delinquency rates. The full bar,
including both dark and light shading, represents the middle  of the distribution
of average delinquency rates. The bars exclude the  at the extremes of each end of
the distribution. For example, at the end of , the black portion of the GSE bar
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Loan Performance in Various Mortgage-Market Segments

Bars shows distribution of average rate of serious delinquency.
IN PERCENT MIDDLE 50%

2008 MIDDLE 90% 2009

GSE GSE

SUB SUB

ALT ALT

FHA FHA

0 10 20 30 40% 0 10 20 30 40%

NOTE: Serious delinquencies include mortgages 90 days or more past due and those in foreclosure.
SOURCE: FCIC calculations, based on CoreLogic and Loan Processing Service Inc.

Figure .

spans a . average delinquency rate on the low end and a . average delin-
quency rate on the high end. The full bar for the GSEs spans average delinquency
rates from . to .. That means that only  of GSE loans were in subgroups
with average delinquency rates above .. In sharp contrast, the black bar for pri-
vate-label subprime securitizations (SUB) spans average delinquency rates between
. on the low end and . on the high end, and the full bar spans average
delinquency rates between . and .. That means that only  of SUB loans
were in subgroups with average delinquency rates below . The worst-performing
 of GSE loans are in subgroups with rates of serious delinquency similar to the
best-performing  of SUB loans.
By the end of , performance within all segments of the market had weakened.
The median delinquency rate—the midpoints of the black bars—rose from  in
 to . for GSE loans, from  to  for SUB loans, from  to  for
Alt-A loans, and remained at roughly  for FHA loans.
The data illustrate that in  and , GSE loans performed significantly bet-
ter than privately securitized, or non-GSE, subprime and Alt-A loans. That holds
true even when comparing loans in GSE pools that share the same key characteristics
with the loans in privately securitized mortgages, such as low FICO scores. For exam-
ple, among loans to borrowers with FICO scores below , a privately securitized
mortgage was more than four times as likely to be seriously delinquent as a GSE.
 THE BUST 

In , the respective average delinquency rates for the non-GSE and GSE loans
were . and .. These patterns are most likely driven by differences in under-
writing standards as well as by some differences not captured in these mortgages.
For instance, in the GSE pool, borrowers tended to make bigger down payments. The
FCIC’s data show that  of GSE loans with FICO scores below  had an original
loan-to-value ratio below , indicating that the borrower made a down payment
of at least  of the sales price. This relatively large down payment would help offset
the effect of the lower FICO score. In contrast, only  of loans with FICO scores
below  in non-GSE subprime securitizations had an LTV under . The data il-
lustrate that non-agency securitized loans were much more likely to have more than
one risk factor and thereby exhibit so-called risk layering, such as low FICO scores
on top of small down payments.
GSE mortgages with Alt-A characteristics also performed significantly better than
mortgages packaged into non-GSE Alt-A securities. For example, in  among
loans with an LTV above , the GSE pools have an average rate of serious delin-
quency of ., versus a rate of . for loans in private Alt-A securities. These
results are also, in large part, driven by differences in risk layering.
Others frame the situation differently. According to Ed Pinto, a mortgage finance
industry consultant who was the chief credit officer at Fannie Mae in the s, GSEs
dominated the market for risky loans. In written analyses reviewed by the FCIC staff
and sent to Commissioners as well as in a number of interviews, Pinto has argued
that the GSE loans that had FICO scores below , a combined loan-to-value ratio
greater than , or other mortgage characteristics such as interest-only payments
were essentially equivalent to those mortgages in securitizations labeled subprime
and Alt-A by issuers.
Using strict cutoffs on FICO score and loan-to-value ratios that ignore risk layer-
ing and thus are only partly related to mortgage performance (as well as relying on a
number of other assumptions), Pinto estimates that as of June , ,  of all
mortgages in the country—. million of them—were risky mortgages that he de-
fines as subprime or Alt-A. Of these, Pinto counts . million, or , that were
purchased or guaranteed by the GSEs. In contrast, the GSEs categorize fewer than
 million of their loans as subprime or Alt-A.
Importantly, as the FCIC review shows, the GSE loans classified as subprime or
Alt-A in Pinto’s analysis did not perform nearly as poorly as loans in non-agency sub-
prime or Alt-A securities. These differences suggest that grouping all of these loans
together is misleading. In direct contrast to Pinto’s claim, GSE mortgages with some
riskier characteristics such as high loan-to-value ratios are not at all equivalent to
those mortgages in securitizations labeled subprime and Alt-A by issuers. The per-
formance data assembled and analyzed by the FCIC show that non-GSE securitized
loans experienced much higher rates of delinquency than did the GSE loans with
similar characteristics.
In addition to examining loans owned and guaranteed by the GSEs, Pinto also com-
mented on the role of the Community Reinvestment Act (CRA) in causing the crisis,
declaring, “The pain and hardship that CRA has likely spawned are immeasurable.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Contrary to this view, two Fed economists determined that lenders actually made
few subprime loans to meet their CRA requirements. Analyzing a database of nearly
 million loans originated in , they found that only a small percentage of all
higher-cost loans as defined by the Home Mortgage Disclosure Act had any connec-
tion to the CRA. These higher-cost loans serve as a rough proxy for subprime mort-
gages. Specifically, the study found that only  of such higher-cost loans were made
to low- or moderate-income borrowers or in low- or moderate-income neighbor-
hoods by banks and thrifts (and their subsidiaries and affiliates) covered by the CRA.
The other  of higher-cost loans either were made by CRA-covered institutions
that did not receive CRA credit for these loans or were made by lenders not covered
by the CRA. Using other data sources, these economists also found that CRA-related
subprime loans appeared to perform better than other subprime loans. “Taken to-
gether, the available evidence seems to run counter to the contention that the CRA
contributed in any substantive way to the current crisis,” they wrote.
Subsequent research has come to similar conclusions. For example, two econo-
mists at the San Francisco Fed, using a different methodology and analyzing data on
the California mortgage market, found that only  of loans made by CRA-covered
lenders were located in low- and moderate-income census tracts versus over  for
independent mortgage companies not covered by the CRA. Further, fewer than 
of the loans made by CRA lenders in low-income communities were higher priced,
even at the peak of the market. In contrast, about one-half of the loans originated by
independent mortgage companies in these communities were higher priced. And af-
ter accounting for characteristics of the loans and the borrowers, such as income and
credit score, the authors found that loans made by CRA-covered lenders in the low-
and moderate-income areas they serve were half as likely to default as similar loans
made by independent mortgage companies, which are not subject to CRA and are
subject to less regulatory oversight in general. “While certainly not conclusive, this
suggests that the CRA, and particularly its emphasis on loans made within a lender’s
assessment area, helped to ensure responsible lending, even during a period of over-
all declines in underwriting standards,” they concluded.
Overall, in , , and , CRA-covered banks and thrifts accounted for at
least  of all mortgage lending but only between  and  of higher-priced
mortgages. Independent mortgage companies originated less than one-third of all
mortgages but about one-half of all higher-priced mortgages. Finally, lending by
nonbank affiliates of CRA-covered depository institutions is counted toward CRA
performance at the discretion of the bank or thrift. These affiliates accounted for an-
other roughly  of mortgage lending but about  of high-price lending.
Bank of America provided the FCIC with performance data on its CRA-qualify-
ing portfolio, which represented only  of the bank’s mortgage portfolio. In the
end of the first quarter of ,  of the bank’s  billion portfolio of residential
mortgages was nonperforming:  of the  billion CRA-qualifying portfolio was
nonperforming at that date.
John Reed, a former CEO of Citigroup, when asked whether he thought govern-
ment policies such as the CRA played a role in the crisis, said that he didn’t believe
 THE BUST 

banks would originate “a bad mortgage because they thought the government policy
allowed it” unless the bank could sell off the mortgage to Fannie or Freddie, which
had their own obligations in this arena. He said, “It’s hard for me to answer. If the rea-
son the regulators didn’t jump up and down and yell at the low-doc, no-doc sub-
prime mortgage was because they felt that they, Congress had sort of pushed in that
direction, then I would say yes.”
“You know, CRA could be a pain in the neck,” the banker Lewis Ranieri told the
FCIC. “But you know what? It always, in my view, it always did much more good
than it did anything. You know, we did a lot. CRA made a big difference in communi-
ties. . . . You were really putting money in the communities in ways that really stabi-
lized the communities and made a difference.” But lenders including Countrywide
used pro-homeownership policies as a “smokescreen” to do away with underwriting
standards such as requiring down payments, he said. “The danger is that it gives air
cover to all of this kind of madness that had nothing to do with the housing goal.”

RATING DOWNGRADES: “NEVER BEFORE”

Prior to , the ratings of mortgage-backed securities at Moody’s were monitored
by the same analysts who had rated them in the first place. In , 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 , the surveillance team began to see a rise in early payment de-
faults 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 Service.
In early , a Moody’s special report, overseen by Weill, about the sharp in-
creases in early payment defaults stated that the foreclosures were concentrated in
subprime mortgage pools. In addition, more than . of the subprime mortgages
securitized in the second quarter of  were  days delinquent within six months,
more than double the rate a year earlier (.). 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 ex-
pected loss.”
For the next few months, the company published regular updates about the sub-
prime mortgage market. Over the next three months, Moody’s took negative rating
actions on . of the outstanding subprime mortgage securities rated Baa. Then, on
July , , in an unprecedented move, Moody’s downgraded  subprime mort-
gage-backed securities that had been issued in  and put an additional  securi-
ties on watch. The . billion of securities that were affected, all rated Baa and lower,
made up  of the subprime securities that Moody’s rated Baa in . For the time
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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  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 mar-
ket. A few days later, Standard & Poor’s downgraded  similar tranches. These
initial downgrades were remarkable not only because of the number of securities in-
volved but also because of the sharp rating cuts—an average of four notches per se-
curity, 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
 were the bottom three mezzanine tranches (M, M, and M) of the Citi-
group deal that we have been examining, CMLTI -NC. By that point, nearly
 of the original loan pool had prepaid but another  were  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 Man-
agement detailed its exposure. One of its CDOs, Tall Ships, had direct exposure to
our sample deal, owning  million of the M and M tranches. BSAM’s High-Grade
hedge fund also had exposure through a  million credit default swap position
with Lehman referencing the M tranche. And BSAM’s Enhanced Leverage hedge
fund owned parts of the equity in Independence CDO, which in turn owned the M
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 , Moody’s downgraded another , tranches (. bil-
lion) of subprime mortgage–backed securities and placed  tranches (. bil-
lion) on watch for potential downgrade. Now the total of securities downgraded and
put on watch represented . of the original dollar volume of all  subprime
mortgage–backed securities that Moody’s had rated. Of the securities placed on
watch in October,  tranches (. billion) were originally Aaa-rated and  (.
billion) were Aa-rated. All told, in the first  months of ,  of the mortgage-
backed security deals issued in  had at least one tranche downgraded or put on
watch.
By this point in October,  of the loans in our case study deal CMLTI -
NC were seriously delinquent and some homes had already been repossessed. The
M through M tranches were downgraded as part of the second wave of mass
downgrades. Five additional tranches would eventually be downgraded in April
.
Before it was over, Moody’s would downgrade  of all the  Aaa mortgage-
backed securities tranches and all of the Baa tranches. For those securities issued in
the second half of , nearly all Aaa and Baa tranches were downgraded. Of all
 THE BUST 

tranches initially rated investment grade—that is, rated Baa or higher— of

those issued in  were downgraded to junk, as were  of those from .

CDO S : “CLIMBING THE WALL OF SUBPRIME WORRY”

In March , 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 Presi-
dent 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 ] was the result of some arrangers fever-
ishly working to clear inventory and reduce their balance sheet exposure to the sub-
prime 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 assumptions.
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 consequences.”
In July, McDaniel gave a presentation to the board on the company’s  strate-
gic plan. His slides had such bleak titles as “Spotlight on Mortgages: Quality Contin-
ues to Erode,” “House Prices Are Falling  .  .  . ,” “Mortgage Payment Resets Are
Mounting,” and “. MM Mortgage Defaults Forecast –.” Despite all the evi-
dence that the quality of the underlying mortgages was declining, Moody’s did not
make any significant adjustments to its CDO ratings assumptions until late Septem-
ber. Out of  billion in CDOs that Moody’s rated after its mass downgrade of sub-
prime mortgage–backed securities on July , ,  were rated Aaa.
Moody’s had hoped that rating downgrades could be staved off by mortgage mod-
ifications—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.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

By the end of , more than  of all tranches of CDOs had been down-
graded. Moody’s downgraded nearly all of the  Aaa and all of the Baa CDO
tranches. And, again, the downgrades were large—more than  of Aaa CDO
bonds and more than  of Baa CDO bonds were eventually downgraded to junk.

LEGAL REMEDIES: “ON THE BASIS OF THE INFORMATION”

The housing bust exposed the flaws in the mortgages that had been made and securi-
tized. 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 orig-
inators 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 un-
derlying the mortgage-backed securities as well as in their disclosure about the char-
acteristics 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 dele-
gated underwriting authority to originators subject to a legal agreement—representa-
tions 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.
As a result of such sampling, during the three years and eight months ending Au-
gust , , Freddie and Fannie required sellers to repurchase , loans total-
ing . billion. So far, Freddie has received . billion from sellers, and Fannie has
received . billion—a total of . billion. The amount put back is notable in
that it represents  of  billion in credit-related expenses recorded by the GSEs
since the beginning of  through September .
In testing to ensure compliance with its standards, Freddie reviews a small per-
centage of performing loans and a high percentage of foreclosed loans (including
well over  of all loans that default in the first two years). In total, Freddie re-
viewed . billion of loans (out of . trillion in loans acquired or guaranteed)
and found . billion to be ineligible, meaning they did not meet representations
and warranties.
Among the performing loans that were sampled, over time an increasing percent-
age were found to be ineligible, rising from  for mortgages originated in  to
 in . Still, Freddie put back very few of these performing loans to the origina-
tors. Among mortgages originated from  to , it found that  of the delin-
quent loans were ineligible, as were  of the loans in foreclosure. Most of these
were put back to originators—again, in cases in which the originators were still in op-
 THE BUST 

eration. Sometimes, if the reasons for ineligibility were sufficiently minor, the loans
were not put back.
Overall, of the delinquent loans and loans in foreclosure sampled by Freddie, 
were put back. In  and , Freddie put back significant loan volumes to the
following lenders: Countrywide, . billion; Wells Fargo, . billion; Chase Home
Financial, . billion; Bank of America,  million; and Ally Financial,  mil-
lion.
Using a method similar to Freddie’s to test for loan eligibility, Fannie reviewed be-
tween  and  of the mortgages originated since —sampling at the higher
rates for delinquent loans. From  through , Fannie put back loans to the fol-
lowing large lenders: Bank of America, . billion; Wells Fargo, . billion; JP Mor-
gan Chase, . billion; Citigroup, . billion; SunTrust Bank,  million; and
Ally Financial,  million. In early January , Bank of America reached a deal
with Fannie and Freddie, settling the GSEs’ claims with a payment of more than .
billion. 
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 , PMI compa-
nies had insured a total of  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 , the seven largest PMI
companies, which share  of the market, had rejected about  of the claims (or
 billion of  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  billion of subprime and Alt-A private-label
securities. The GSEs have recorded  billion in charges on securities from Janu-
ary ,  to September , . Frustrated with the lack of information from the
securities’ servicers and trustees, in many cases large banks, on July , , the
GSEs through their regulator, the Federal Housing Finance Agency, issued  sub-
poenas 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 in-
vestors 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-, court actions embroiled almost all major loan originators and
underwriters—there were more than  lawsuits related to breaches of representa-
tions and warranties, by one estimate. These lawsuits filed in the wake of the finan-
cial crisis include those alleging “untrue statements of material fact” or “material
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

misrepresentations” in the registration statements and prospectuses provided to in-

vestors who purchased securities. They generally allege violations of the Securities
Exchange Act of  and the Securities Act of .
Both private and government entities have gone to court. For example, the invest-
ment 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 disclo-
sure relating to their sales of mortgage-backed securities. Morgan Stanley agreed to
pay  million and Goldman Sachs agreed to pay  million.
To take another example, the Federal Home Loan Bank of Chicago has sued sev-
eral defendants, including Bank of America, Credit Suisse Securities, Citigroup, and
Goldman Sachs, over its . billion investment in private mortgage-backed securi-
ties, claiming they failed to provide accurate information about the securities. Simi-
larly, Cambridge Place Investment Management has sued units of Morgan Stanley,
Citigroup, HSBC, Goldman Sachs, Barclays, and Bank of America, among others, “on
the basis of the information contained in the applicable registration statement,
prospectus, and prospective supplements.”

LOSSES: “WHO OWNS RESIDENTIAL CREDIT RISK? ”

Through  and into , 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 neces-
sary. Potential investors worried they might get stuck holding these securities as mar-
ket 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
, the largest banks and investment banks began complying with a new account-
ing rule and for the first time reported their assets in one of three valuation cate-
gories: “Level  assets,” which had observable market prices, like stocks on the stock
exchange; “Level  assets,” which were not as easily priced because they were not ac-
tively traded; and “Level  assets,” which were illiquid and had no discernible market
prices or other inputs. To determine the value of Level  and in some cases Level  as-
sets where market prices were unavailable, firms used models that relied on assump-
tions. Many financial institutions reported Level  assets that substantially exceeded
their capital. For example, for the first quarter of , Bear Stearns reported about
 billion in Level  assets, compared to  billion in capital; Morgan Stanley re-
 THE BUST 

ported about  billion in Level  assets, against capital of  billion; and Goldman
reported about  billion, and capital of  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 rat-
ing agencies’ and investors’ expectations that the mortgages would default. But only
when those defaults came to pass would holders of the securities actually have real-
ized losses. Determining the market value of securities that did not trade was diffi-
cult, was subjective, and became a contentious issue during the crisis. Why? Because
the write-downs reduced earnings and capital, and triggered collateral calls.
These mark-to-market accounting rules received a good deal of criticism in re-
cent years, as firms argued that the lower market prices did not reflect market values
but rather fire-sale 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  to  billion; so far, by , the figure has turned out not to be
much more than that. As of year-end , the dollar value of all impaired Alt-A and
subprime mortgage–backed securities total about  billion. Securities are im-
paired when they have suffered realized losses or are expected to suffer realized
losses imminently. While those numbers are small in relation to the  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  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 conta-
gion, 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 ef-
fects 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 experi-
enced 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  report. The answer: three-quarters
of subprime and Alt-A mortgages had been securitized—and “much of the risk in
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

these securitizations is in the investment-grade securities and has been almost en-
tirely transferred to AAA collateralized debt obligation (CDO) holders.” A set of
large, systemically important firms with significant holdings or exposure to these se-
curities 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 authori-
ties too big to fail in the midst of a financial crisis.
The International Monetary Fund’s Global Financial Stability Report published in
October  examined where the declining assets were held and estimated how se-
vere the write-downs would be. All told, the IMF calculated that roughly  trillion
in mortgage assets were held throughout the financial system. Of these, . trillion
were GSE mortgage–backed securities; the IMF expected losses of  billion, but in-
vestors holding these securities would lose no money, because of the GSEs’ guaran-
tee. Another . 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  billion in write-downs due to declines in market value. The
remaining . trillion in assets were estimated to be mortgage-backed securities and
CDOs. Write-downs on those assets were expected to be  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
non-agency mortgage–backed securities were shared among institutions such as in-
surance companies, pension funds, the GSEs, and hedge funds. The October report
also expected another  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.
Furthermore, when the crisis began, uncertainty (suggested by the sizable revi-
sions 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 lever-
aged 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 , at
the end of  most of the triple-A tranches of mortgage-backed securities have
avoided actual losses in cash flow through  and may avoid significant realized
losses going forward.
Overall, for  to  vintage tranches of mortgage-backed securities origi-
nally rated triple-A, despite the mass downgrades, only about  of Alt-A and  of
subprime securities had been “materially impaired”—meaning that losses were im-
 THE BUST 

Impaired Securities
Impairment of 2005-2007 vintage mortgage-backed securities (MBS) and CDOs as
of year-end 2009, by initial rating. A security is impaired when it is downgraded to
C or Ca, or when it suffers a principal loss.

IN BILLIONS OF DOLLARS

$1,000

Not impaired
800 Impaired

600

400

200

0
Aaa Aa thru B Aaa Aa thru B Aaa Aa thru B
Alt-A MBS Subprime MBS CDOs

SOURCE: Moody’s Investors Service, “Special Comment: Default & Loss Rates of Structured Finance Securities:
1993-2009”; Moody’s SFDRS.

Figure .

minent or had already been suffered—by the end of  (see figure .). For the
lower-rated Baa tranches, . of Alt-A and . of subprime securities were im-
paired. In all, by the end of ,  billion worth of subprime and Alt-A tranches
had been materially impaired—including . billion originally rated triple-A. The
outcome would be far worse for CDO investors, whose fate largely depended on the
performance of lower-rated mortgage-backed securities. More than  of Baa CDO
bonds and . of Aaa CDO bonds were ultimately impaired.
The housing bust would not be the end of the story. As Chairman Bernanke testi-
fied to the FCIC: “What I did not recognize was the extent to which the system had
flaws and weaknesses in it that were going to amplify the initial shock from subprime
and make it into a much bigger crisis.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

COMMISSION CONCLUSIONS ON CHAPTER 11

The Commission concludes that the collapse of the housing bubble began the
chain of events that led to the financial crisis.
High leverage, inadequate capital, and short-term funding made many finan-
cial institutions extraordinarily vulnerable to the downturn in the market in .
The investment banks had leverage ratios, by one measure, of up to  to . This
means that for every  of assets, they held only  of capital. Fannie Mae and
Freddie Mac (the GSEs) had even greater leverage—with a combined  to  ratio.
Leverage or capital inadequacy at many institutions was even greater than re-
ported when one takes into account “window dressing,” off-balance-sheet expo-
sures such as those of Citigroup, and derivatives positions such as those of AIG.
The GSEs contributed to, but were not a primary cause of, the financial crisis.
Their  trillion mortgage exposure and market position were significant, and
they were without question dramatic failures. They participated in the expansion
of risky mortgage lending and declining mortgage standards, adding significant
demand for less-than-prime loans. However, they followed, rather than led, the
Wall Street firms. The delinquency rates on the loans that they purchased or guar-
anteed were significantly lower than those purchased and securitized by other fi-
nancial institutions.
The Community Reinvestment Act (CRA)—which requires regulated banks
and thrifts to lend, invest, and provide services consistent with safety and sound-
ness to the areas where they take deposits—was not a significant factor in sub-
prime lending. However, community lending commitments not required by the
CRA were clearly used by lending institutions for public relations purposes.
 PART IV

The Unraveling
 12
EARLY 2007:
SPREADING SUBPRIME WORRIES

CONTENTS
Goldman: “Let’s be aggressive distributing things”..............................................
Bear Stearns’s hedge funds: “Looks pretty damn ugly”........................................
Rating agencies: “It can’t be . . . all of a sudden”..................................................
AIG: “Well bigger than we ever planned for” .....................................................

Over the course of , the collapse of the housing bubble and the abrupt shutdown
of subprime lending led to losses for many financial institutions, runs on money mar-
ket funds, tighter credit, and higher interest rates. Unemployment remained rela-
tively steady, hovering just below . until the end of the year, and oil prices rose
dramatically. By the middle of , home prices had declined almost  from their
peak in . Early evidence of the coming storm was the . drop in November
 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 .
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  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 . “There is a broad recogni-
tion 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 Di-
rector Erik Sirri in a January , , memorandum.
That became more and more evident. In January, Mortgage Lenders Network an-
nounced 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 . 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.


 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 with-
holding 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  and  assets at these firms was “eye-
popping in terms of the amount of leverage the banks and investment banks had,” ac-
cording 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 ’, when the figures began to be published, and
then it was as if someone rang a bell, because almost immediately upon the publica-
tion of these numbers, journalists began writing about it, and hedge funds began
talking about it, and people began speaking about it in the marketplace.”
In late  and early , some banks moved to reduce their subprime expo-
sures 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 cre-
ating 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 quanti-
ties 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 ,
SEC officials noted that investment banks had credit exposure to struggling subprime
lenders but argued that “none of these exposures are material.” The Treasury and
Fed insisted throughout the spring and early summer that the damage would be lim-
ited. “The impact on the broader economy and financial markets of the problems in
the subprime market seems likely to be contained,” Fed Chairman Ben Bernanke
testified before the Joint Economic Committee of Congress on March . That same
day, Treasury Secretary Henry Paulson told a House Appropriations subcommittee:
“From the standpoint of the overall economy, my bottom line is we’re watching it
closely but it appears to be contained.”
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GOLDMAN: “LET’S BE AGGRESSIVE DISTRIBUTING THINGS”

In December , following the initial decline in ABX BBB indices and after  con-
secutive days of trading losses on its mortgage desk, executives at Goldman Sachs de-
cided 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 , , regarding “the major risk in the Mortgage
business” to Chief Financial Officer David Viniar and Chief Risk Officer Craig Brod-
erick. 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 refo-
cus on retained new issue bond positions and move them out. There will be big op-
portunities 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  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 mes-
sage was let’s be aggressive distributing things because there will be very good oppor-
tunities as the market goes into what is likely to be even greater distress and we want
to be in position to take advantage of them.”
Subsequent emails suggest that the “everything else” meant mortgage-related as-
sets. On December , in an internal email with broad distribution, Goldman’s Stacy
Bash-Polley, a partner and the co-head of fixed income sales, noted that the firm, un-
like 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 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, Gold-
man 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 indi-
cate that the firm targeted less-sophisticated customers in its efforts to reduce sub-
prime exposure. In a December  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”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 suc-
cess 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 necessar-
ily understanding all the implications of those monstrosities.”
On February , Goldman CEO Lloyd Blankfein questioned Montag about the
 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  million write-off and billions of dollars of subprime exposure still
retained. In the first quarter of , its mortgage business earned a record  mil-
lion, driven primarily by short positions, including a  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 continu-
ing to create and sell mortgage-related products to its clients. From December 
through August , it created and sold approximately . billion of CDOs—
including . 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 secu-
rities to clients while simultaneously betting against those securities. Sylvain Raynes,
a structured finance expert at R&R Consulting in New York, reportedly called Gold-
man’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.”
During a FCIC hearing, Goldman CEO Lloyd Blankfein was asked if he believed
it was a proper, legal, or ethical practice for Goldman to sell clients mortgage securi-
ties that Goldman believed would default, while simultaneously shorting them.
Blankfein responded, “I do think that the behavior is improper and we regret the re-
sult—the consequence [is] that people have lost money” The next day, Goldman is-
sued a press release declaring Blankfein did not state that Goldman’s “practices with
respect to the sale of mortgage-related securities were improper. . . . Blankfein was re-
sponding to a lengthy series of statements followed by a question that was predicated
on the assumption that a firm was selling a product that it thought was going to de-
fault. Mr. Blankfein agreed that, if such an assumption was true, the practice would
be improper. Mr. Blankfein does not believe, nor did he say, that Goldman Sachs had
behaved improperly in any way.”
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In addition, Goldman President and Chief Operating Officer Gary Cohn testified:
“During the two years of the financial crisis, Goldman Sachs lost . billion in its
residential mortgage–related business. . . . We did not bet against our clients, and
these numbers underscore that fact.”
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, Gold-
man’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 con-
tinuing 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 . million in Goldman’s Timberwolf CDO, sued Goldman for fraud in
. The Timberwolf deal was heavily criticized by Senator Carl Levin and other
members of the Permanent Subcommittee on Investigations during an April 
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 mak-
ing margin calls on the deal. By the end of July , it had demanded more than 
million. According to the hedge fund, Goldman’s demands forced it into bank-
ruptcy in August —Goldman received about  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 po-
sitions 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 partici-
pant, Goldman “marked,” or valued, its securities after considering both actual mar-
ket trades and surveys of how other institutions valued the assets. As the crisis
unfolded, Goldman marked mortgage-related securities at prices that were signifi-
cantly lower than those of other companies. Goldman knew that those lower marks
might hurt those other companies—including some clients—because they could re-
quire 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  email, Craig Broderick, who as Gold-
man’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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 associ-
ated 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 implica-
tions, etc. This is getting lots of th floor attention right now.”
Broderick was right about the impact of Goldman’s marks on clients and counter-
parties. The first significant dispute about these marks began in May : it con-
cerned the two high-flying, mortgage-focused hedge funds run by Bear Stearns Asset
Management (BSAM).

BEAR STEARNS’S HEDGE FUNDS:

“LOOKS PRETTY DAMN UGLY”
In , 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  they be-
came even busier.
By April , internal BSAM risk exposure reports showed about  of the
High-Grade 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
 “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  in the
last three months of ; then another  in January and  in February. The
market’s confidence fell with the ABX. Investors began to bail out of both Enhanced
and High-Grade. Cioffi and Tannin stepped up their marketing. On March , ,
Tannin said in an email to investors, “we see an opportunity here—not crazy oppor-
tunity—but prudent opportunity—I am putting in additional capital—I think you
should as well.” On a March  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 in-
creasing 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  million of his own . million investment in En-
hanced 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  billion of
CDO assets off the hedge funds’ books. The senior-most tranches, worth . billion,
 E A R LY     : S P R E A D I N G S U B P R I M E W O R R I E S 

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  billion on this arrangement.

“ 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 invest-
ments. 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, mark-
ing 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. 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 co-president, 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 , marks by broker-
dealers finally started to reflect the lower values. On April , , Goldman sent
BSAM marks ranging from  cents to  cents on the dollar—meaning that some
securities were worth as little as  of their initial value. On Thursday, April ,
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 per-
sonal 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 , , the two hedge funds had at-
tracted more than  million in new funds, but more than  million was re-
deemed by investors.
That same day, Goldman sent BSAM marks ranging from  cents to  cents on
the dollar. Cioffi disputed Goldman’s marks as well as marks from Lehman, Citigroup,
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

and JP Morgan. On May , in a preliminary estimate, Cioffi told investors that the
net asset value of the Enhanced Leverage Fund was down . in April. In computing
the final numbers later that month, he requested that BSAM’s Pricing Committee in-
stead use fair value marks based on his team’s modeling, which implied losses that were
 to  million less than losses using Goldman’s marks. On June , although Gold-
man’s marks were considered low, the Pricing Committee decided to continue to aver-
age dealer marks rather than to use fair value. The committee also noted that the
decline in net asset value would be greater than the . estimate, because “many of the
positions that were marked down received dealer marks after release of the estimate.”
The decline was revised from . to . 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 ac-
ademic anyway— [value] is doomsday.” On June , BSAM announced the 
drop and froze redemptions.

“Canary in the mine shaft”

When JP Morgan contacted Bear’s co-president Alan Schwartz in April about its up-
coming 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 -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 
refused 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  mil-
lion of its collateral posted by Bear for its outstanding repo loans. Merrill was able to
sell just  million of the seized collateral at auction by July —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 busi-
ness, Bear’s equity positions in the two BSAM hedge funds were relatively small. On
April , Bear’s co-president Warren Spector approved a  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 invest-
ment 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-
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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 . billion—and ulti-
mately loaned . billion—to take out the High-Grade Fund repo lenders and be-
come 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 fundamen-
tals 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 . Chairman Bernanke noted that the problems the hedge funds experienced
were a good example of how leverage can increase liquidity risk, especially in situa-
tions 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.
Some members were concerned about the lack of transparency around hedge
funds, the consequent lack of market discipline on valuations of hedge fund hold-
ings, and the fact that the Federal Reserve could not systematically collect informa-
tion from hedge funds because they were outside its jurisdiction. These facts caused
members to be concerned about whether they understood the scope of the problem.
During the same meeting, FOMC members noted that the size of the credit deriv-
atives market, its lack of transparency and activities related to subprime debt could
be a gathering cloud in the background of policy.
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 al-
most nothing: High-Grade Fund was down ; Enhanced Leverage Fund, .
On July , 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 . Civil charges brought by the SEC were still pending as of
the date of this report.
Looking back, Marano told the FCIC, “We caught a lot of flak for allowing the
funds to fail, but we had no option.” In an internal email in June, Bill Jamison of Fed-
erated Investors, one of the largest of all mutual fund companies, referred to the Bear
Stearns hedge funds as the “canary in the mine shaft” and predicted more market tur-
moil. As the two funds were collapsing, repo lending tightened across the board.
Many repo lenders sharpened their focus on the valuation of any collateral with po-
tential subprime exposure, and on the relative exposures of different financial institu-
tions. They required increased margins on loans to institutions that appeared to be
exposed to the mortgage market; they often required Treasury securities as collateral;
in many cases, they demanded shorter lending terms. Clearly, the triple-A-rated
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mortgage-backed securities and CDOs were not considered the “super-safe” invest-
ments in which investors—and some dealers—had only recently believed.
Cayne called Spector into the office and asked him to resign. On Sunday, August
, Spector submitted his resignation to the board.

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 , , they issued comprehensive rating down-
grades and credit watch warnings on an array of residential mortgage–backed securi-
ties. These announcements foreshadowed the actual losses to come.
S&P announced that it had placed  tranches backed by U.S. subprime collat-
eral, or some . 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 down-
graded  mortgage-backed securities issued in  backed by U.S. subprime col-
lateral and put an additional  tranches on watch. These Moody’s downgrades
affected about . billion in securities. The following day, Moody’s placed 
tranches of CDOs, with original face value of about  billion, on watch for possible
downgrade. Two days after its original announcement, S&P downgraded  of the
 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  of mortgage-backed securities issued in ), investors knew that more
downgrades might come. Many investors were critical of the rating agencies, lam-
basting them for their belated reactions. By July , by one measure, housing
prices had already fallen about  nationally from their peak at the spring of .
On a July  conference call with S&P, the hedge fund manager Steve Eisman ques-
tioned Tom Warrack, the managing director of S&P’s residential mortgage–backed se-
curities 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  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,
 E A R LY     : S P R E A D I N G S U B P R I M E W O R R I E S 

and each sale had the potential to further depress prices. If at all possible, the borrow-
ers sold other assets in more liquid markets, for which prices were readily available,
pushing prices downward in those markets, too.

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 sub-
sidiary had written  billion in over-the-counter credit default swap (CDS) protec-
tion on super-senior tranches of multisector CDOs backed mostly by subprime
mortgages.
In a phone call made July , 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 re-
quired that collateral be posted to the purchasers, should the market value of the ref-
erenced securities decline by a certain amount, or should rating agencies downgrade
AIG’s long-term 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 Mar-
tin 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 regula-
tors 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 , Goldman
Sachs, which held  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 Frost:

DAVILMAN: Sorry to bother you on vacation. Margin call coming your way. Want to
give you a heads up.
FROST,  minutes later: On what?
DAVILMAN, one minute later: bb [ billion] of supersenior.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

The next day, Goldman made the collateral call official by forwarding an invoice
requesting . billion. On the same day, Goldman purchased  million of five-
year protection—in the form of credit default swaps—against the possibility that AIG
might default on its obligations.
Frost never responded to Davilman’s email. And when he returned from vaca-
tion, 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 .
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 , 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 acknowl-
edged that dealers might say the marks “could be anything from  to sort of, you
know, ” 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  cents on the dollar, because values might drop
further. Additionally, AIG would be required to value its own portfolio of similar as-
sets 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 , you must be able to mark your bonds then.”
Tough, lengthy negotiations followed. Goldman “was not budging” on its collat-
eral demands, according to Tom Athan, a managing director at AIG Financial Prod-
ucts, describing a conference call with Goldman executives on August . “I played
almost every card I had, legal wording, market practice, intent of the language, mean-
ing 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  months, more such disputes would cost AIG tens of
billions of dollars and help lead to one of the biggest government bailouts in Ameri-
can history.
 E A R LY     : S P R E A D I N G S U B P R I M E W O R R I E S 

COMMISSION CONCLUSIONS ON CHAPTER 12

The Commission concludes that entities such as Bear Stearns’s hedge funds and
AIG Financial Products that had significant subprime exposure were affected by
the collapse of the housing bubble first, creating financial pressures on their par-
ent companies. The commercial paper and repo markets—two key components
of the shadow banking lending markets—quickly reflected the impact of the
housing bubble collapse because of the decline in collateral asset values and con-
cern about financial firms’ subprime exposure.
 13
SUMMER 2007:
DISRUPTIONS IN FUNDING

CONTENTS
IKB of Germany: “Real money investors” ..........................................................
Countrywide: “That’s our /” .........................................................................
BNP Paribas: “The ringing of the bell”...............................................................
SIVs: “An oasis of calm”......................................................................................
Money funds and other investors: “Drink[ing] from a fire hose.........................

In the summer of , 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 . Mean-
while, 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 asset-backed
commercial paper (ABCP), a crucial, usually boring backwater of the financial sector.
This kind of financing allowed companies to raise money by borrowing against
high-quality, short-term assets. By mid-, hundreds of billions out of the .
trillion U.S. ABCP market were backed by mortgage-related assets, including some
with subprime exposure.
As noted, the rating agencies had given all of these ABCP programs their top in-
vestment-grade ratings, often because of liquidity puts from commercial banks.
When the mortgage securities market dried up and money market mutual funds be-
came 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.

IKB OF GERMANY: “REAL MONEY INVESTORS”

The first big casualty of the run on asset-backed commercial paper was a German


 SUM M E R     : DI SRU P T ION S IN FUNDING 

bank, IKB Deutsche Industriebank AG. Since its foundation in , IKB had fo-
cused on lending to midsize German businesses, but in the past decade, management
diversified. In , 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  billion (. billion) of assets,  of which were CDOs and
CLOs (collateralized loan obligations—that is, securitized leveraged loans). And at
least  billion (. 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 , when so many were bailing out of the structured products
market, IKB was still planning to expand its off-balance-sheet holdings and was will-
ing 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 , when Goldman was looking for buyers for Abacus -AC, the
synthetic CDO mentioned in part III, 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 sub-
prime [residential mortgage–backed securities] wipeout scenario,” the Paulson em-
ployee wrote in an email. “In my opinion this situation is due to the fact that rating
agencies, CDO managers and underwriters have all the incentives to keep the game
going, while ‘real money’ investors have neither the analytical tools nor the institu-
tional framework to take action before the losses that one could anticipate based [on]
the ‘news’ available everywhere are actually realized.” IKB subsequently purchased
 million of the A and A tranches of the Abacus CDO and placed them in
Rhineland. It would lose  of that investment.
In mid-, Rhineland’s asset-backed commercial paper was held by a number
of American investors, including the Montana Board of Investments, the city of Oak-
land, California, and the Robbinsdale Area School District in suburban Minneapolis.
On July , 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 , 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 en-
couragement, IKB’s largest shareholder, KfW Bankengruppe, announced on July 
that it would bail out IKB. On August , Rhineland exercised its liquidity puts with
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 .
The IKB episode served notice that exposures to toxic mortgage assets were lurk-
ing 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 . billion on August , the asset-backed commercial paper
market would decline by almost  billion by the end of .

COUNTRYWIDE: “THAT’S OUR 9/11”

On August , three days after the IKB rescue, Countrywide CEO Angelo Mozilo re-
alized that his company was unable to roll its commercial paper or borrow on the
repo market. “When we talk about [August ] at Countrywide, that’s our /,” 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.”
On August , 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 A ratings and stable out-
look on the company.
The ratings agencies and the company itself would quickly reverse their positions.
On August , 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 mort-
gage[-]backed securities.” President and COO David Sambol told the board, “Man-
agement 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 al-
ternative 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
 SUM M E R     : DI SRU P T ION S IN FUNDING 

Committee members discussed the “considerable financial turbulence” in the sub-

prime 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 mar-
ket 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 con-
cern 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 dete-
rioration 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 , Countrywide released its July  operational
results, reporting that foreclosures and delinquencies were up and that loan produc-
tion had fallen by  during the preceding month. A company spokesman said lay-
offs 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
, 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, espe-
cially, on ABCP. In current market conditions, the viability of that strat-
egy 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.

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 deposi-
tors, or perhaps through discount-window lending, which would require the Fed to
accept risky mortgage-backed securities as collateral, something it never had done
and would not do—until the following spring. The Fed did not intervene: “Substan-
tial 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 cur-
rent circumstances seemed highly improbable.”
The following day, lacking any other funding, Mozilo recommended to his board
that the company notify lenders of its intention to draw down . billion on backup
lines of credit. Mozilo and his team knew that the decision could lead to ratings
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 cus-
tomers, ‘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 ass.”
On the same day that Countrywide’s board approved the . billion draw-
down—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 possi-
ble for [Countrywide] to go bankrupt.”
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 , closing at .; for
the year, the company’s stock was down . The bad news led to an old-fashioned
bank run. Mozilo singled out an August  Los Angeles Times article covering Bruce’s
report, which, he said, “caused a run on our bank of  billion on Monday.” The arti-
cle spurred customers to withdraw their funds by noting specific addresses of Coun-
trywide 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 , Bank of America announced it would invest  bil-
lion for a  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 Country-
wide’s position as one of the “strongest and best-run companies in the country.”
In October, Countrywide reported a net loss of . billion, its first quarterly loss
in  years. As charge-offs on its mortgage portfolio grew, Countrywide raised provi-
sions for loan losses to  million from only  million one year earlier. On
January , , Bank of America issued a press release announcing a “definitive
agreement” to purchase Countrywide for approximately  billion. It said the com-
bined entity would stop originating subprime loans and would expand programs to
help distressed borrowers.

BNP PARIBAS: “THE RINGING OF THE BELL”

Meanwhile, problems in U.S. financial markets hit the largest French bank. On Au-
gust , BNP Paribas SA suspended redemptions from three investment funds that
had plunged  in less than two weeks. Total assets in those funds were . 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 com-
plete evaporation of liquidity in certain market segments of the US securitization
 SUM M E R     : DI SRU P T ION S IN FUNDING 

Asset-Backed Commercial Paper Outstanding

At the onset of the crisis in summer 2007, asset-backed commercial paper
outstanding dropped as concerns about asset quality quickly spread. By the end of
2007, the amount outstanding had dropped nearly $400 billion.

IN BILLIONS OF DOLLARS
$1,250

1,000

750

500

250

0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

NOTE: Seasonally adjusted

SOURCE: Federal Reserve Board of Governors

Figure .

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  liquidity crisis. August  “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 , the interest rates for overnight lending of A- rated asset-
backed commercial paper rose from . to .—the highest level since January
. It would continue rising unevenly, hitting . in August , . Figure
. shows how, in response, lending declined.
In August alone, the asset-backed commercial paper market shrank by  bil-
lion, or . On August , 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 pro-
grams with similar provisions, which shrank that market from  billion to  bil-
lion between May and August.
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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

about  days in late July to about  days by mid-September, though the over-
whelming majority was issued for just  to  days.
Disruptions quickly spread to other parts of the money market. In a flight to qual-
ity, investors dumped their repo and commercial paper holdings and increased their
holdings in seemingly safer money market funds and Treasury bonds. Market partici-
pants, 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 , it rose sharply, increasing three-to fourfold over
historical values, and by September , it climbed by another . In , it would
peak much higher.
The panic in the repo, commercial paper, and interbank markets was met by imme-
diate government action. On August , the day after BNP Paribas suspended redemp-
tions, 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 , the Fed cut the dis-
count rate by  basis points—from . to .. This would be the first of many
such cuts aimed at increasing liquidity. The Fed also extended the term of discount-
window lending to  days (from the usual overnight or very short-term period) to of-
fer banks a more stable 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.”

SIV S : “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 lit-
tle subprime mortgage exposure. SIVs had a stable history since their introduction in
. These investments had weathered a number of credit crises—even through
early summer of , as noted in a Moody’s report issued on July , , titled
“SIVs: An Oasis of Calm in the Sub-prime Maelstrom.”
Unlike typical asset-backed commercial paper programs, SIVs were funded pri-
marily 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 sponsors.
The SIV sector tripled in assets between  and . On the eve of the crisis,
there were  SIVs with almost  billion in assets. About one-quarter of that
money was invested in mortgage-backed securities or in CDOs, but only  was in-
vested in subprime mortgage–backed securities and CDOs holding mortgage-backed
securities.
Not surprisingly, the first SIVs to fail were concentrated in subprime mortgage–
 SUM M E R     : DI SRU P T ION S IN FUNDING 

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). Be-
tween 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 sen-
sationalize 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 any-
thing approaching its true value,” Moody’s wrote on September .
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-qual-
ity 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  of their portfo-
lios, 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, re-
couped only some of their money. In the case of Rhinebridge, investors lost  and
only gradually received their payments over the next year. Investors in one SIV, Sigma,
lost more than . As of fall , 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.

MONEY FUNDS AND OTHER INVESTORS:

“DRINKING FROM A FIRE HOSE”
The next dominoes were the money market funds and other funds. Most were spon-
sored 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 reflect-
ing 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 . below  (to
.) 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  of a
fund’s portfolio is in an investment that loses just  of its value. So a fund manager
cannot afford big risks.
But SIVs were considered very safe investments—they always had been—and
were widely held by money market funds. In fall , 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  sponsors, including large banks such
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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  million
or more. Enhanced cash funds fall outside most SEC regulations and disclosure re-
quirements. 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  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  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  of its assets in
mortgage-backed securities. When the fund reportedly lost  million and closed
in November , investors redeemed their interests at .. Bank of America
supported its Strategic Cash Portfolio—the nation’s largest enhanced cash fund, with
 billion in assets at its peak—after one of that fund’s largest investors withdrew
 billion in November .
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 in-
vestors through Internet-based trading platforms called “portals,” which supplied an
estimated  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 re-
turn 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 van-
ish just as quickly. The Credit Suisse fund posted the highest returns in the industry
during the  months before the liquidity crisis, and increased its assets from about
 billion in the summer of  to more than  billion in the summer of . To
deliver those high returns and attract investors, though, it focused on structured fi-
nance products, including CDOs and SIVs such as Cheyne. When investors became
concerned about such assets, they yanked about  billion out of the fund in August
 alone. Credit Suisse, the Swiss bank that sponsored the fund, was forced to bail
it out, purchasing . 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 dol-
lars in these securities. Pooling provides municipalities, school districts, and other
government agencies with economies of scale, investment diversification, and liquid-
ity. In some cases, participation is mandatory.
With  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,
 SUM M E R     : DI SRU P T ION S IN FUNDING 

and bonds issued by other U.S. government agencies,” as an investigation by the state
legislature noted. But by November , because of ratings downgrades, the fund
held at least . billion in securities that no longer met the state’s requirements. It
had more than  billion in SIVs and other distressed securities, of which about 
million had already defaulted. And it held  million in Countrywide certificates
of deposit with maturities that stretched out as far as June . In early November,
following a series of news reports, the fund suffered a run. Local governments with-
drew  billion in just two weeks. Orange and Pinellas counties pulled out their en-
tire investments. On November , 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 holdings.

COMMISSION CONCLUSIONS ON CHAPTER 13

The Commission concludes that the shadow banking system was permitted to
grow to rival the commercial banking system with inadequate supervision and
regulation. That system was very fragile due to high leverage, short-term funding,
risky assets, inadequate liquidity, and the lack of a federal backstop. When the
mortgage market collapsed and financial firms began to abandon the commercial
paper and repo lending markets, some institutions depending on them for fund-
ing their operations failed or, later in the crisis, had to be rescued. These markets
and other interconnections created contagion, as the crisis spread even to mar-
kets and firms that had little or no direct exposure to the mortgage market.
In addition, regulation and supervision of traditional banking had been weak-
ened significantly, allowing commercial banks and thrifts to operate with fewer
constraints and to engage in a wider range of financial activities, including activi-
ties in the shadow banking system.
The financial sector, which grew enormously in the years leading up to the fi-
nancial crisis, wielded great political power to weaken institutional supervision
and market regulation of both the shadow banking system and the traditional
banking system. This deregulation made the financial system especially vulnera-
ble to the financial crisis and exacerbated its effects.
 14
LATE 2007 TO EARLY 2008:
BILLIONS IN SUBPRIME LOSSES

CONTENTS
Merrill Lynch: “Dawning awareness over the course of the summer”.................
Citigroup: “That would not in any way have excited my attention”...................
AIG’s dispute with Goldman: “There could never be losses”...............................
Federal Reserve: “The discount window wasn’t working”...................................
Monoline insurers: “We never expected losses”...................................................

While a handful of banks were bailing out their money market funds and commer-
cial paper programs in the fall of , 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 obliga-
tion (CDO) businesses, writing down a total of . billion and . billion, re-
spectively, by the end of the year. Billions more in losses were reported by large
financial institutions such as Bank of America (. billion), Morgan Stanley (.
billion), JP Morgan (. billion), and Bear Stearns (. billion). Insurance compa-
nies, hedge funds, and other financial institutions collectively had taken additional
mortgage-related losses of about  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  the cost of five-year
protection against default on their obligations in the credit default swap market stood
at, respectively, , and , annually for every  million, while the cost
for the relatively stronger Goldman Sachs stood at ,.
Meanwhile, the economy was beginning to show signs of stress. Facing turmoil in
financial markets, declining home prices, and oil prices above  a barrel, consumer
spending was slowing. The Federal Reserve lowered the overnight bank borrowing
rate from . earlier in the year to . in September, . in October, and then
. in December.


 L AT E    TO E A R LY     : B I L L I O N S IN SUBPRIME LOSSES 

MERRILL LYNCH: “DAWNING AWARENESS

OVER THE COURSE OF THE SUMMER”
On October , Merrill Lynch stunned investors when it announced that third-
quarter earnings would include a . billion loss on CDOs and  billion on sub-
prime mortgages—. billion in total, the largest Wall Street write-down to that
point, and nearly twice the . billion loss that the company had warned investors to
expect just three weeks earlier. Six days later, the embattled CEO Stanley O’Neal, a
-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 ex-
tremely safe. As late as fall , 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: . billion from Mortgage Lenders, . billion from Ownit.
Merrill, like many of its competitors, started to ramp up its sales efforts, packag-
ing 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 found that it could not sell the super-senior tranches of those CDOs at accept-
able 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  to
reduce the firm’s inventory of subprime and Alt-A mortgages. Sell the lower-rated
CDO tranches, retain the super-senior tranches: those had been his instructions to
his managers at the end of , 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 invol-
untary: his people were having trouble selling these investments, and some were even
sold at a loss.
Initially, the strategy seemed to work. By May, the amount of mortgage loans and
securities to be packaged into CDOs had declined to . billion from . billion
in March. According to a September  internal Merrill presentation, the net
amount in retained super-senior CDO tranches had increased from . billion in
September  to . billion by March  and . billion by May. But as the
mortgage market came under increasing pressure and as the market value of even su-
per-senior tranches crumbled, the strategy would come back to haunt the firm.
Merrill’s first-quarter earnings for —net revenues of . billion—were its
second-highest quarterly results ever, including a record for the Fixed Income, Cur-
rencies and Commodities business, which housed the retained CDO positions. These
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

results were announced during a conference call with analysts—an event that in-
vestors and analysts rely on to obtain important information about the company and
that, like other public statements, is subject to federal securities laws.
Merrill’s then-CFO Jeffrey Edwards indicated that the company’s results would
not be hurt by the dislocation in the subprime market, because “revenues from sub-
prime mortgage-related activities comprise[d] less than  of our net revenues” over
the past five quarters, and because Merrill’s “risk management capabilities are better
than ever, and crucial to our success in navigating turbulent markets.” Providing fur-
ther assurances, he stated, “We believe the issues in this narrow slice of the market re-
main contained and have not negatively impacted other sectors.”
However, Edwards did not disclose the large increase in retained super-senior
CDO tranches or the difficulty of selling those tranches, even at a loss—though spe-
cific questions on the subject were raised.
In July, Merrill followed its strong first-quarter report with another for the second
quarter that “enabled the company to achieve record net revenues, net earnings and
net earnings per diluted share for the first half of .” During the conference call
announcing the results, the analyst Glenn Schorr of UBS, a large Swiss bank, asked
the CFO to provide some “color around myth versus reality” on Merrill’s exposure to
retained CDO positions. As he had three months earlier, Edwards stressed Merrill’s
risk management and the fact that the CDO business was a small part of Merrill’s
overall business. He said that there had been significant reductions in Merrill’s re-
tained exposures to lower-rated segments of the market, although he did not disclose
that the total amount of Merrill’s retained CDOs had reached . billion by June.
Edwards declined to provide details about the company’s exposure to subprime
mortgage CDOs and any inventory of mortgage-backed securities to be packaged
into CDOs. “We don’t disclose our capital allocations against any specific or even
broader group,” Edwards said.
On July , after the super-senior tranches had been accumulating for many
months, Merrill executives first officially informed its board about the buildup. At a
presentation to the board’s Finance Committee, Dale Lattanzio, co-head of the Amer-
ican branch of the Fixed Income, Currencies and Commodities business, reported a
“net” exposure of  billion in CDO-related assets, essentially all of them rated triple-
A, with exposure to the lower-rated asset class significantly reduced. This net
exposure was the amount of CDO positions left after the subtraction of the hedges—
guarantees in one form or another—that Merrill had purchased to pass along its ulti-
mate risk to third parties willing to provide that protection and take that risk for a fee.
AIG and the small club of monoline insurers were significant suppliers of these guar-
antees, commonly done as credit default swaps. In July , Merrill had begun to
increase the amount of CDS protection to offset the retained CDO positions.
Lattanzio told the committee, “[Management] decided in the beginning of this
year to significantly reduce exposure to lower-rated assets in the sub-prime asset
class and instead migrate exposure to senior and super senior tranches.” Edwards
did not see any problems. As Kim insisted, “Everyone at the firm and most people in
the industry felt that super-senior was super safe.”
 L AT E    TO E A R LY     : B I L L I O N S IN SUBPRIME LOSSES 

Former CEO O’Neal told FCIC investigators he had not known that the com-
pany was retaining the super-senior tranches of the CDOs until Lattanzio’s presen-
tation to the Finance Committee. He was startled, if only because he had been under
the impression that Merrill’s mortgage-backed-assets business had been driven by
demand: he had assumed that if there were no new customers, there would be no
new offerings. If customers demanded the CDOs, why would Merrill have to retain
CDO tranches on the balance sheet? O’Neal said he was surprised about the re-
tained positions but stated that the presentation, analysis, and estimation of poten-
tial losses were not sufficient to sound “alarm bells.” Lattanzio’s report in July
indicated that the retained positions had experienced only  million in losses.
Over the next three months, the market value of the super-senior tranches plum-
meted and losses ballooned; O’Neal told the FCIC: “It was a dawning awareness
over the course of the summer and through September as the size of the losses were
being estimated.”
On October , Merrill executives gave its board a detailed account of how the
firm found itself with what was by that time . billion in net exposure to the su-
per-senior tranches—down from a peak in July of . billion because the firm had
increasingly hedged, written off, and sold its exposure. On October , Merrill an-
nounced its third-quarter earnings: a stunning . billion mortgage-related write-
down contributing to a net loss of . billion. Merrill also reported—for the first
time—its . billion net exposure to retained CDO positions. Still, in their confer-
ence 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 suffi-
cient.” According to the Securities and Exchange Commission, by September ,
Merrill had accumulated  billion of “gross” retained CDO positions, almost four
times the . billion of “net” CDO positions reported during the October  con-
ference call.
On October , when O’Neal resigned, he left with a severance package worth
. million—on top of the . million in total compensation he earned in
, 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 
after being paid  million for his work in , which was a profitable year for
Merrill as a firm.
By late , the viability of the monoline insurers from which Merrill had pur-
chased almost  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 Mer-
rill 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 . billion on January , . By the end of
, Merrill would put aside a total of  billion related to monolines and had
recorded total write-downs on nearly  billion of other mortgage-related exposures.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

CITIGROUP: “THAT WOULD NOT IN ANY WAY

HAVE EXCITED MY ATTENTION”
Five days after O’Neal’s October  departure from Merrill Lynch, Citigroup an-
nounced that its total subprime exposure was  billion, which was  billion more
than it had told investors just three weeks earlier. Citigroup also announced it would
be taking an  to  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-related CDO exposures. Prince and Robert Rubin, chairman
of the Executive Committee of the board, told the FCIC that before September ,
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
 trillion balance sheet,  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  trillion on the balance sheet of
assets. I want to point out to you there is a one in a billion chance that this  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 ,
a triple-A tranche of a CDO had a  in  chance of being downgraded within  years
of its original rating.
Certainly, Citigroup was a large and complex organization. That  trillion bal-
ance sheet—and . trillion off-balance sheet—was spread among more than ,
operating subsidiaries in . 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  billion in concentrated exposure—
 of the company’s balance sheet and more than a third of its capital—because it
was perceived to be “zero-risk paper.”
Significantly, Citigroup’s Financial Control Group had argued in  that the liq-
uidity puts that Citigroup had written on its CDOs had been priced for investors too
cheaply in light of the risks. Also, in early , Susan Mills, a managing director in
the securitization unit—which bought mortgages from other companies and bun-
dled 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-, her group saw a deterioration in loan quality and an increase in early pay-
ment defaults—that is, more borrowers were defaulting within a few months of get-
ting a loan. From  to , Mills recalled before the FCIC, the early payment
default rates nearly tripled from  to  or . In response, the securitization unit
slowed down its purchase of loans, demanded higher-quality mortgages, and con-
ducted 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 Citi-
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group, including the CDO desk. Around March or April , 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.
“Effective communication across businesses was lacking,” the company’s regula-
tors later observed. “Management acknowledged that, in looking back, it should have
made the mortgage deterioration known earlier throughout the firm. The Global
Consumer Group saw signs of sub-prime issues and avoided losses, as did mortgage
backed securities traders, but CDO structures business did so belatedly—[there was]
no dialogue across businesses.”
Co-head of the CDO desk Janice Warne told the FCIC that she first saw weaknesses
in the underlying market in early . In February, when the ABX.HE.BBB- - fell
to  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  below par in March and holding around that level
through May. So, the CDO desk reversed course and accelerated its purchases of inven-
tory 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  below par.
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 ad-
mitted “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  billion to  billion in the first half of . 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 be-
gan 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 se-
curities, and mortgage-related CDOs would total about  billion, nearly half of
Citigroup’s capital at the end of . About  billion of that loss related to protec-
tion 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. Bush-
nell—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 grow-
ing. He described a “firm-wide initiative” to increase Citigroup’s structured prod-
ucts business.
Perhaps what is most remarkable about the conflicting strategies employed by the
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

securitization and CDO desks is that their respective risk officers attended the same
weekly independent risk meetings. Duke reflected that she was not overly concerned
when the issue came up, saying she and her risk team were “seduced by structuring
and failed to look at the underlying collateral.” According to Barnes, the CDO desk
didn’t look at the CDOs’ underlying collateral because it lacked the “ability” to see
loan performance data, such as delinquencies and early payment defaults. Yet the
surveillance unit in Citigroup’s securitization desk might have been able to provide
some insights based on its own data. Barnes told the FCIC that Citigroup’s risk
management tended to be managed along business lines, noting that he was only two
offices away from his colleague who covered the securitization business and yet didn’t
understand the nuances of what was happening to the underlying loans. He regretted
not reaching out to the consumer bank to “get the pulse” of mortgage origination.

“That has never happened since the Depression”

Prince and Rubin appeared to believe up until the fall of  that any downside risk
in the CDO business was minuscule. “I don’t think anybody focused on the CDOs.
This was one business in a vast enterprise, and until the trouble developed, it wasn’t
one that had any particular profile,” Rubin—in Prince’s words, a “very important
member of [the] board”—told the FCIC. “You know, Tom Maheras was in charge of
trading. Tom was an extremely well regarded trading figure on the street. . . . And this
is what traders do, they handle these kinds of problems.” Maheras, the co-head of
Citigroup’s investment bank, told the FCIC that he spent “a small fraction of ” of
his time thinking about or dealing with the CDO business.
Citigroup’s risk management function was simply not very concerned about hous-
ing market risks. According to Prince, Bushnell and others told him, in effect, “‘Gosh,
housing prices would have to go down  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  when Citigroup began having problems because of write-downs and the
liquidity puts it had written.
By June , national house prices had fallen ., and about  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 , , Citigroup made a presenta-
tion to the SEC about subprime exposure in its CDO business. The presentation noted
that Citigroup did not factor two positions into this exposure: . billion in super-
senior tranches and . 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.”
Just a few weeks later, the July  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
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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 na-
tional bank subsidiary, had expressed no apprehensions about the liquidity puts in
. But by the summer of , OCC Examiner-in-Charge John Lyons told the
FCIC, the OCC became concerned. Buying the commercial paper would drain 
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 pur-
chased all  billion of the paper that had been subject to its liquidity puts.
On a July  conference call, CFO Gary Crittenden told analysts and investors
that the company’s subprime exposures had fallen from  billion at the end of 
to  billion on June . 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 re-
duce our exposure over the last six months,” he said. A week later, on a July  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. How-
ever, 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
exposures.”
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 mar-
kets, 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 point-
ing out “that the business was appropriately supervised by experienced and highly
competent managers and by an independent risk group and that I was properly ap-
prised 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 discus-
sion 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 wasn’t presented at the time in a startling fashion . . . [but]
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

then it got bigger and bigger and bigger, obviously, over the next  days.” In late
August, Citigroup’s valuation models suggested that losses on the super-senior
tranches might range from  million to  billion. This number was recalculated as
 to  million in mid-September, as the valuation methodology was refined.
In the weeks ahead, those numbers would skyrocket.

“DEFCON calls”
To get a handle on potential losses from the CDOs and liquidity puts, starting on
September  Prince convened a series of meetings—and later, nightly “DEFCON
calls”—with members of his senior management team; they included Rubin, Ma-
heras, Crittenden, and Bushnell, as well as Lou Kaden, the chief administrative offi-
cer. 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 dif-
ferent 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 answers.”
A second meeting was held September , 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 mort-
gage 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 mar-
ket deteriorated; he added that he became increasingly uneasy with Maheras’s assess-
ment. “Tom had said and said till his last day at work [October ]: ‘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 uncomfort-
able with this and more and more uncomfortable with Tom’s conclusions on ultimate
valuations, that is when I really began to have some very serious concerns about what
was going to happen.”
Despite Prince’s concerns, Citigroup remained publicly silent about the additional
subprime exposure from the super-senior positions and liquidity puts, even as it pre-
announced some details of its third-quarter earnings on October , .
On October , 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
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Committee meeting and brought up to the full board. A presentation concluded that
“total sub-prime exposure in [the investment bank] was bn with an additional
bn in Direct Super Senior and bn in Liquidity and Par Puts.” Citigroup’s total
subprime exposure was  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-senior- and liquidity-put-related exposure as he told par-
ticipants that Citigroup had under  billion in subprime exposure.
A week later, on Saturday, October , Prince learned from Crittenden that the
company would have to report subprime-related losses of  to  billion; on Mon-
day 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  million but it was go-
ing 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 resigning.”
On November , Citigroup revealed the accurate subprime exposure—now esti-
mated at  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: . million
in cash and  million in stock, bringing his total compensation to  million from
 to . The SEC later sued Citigroup for its delayed disclosures. To resolve
the charges, the bank paid  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 Man-
agement 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 Pan-
dit—were announced in December. Rubin would stay until January , having
been paid more than  million from  to  during his tenure at the com-
pany, including his role as chairman of the Executive Committee, a position that car-
ried “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
 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.”

AIG’S DISPUTE WITH GOLDMAN:

“THERE COULD NEVER BE LOSSES”
Beginning on July , , when Goldman’s Davilman sent the email that disrupted
the vacation of AIG’s Alan Frost, the dispute between Goldman and AIG over the need
for collateral to back credit default swaps captured the attention of the senior manage-
ment of both companies. For  months, Goldman pressed its case and sent AIG a for-
mal demand letter every single business day. It would pursue AIG relentlessly with
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

demands for collateral based on marks that were initially well below those of other
firms—while AIG and its management struggled to come to grips with the burgeoning
crisis.
The initial collateral call was a shock to AIG’s senior executives, most of whom
had not even known that the credit default swaps with Goldman contained collateral
call provisions.
They had known there were enormous exposures— billion, backed in large
part by subprime and Alt-A loans, in , compared with the parent company’s to-
tal reported capital of . billion—but executives said they had never been con-
cerned. “The mantra at [AIG Financial Products] had always been (in my
experience) that there could never be losses,” Vice President of Accounting Policy
Joseph St. Denis said.
Then came that first collateral call. St. Denis told FCIC staff that he was so
“stunned” when he got the news that he “had to sit down.” The collateral provisions
surprised even Gene Park, the executive who had insisted  months earlier that AIG
stop writing the swaps. He told the FCIC that “rule Number  at AIG FP” was to
never post collateral. This was particularly important in the credit default swap busi-
ness, he said, because it was the only unhedged business that AIG ran.
But Jake Sun, the general counsel of the Financial Products subsidiary, who re-
viewed the swap contracts before they were executed, told the FCIC that the provi-
sions were standard both at AIG and in the industry. Frost, who was the first to
learn of the collateral call, agreed and said that other financial institutions also com-
monly did deals with collateral posting provisions. Pierre Micottis, the Paris-based
head of the AIG Financial Products’ Enterprise Risk Management department, told
the FCIC that collateral provisions were indeed common in derivatives contracts—
but surprising in the super-senior CDS contracts, which were considered safe. In-
surance supervisors did not permit regulated insurance companies like MBIA and
Ambac to pay out except when the insured entity suffered an actual loss, and there-
fore those companies were forbidden to post collateral for a decline in market value
or unrealized losses. Because AIG Financial Products was not regulated as an insur-
ance company, it was not subject to this prohibition.
As disturbing as the senior AIG executives’ surprise at the collateral provisions
was their firm’s inability to assess the validity of Goldman’s numbers. AIG Financial
Products did not have its own model or otherwise try to value the CDO portfolio
that it guaranteed through credit default swaps, nor did it hedge its exposure. Gene
Park explained that hedging was seen as unnecessary in part because of the mistaken
belief that AIG would have to pay counterparties only if holders of the super-senior
tranches incurred actual losses. He also said that purchasing a hedge from UBS, the
Swiss bank, was considered, but that Andrew Forster, the head of credit trading at
AIG Financial Products, rejected the idea because it would cost more than the fees
that AIG Financial Products was receiving to write the CDS protection. “We’re not
going to pay a dime for this,” Forster told Park.
Therefore, AIG Financial Products relied on an actuarial model that did not pro-
vide a tool for monitoring the CDOs’ market value. The model was developed by
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Gary Gorton, then a finance professor at the University of Pennsylvania’s Wharton

School, who began working as a consultant to AIG Financial Products in  and
was close to its CEO, Joe Cassano. The Gorton model had determined with .
confidence that the owners of the super-senior tranches of the CDOs insured by AIG
Financial Products would never suffer real economic losses, even in an economy as
troubled as the worst post–World War II recession. The company’s auditors, Pricewa-
terhouseCoopers (PwC), who were apparently also not aware of the collateral re-
quirements, concluded that “the risk of default on [AIG’s] portfolio has been
effectively removed and as a result from a risk management perspective, there are no
substantive economic risks in the portfolio and as a result the fair value of the liability
stream on these positions from a risk management perspective could reasonably be
considered to be zero.”
In speaking with the FCIC, Cassano was adamant that the “CDS book” was effec-
tively hedged. He said that AIG could never suffer losses on the swaps, because the
CDS contracts were written only on the super-senior tranches of top-rated securities
with high “attachment points”—that is, many securities in the CDOs would have to
default in order for losses to reach the super-senior tranches—and because the bulk
of the exposure came from loans made before , when he thought underwriting
standards had begun to deteriorate. Indeed, according to Gene Park, Cassano put a
halt to a  million hedge, in which AIG had taken a short position in the ABX in-
dex. As Park explained, “Joe stopped that because after we put on the first  . . . the
market moved against us . . . we were losing money on the  million. . . . Joe said,
‘You know, I don’t think the world is going to blow up . . . I don’t want to spend that
money. Stop it.’”
Despite the limited market transparency in the summer of , Goldman used
what information there was, including information from ABX and other indices, to
estimate what it considered to be realistic prices. Goldman also spoke with other
companies to see what values they assigned to the securities. Finally, Goldman
looked to its own experience: in most cases, when the bank bought credit protection
on an investment, it turned around and sold credit protection on the same invest-
ment to other counterparties. These deals yielded more price information.
Until the dispute with Goldman, AIG relied on the Gorton model, which did not
estimate the market value of underlying securities. So Goldman’s marks caught AIG
by surprise. When AIG pushed back, Goldman almost immediately reduced its July
 collateral demand from . billion to . billion, a move that underscored the
difficulty of finding reliable market prices. The new demand was still too high, in
AIG’s view, which was corroborated by third-party marks. Goldman valued the
CDOs between  and  cents on the dollar, while Merrill Lynch, for example, val-
ued the same securities between  and  cents.
On August , Cassano told PwC that there was “little or no price transparency”
and that it was “difficult to determine whether [collateral calls] were indicative of true
market levels moving.” AIG managers did call other dealers holding similar bonds
to check their marks in order to help its case with Goldman, but those marks were
not “actionable”—that is, the dealers would not actually execute transactions at the
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quoted prices. “The above estimated values . . . do not represent actual bids or offers
by Merrill Lynch” was the disclaimer in a listing of estimated market values provided
by Merrill to AIG. Goldman Sachs disputed the reliability of such estimates.

“Without being flippant”

On August , for the first time, AIG executives publicly disclosed the  billion in
credit default swaps on the super-senior tranches of CDOs during the company’s sec-
ond-quarter earnings call. They acknowledged that the great majority of the underly-
ing bonds thus insured— billion—were backed by subprime mortgages. Of this
amount,  billion was written on CDOs predominantly backed by risky BBB-rated
collateral. On the call, Cassano maintained that the exposures were no problem: “It is
hard for us, without being flippant, to even see a scenario within any kind of realm or
reason that would see us losing  in any of those transactions.” He concluded: “We
see no issues at all emerging. We see no dollar of loss associated with any of [the
CDO] business. Any reasonable scenario that anyone can draw, and when I say rea-
sonable, I mean a severe recession scenario that you can draw out for the life of the
securities.” Senior Vice President and Chief Risk Officer Robert Lewis seconded that
reassurance: “We believe that it would take declines in housing values to reach de-
pression proportions, along with default frequencies never experienced, before our
AAA and AA investments would be impaired.”
These assurances focused on the risk that actual mortgage defaults would create
real economic losses on the company’s credit default swap positions. But more im-
portant at the time were the other tremendous risks that AIG executives had already
discussed internally. No one on the conference call mentioned Goldman’s demand
for . billion in collateral; the clear possibility that future, much-larger collateral
calls could jeopardize AIG’s liquidity; or the risk that AIG would be forced to take an
“enormous mark” on its existing book, the concern Forster had noted.
The day after the conference call, AIG posted  million in cash to Goldman,
its first collateral posting since Goldman had requested the . billion. As Frost
wrote to Forster in an August , , email, the idea was “to get everyone to chill
out.” For one thing, some AIG executives, including Cassano, had late-summer va-
cations planned. Cassano signed off on the  million “good faith deposit” before
leaving for a cycling trip through Germany and Austria. The parties executed a side
letter making clear that both disputed the amount. For the time being, two compa-
nies that had been doing business together for decades agreed to disagree.
On August , Frost went to Goldman’s offices to “start the dialog,” which had
stalled while Cassano and other key executives were on vacation. Two days later, Frost
wrote to Forster: “Trust me. This is not the last margin call we are going to debate.”
He was right. By September , Société Générale—known more commonly as Soc-
Gen—had demanded  million in collateral on CDS it had purchased from AIG Fi-
nancial Products, UBS had demanded  million, and Goldman had upped its
demand by  million. The SocGen demand was based on an . bid price pro-
vided by Goldman, which AIG disputed. Tom Athan, managing director at AIG Fi-
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nancial Products, told Forster that SocGen “received marks from GS on positions that
would result in big collateral calls but SG disputed them with GS.” Several weeks
later, Cassano told AIG Financial Services CFO Elias Habayeb that he believed the
SocGen margin call had been “spurred by Goldman,” and that AIG “disputed the call
and [had] not heard from SocGen again on that specific call.” In the second week of
October, the rating agencies announced hundreds of additional downgrades affecting
tens of billions of dollars of subprime mortgage–backed securities and CDOs. By
November , Goldman’s demand had almost doubled, to . billion. On November ,
Bensinger, the CFO, informed AIG’s Audit Committee that Financial Products had re-
ceived margin calls from five counterparties and was disputing every single one.
This stance was rooted in the company’s continuing belief that Goldman had set
values too low. AIG’s position was corroborated, at least in part, by the wide disparity
in marks from other counterparties. At one point, Merrill Lynch and Goldman made
collateral demands on the very same CDS positions, but Goldman’s marks were al-
most  lower than Merrill’s. Goldman insisted that its marks represented the
“constantly evolving additional information from our market making activities, in-
cluding trades that we had executed, market activity we observed, price changes in
comparable securities and derivatives and the current prices of relevant liquid . . . in-
dices.” Trading in the ABX would fall from over  trades per week through the
end of September  to less than  per week in the fourth quarter of ; trad-
ing in the TABX, which focuses on lower-rated tranches, dropped from roughly 
trades per week through mid-July to almost zero by mid-August.
But Cassano believed that the quick reduction in Goldman’s first collateral de-
mand (from . billion on July  to . billion on August ) and the interim
agreement on the  million deposit confirmed that Goldman was not as certain of
its marks as it later insisted. According to Cassano, Michael Sherwood, co-CEO of
Goldman Sachs International, told him that Goldman “didn’t cover ourselves in glory
during this period” but that “the market’s starting to come our [Goldman’s] way”;
Cassano took those comments as an implicit admission that Goldman’s initial marks
had been aggressive.

“More love notes”

In mid-August, Forster told Frost in an email that Goldman was pursuing a strategy
of aggressively marking down assets to “cause maximum pain to their competi-
tors.” PricewaterhouseCoopers, which served as auditor for both AIG and Gold-
man during this period, knew full well that AIG had never before marked these
positions to market. In the third quarter of , with the collateral demands piling
up, PwC prompted AIG to begin developing a model of its own. Prior to the Gold-
man margin call, PwC had concluded that “compensating controls” made up for
AIG’s not having a model. Among those was notice from counterparties that collat-
eral was due. In other words, one of AIG’s risk management tools was to learn of its
own problems from counterparties who did have the ability to mark their own posi-
tions to market prices and then demand collateral from AIG.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

The decision to develop a valuation model was not unanimous. In mid-Septem-

ber, Cassano and Forster met with Habayeb and others to discuss marking the posi-
tions down and actually recording valuation losses in AIG’s financial statements.
Cassano still thought the valuation process unnecessary because the possibility of de-
faults was “remote.” He sent Forster and others emails describing requests from
Habayeb as “more love notes . . . [asking us to go through] the same drill of drafting
answers.” Nevertheless, by October, and in consultation with PwC, AIG started to
evaluate the pricing model for subprime instruments developed and used by
Moody’s. Cassano considered the Moody’s model only a “gut check” until it was fully
validated internally. AIG coupled this model with generic CDO tranche data sold
by JP Morgan that were considered to be relatively representative of the market. Of
course, by this time—and for several preceding months—there was no active market
for many of these tranches. Everyone understood that this was not a perfect solution,
but AIG and its auditors thought it could serve as an interim step. The makeshift
model was up and running in the third quarter.

“Confident in our marks”

On November , when AIG reported its third-quarter earnings, it disclosed that it
was taking a  million charge “related to its super senior credit default swap port-
folio” and “a further unrealized market valuation loss through October  of ap-
proximately  million before tax [on that] portfolio.” On a conference call, CEO
Sullivan assured investors that the insurance company had “active and strong risk
management.” He said, “AIG continues to believe that it is highly unlikely that AIGFP
will be required to make payments with respect to these derivatives.” Cassano added
that AIG had “more than enough resources to meet any of the collateral calls that
might come in.” While the company remained adamant that there would be no re-
alized economic losses from the credit default swaps, it used the newly adopted—and
adapted—Moody’s model to estimate the  million charge. In fact, PwC had ques-
tioned the relevance of the model: it hadn’t been validated in advance of the earnings
release, it didn’t take into account important structural information about the swap
contracts, and there were questions about the quality of the data. AIG didn’t men-
tion those caveats on the call.
Two weeks later, on November , Goldman demanded an additional  billion in
cash. AIG protested, but paid . billion, bringing the total posted to  billion.
Four days later, Cassano circulated a memo from Forster listing the pertinent marks
for the securities from Goldman Sachs, Merrill Lynch, Calyon, Bank of Montreal,
and SocGen. The marks varied widely, from as little as  of the bonds’ original
value to virtually full value. Goldman’s estimated values were much lower than those
of other dealers. For example, Goldman valued one CDO, the Dunhill CDO, at 
of par, whereas Merrill valued it at  of par; the Orient Point CDO was valued at
 of par by Goldman but at  of par by Merrill. Forster suggested that the marks
validated AIG’s long-standing contention that “there is no one dealer with more
knowledge than the others or with a better deal flow of trades and all admit to
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‘guesstimating’ pricing.” Cassano agreed. “No one seems to know how to discern a
market valuation price from the current opaque market environment,” Cassano
wrote to a colleague. “This information is limited due to the lack of participants [will-
ing] to even give indications on these obligations.”
One week later, Cassano called Sherwood in Goldman’s London office and de-
manded reimbursement of . billion. He told both AIG and Goldman executives
that independent third-party pricing for  of the , securities underlying the
CDOs on which AIG FP had written CDS and AIG’s own valuation for the other 
indicated that Goldman’s demand was unsupported—therefore Goldman should re-
turn the money. Goldman refused, and instead demanded more.
By late November, there was relative agreement within AIG and with its auditor
that the Moody’s model incorporated into AIG’s valuation system was inadequate for
valuing the super-senior book. But there was no consensus on how that book
should be valued. Inputting generic CDO collateral data into the Moody’s model
would result in a . billion valuation loss; using Goldman’s marks would result in a
 billion valuation loss, which would wipe out the quarter’s profits. On November
, PwC auditors met with senior executives from AIG and the Financial Products
subsidiary to discuss the whole situation. According to PwC meeting notes, AIG re-
ported that disagreements with Goldman continued, and AIG did not have data to
dispute Goldman’s marks. Forster recalled that Sullivan said that he was going to have
a heart attack when he learned that using Goldman’s marks would eliminate the
quarter’s profits. Sullivan told FCIC staff that he did not remember this part of the
meeting.
AIG adjusted the number, and in doing so it chose not to rely on dealer quotes.
James Bridgewater, the Financial Products executive vice president in charge of mod-
els, came up with a solution. Convinced that there was a calculable difference be-
tween the value of the underlying bonds and the value of the swap protection AIG
had written on those bonds, Bridgewater suggested using a “negative basis adjust-
ment,” which would reduce the unrealized loss estimate from . billion (Goldman’s
figure) to about . billion. With their auditor’s knowledge, Cassano and others
agreed that the negative basis adjustment was the way to go.
Several documents given to the FCIC by PwC, AIG, and Cassano reflect discus-
sions during and after the November  meeting. During a second meeting at which
only the auditor and parent company executives were present (Financial Products ex-
ecutives, including Cassano and Forster, did not attend), PwC expressed significant
concerns about risk management, specifically related to the valuation of the credit
default swap portfolio, as well as to the company’s procedures in posting collateral.
AIG Financial Products had paid out  billion without active involvement from the
parent company’s Enterprise Risk Management group. Another issue was “the way in
which AIGFP [had] been ‘managing’ the SS [super senior] valuation process—saying
PwC will not get any more information until after the investor day presentation.”
The auditors laid out their concerns about conflicting strategies pursued by AIG
subsidiaries. Notably, the securities-lending subsidiary had been purchasing mort-
gage-backed securities, using cash raised by lending securities that AIG held on
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

behalf of its insurance subsidiaries. From the end of  through September ,
its holdings rose from  billion to  billion. Meanwhile, Financial Products, act-
ing on its own analysis, had decided in  to begin pulling back on writing credit
default swaps on CDOs. In PwC’s view, in allowing one subsidiary to increase expo-
sure to subprime while another subsidiary worked to exit the market entirely, the
parent company’s risk management failed. PwC also said that the company’s second
quarter of  financial disclosures would have been changed if the exposure of the
securities-lending business had been known. The auditors concluded that “these
items together raised control concerns around risk management which could be a
material weakness.” Kevin McGinn, AIG’s chief credit officer, shared these con-
cerns about the conflicting strategies. In a November , , email, McGinn wrote:
“All units were apprised regularly of our concerns about the housing market. Some
listened and responded; others simply chose not to listen and then, to add insult to
injury, not to spot the manifest signs.” He concluded that this was akin to “Nero play-
ing the fiddle while Rome burns.” On the opposite side, Sullivan insisted to the
FCIC that the conflicting strategies in the securities-lending business and at AIG Fi-
nancial Products simply revealed that the two subsidiaries adopted different business
models, and did not constitute a risk management failure.
On December , six days after receiving PwC’s warnings, Sullivan boasted on an-
other conference call about AIG’s risk management systems and the company’s over-
sight of the subprime exposure: “The risk we have taken in the U.S. residential
housing sector is supported by sound analysis and a risk management structure. . . .
we believe the probability that it will sustain an economic loss is close to zero. . . . We
are confident in our marks and the reasonableness of our valuation methods.” Charlie
Gates, an analyst at Credit Suisse, a Swiss bank, asked directly about valuation and
collateral disputes with counterparties to which AIG had alluded in its third-quarter
financial results. Cassano replied, “We have from time to time gotten collateral calls
from people and then we say to them, well we don’t agree with your numbers. And
they go, oh, and they go away. And you say well what was that? It’s like a drive-by in a
way. And the other times they sat down with us, and none of this is hostile or any-
thing, it’s all very cordial, and we sit down and we try and find the middle ground and
compare where we are.”
Cassano did not reveal the  billion collateral posted to Goldman, the several
hundred million dollars posted to other counterparties, and the daily demands from
Goldman and the others for additional cash. The analysts and investors on the call
were not informed about the “negative basis adjustment” used to derive the an-
nounced . billion maximum potential exposure. Investors therefore did not know
that AIG’s earnings were overstated by . billion—and they would not learn that
information until February , .

“Material weakness”
By January , AIG still did not have a reliable way to determine the market price
of the securities on which it had written credit protection. Nevertheless, on January
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, Cassano sent an email to Michael Sherwood and CFO David Viniar at Goldman
demanding that they return . billion of the  billion posted. He attached a
spreadsheet showing that AIG valued many securities at par, as if there had been no
decline in their value. That was simply not credible, Goldman executives told the
FCIC. Meanwhile, Goldman had by then built up . billion in protection by
purchasing credit default swaps on AIG to cover the difference between the amount
of collateral they had demanded and the amount that AIG had paid.
On February , , PwC auditors met with Robert Willumstad, the chairman of
AIG’s board of directors. They informed him that the “negative basis adjustment”
used to reach the . billion estimate disclosed on the December  investor call had
been improper and unsupported, and was a sign that “controls over the AIG Finan-
cial Products super senior credit default swap portfolio valuation process and over-
sight thereof were not effective.” PwC concluded that “this deficiency was a material
weakness as of December , .” In other words, PwC would have to announce
that the numbers AIG had already publicly reported were wrong. Why the auditors
waited so long to make this pronouncement is unclear, particularly given that PwC
had known about the adjustment in November.
In the meeting with Willumstad, the auditors were broadly critical of Sullivan;
Bensinger, whom they deemed unable to compensate for Sullivan’s weaknesses; and
Lewis, who might not have “the skill sets” to run an enterprise-wide risk manage-
ment department. The auditors concluded that “a lack of leadership, unwillingness to
make difficult decisions regarding [Financial Products] in the past and inexperience
in dealing with these complex matters” had contributed to the problems. Despite
PwC’s findings, Sullivan received  million over four years in compensation from
AIG, including a severance package of  million. When asked about these figures
at a FCIC hearing, he said, “I have no knowledge or recollection of those numbers
whatsoever, sir. . . . I certainly don’t recall earning that amount of money, sir.”
The following day, PwC met with the entire AIG Audit Committee and repeated
the analysis presented to Willumstad. The auditors said they could complete AIG’s
audit, but only if Cassano “did not interfere in the process.” Retaining Cassano was a
“management judgment, but the culture needed to change at FP.” On February ,
AIG disclosed in an SEC filing that its auditor had identified the material weakness,
acknowledging that it had reduced its December valuation loss estimates by . bil-
lion—that is, the difference between the estimates of . billion and . billion—
because of the unsupportable negative basis adjustment.
The rating agencies responded immediately. Moody’s and S&P announced down-
grades, and Fitch placed AIG on “Ratings Watch Negative,” suggesting that a future
downgrade was possible. AIG’s stock declined  for the day, closing at ..
At the end of February, Goldman held  billion in cash collateral, was demand-
ing an additional . billion, and had upped to . billion its CDS protection
against an AIG failure. On February , AIG disappointed Wall Street again—this
time with dismal fourth-quarter and fiscal year  earnings. The company re-
ported a net loss of . billion, largely due to . billion in valuation losses re-
lated to the super-senior CDO credit default swap exposure and more than .
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

billion in losses relating to the securities-lending business’s mortgage-backed pur-

chases. Along with the losses, Sullivan announced Cassano’s retirement, but the news
wasn’t all bad for the former Financial Products chief: He made more than  mil-
lion from the time he joined AIG Financial Products in January of  until his re-
tirement in , including a  million-a-month consulting agreement after his
retirement.
In March, the Office of Thrift Supervision, the federal regulator in charge of regu-
lating AIG and its subsidiaries, downgraded the company’s composite rating from a
, signifying that AIG was “fundamentally sound,” to a , indicating moderate to se-
vere supervisory concern. The OTS still judged the threat to overall viability as re-
mote. It did not schedule a follow-up review of the company’s financial condition
for another six months.
By then, it would be too late.

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  for the year. Between
July and November, asset-backed commercial paper declined about , 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 fi-
nancial markets. The Fed’s discount window hadn’t attracted much bank borrowing
because of the stigma attached 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 , the Federal Home Loan Banks—which are govern-
ment-sponsored entities that lend to banks and thrifts, accepting mortgages as collat-
eral—boosted their lending by  billion to  billion (a  increase) when the
securitization market froze. Between the end of March and the end of December
, Washington Mutual, the largest thrift, increased its borrowing from the Federal
Home Loan Banks from  billion to  billion; Countrywide increased its bor-
rowing from  billion to  billion; Bank of America increased its borrowing
from  billion to  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 diffi-
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cult 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  to about . Over that time, the percentage of loan
officers reporting tightening standards on loans to large and midsize companies in-
creased from  to , its highest level since . “The Federal Reserve pursued
a whole slew of nonconventional policies . . . very creative measures when the dis-
count window wasn’t working as hoped,” Frederic Mishkin, a Fed governor from
 to , told the FCIC. “These actions were very aggressive, [and] they were ex-
tremely controversial.” The first of these measures, announced on December ,
was the creation of the Term Auction Facility (TAF). The idea was to reduce the dis-
count window stigma by making the money available to all banks at once through a
regular auction. The program had some success, with banks borrowing  billion by
the end of the year. Over time, the Fed would continue to tweak the TAF auctions, of-
fering 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 there-
fore under pressure to sell dollar-denominated assets such as mortgage-backed secu-
rities. 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 an-
nounced (also on December ) 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 liquid-
ity to European banks,” Dudley said. Central banks had used similar arrangements
in the aftermath of the / attacks to bolster the global financial markets. In late
, the swap lines totaled  billion. During the financial crisis seven years later,
they would reach  billion.
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. “His-
torically, 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 in-
stitutions in the nonbank 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 provid-
ing SIV conduits either explicitly or implicitly.”
Burdened with capital losses and desperate to cover their own funding commit-
ments, the banks were not stable enough to fill the void, even after the Fed lowered
interest rates and began the TAF auctions. In January , the Fed cut rates again—
and then again, twice within two weeks, a highly unusual move that brought the fed-
eral funds rate from . to ..
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

The Fed also started plans for a new program that would use its emergency au-
thority, the Term Securities Lending Facility, though it wasn’t launched until March.
“The TLSF 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 pres-
sures 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 , the Fed increased the total available in each of the biweekly TAF auc-
tions from  billion to  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  billion in such loans
outstanding at any given time.
Also at this time, the U.S. central bank began contemplating a step that was revo-
lutionary: a program that would allow investment banks—institutions over which
the Fed had no supervisory or regulatory responsibility—to borrow from the dis-
count window on terms similar to those available to commercial banks.

MONOLINE INSURERS: “WE NEVER EXPECTED LOSSES”

Meanwhile, the rating agencies continued to downgrade mortgage-backed securities
and CDOs through . By January , as a result of the stress in the mortgage
market, S&P had downgraded , tranches of residential mortgage–backed securi-
ties and , tranches from  CDOs. MBIA and Ambac, the two largest monoline
insurers, had taken on a combined  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  that Ambac would need up to 
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 guaranteed.
Like many of the monolines, ACA, the smallest of them, kept razor-thin capital—
less than  million—against its obligations that included  billion in credit de-
fault swaps on CDOs. In late , ACA reported a net loss of . billion, almost
entirely due to credit default swaps.
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 agen-
cies, investors, and monoline creditors—had traditionally assumed that the mono-
lines 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 volatil-
ity 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
 L AT E    TO E A R LY     : B I L L I O N S IN SUBPRIME LOSSES 

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 De-
cember , 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  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 stel-
lar ratings, they would have to raise capital. MBIA and Ambac ultimately did raise
. billion and . billion, respectively. Nonetheless, S&P downgraded both to
AA in June . 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 protec-
tion 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 , , state and local governments had issued
 billion in ARS, accounting for half of the  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 se-
curities 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 in-
vestors, the dealers running these auctions, including firms like UBS, Citigroup, and
Merrill Lynch, would step in and pick up the shortfall. Because of these interven-
tions, there were only  failures between  and early  in more than ,
auctions. Dealers highlighted those minuscule failure rates to convince clients that
ARS were very liquid, short-term instruments, even in times of stress.
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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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  affected the ARS market.
Fearing that the monolines would not be able to perform on their guarantees, in-
vestors 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 , in one of
the starkest market dislocations of the financial crisis,  of the ARS auctions failed;
the following week,  failed.
Hundreds of billions of dollars were trapped by ARS instruments as investors
were obligated to retain their investments. And retail investors—individuals invest-
ing less than  million, small businesses, and charities—constituted more than
 billion of this  billion market. Moreover, investors who chose to re-
main in the market demanded a premium to take on the risk. Between investor de-
mands and interest rate resets, countless governments, infrastructure projects, and
nonprofits on tight budgets were slammed with interest rates of  or higher.
Problems in the ARS market cost Georgetown University, a borrower,  million.
New York State was stuck with interest rates that soared from about . to more
than  on  billion of its debt. The Port Authority of New York and New Jersey
saw the interest rate on its debt jump from . to  in a single week in Febru-
ary.
In  alone, the SEC received more than , 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
, the SEC had settled with financial institutions including Bank of America, RBC
Capital Markets, and Deutsche Bank to resolve charges that the firms misled in-
vestors. As a result, these and other banks made more than  billion available to
pay off tens of thousands of ARS investors.
 L AT E    TO E A R LY     : B I L L I O N S IN SUBPRIME LOSSES 

COMMISSION CONCLUSIONS ON CHAPTER 14

The Commission concludes that some large investment banks, bank holding
companies, and insurance companies, including Merrill Lynch, Citigroup, and
AIG, experienced massive losses related to the subprime mortgage market be-
cause of significant failures of corporate governance, including risk management.
Executive and employee compensation systems at these institutions dispropor-
tionally rewarded short-term risk taking.
The regulators—the Securities and Exchange Commission for the large invest-
ment banks and the banking supervisors for the bank holding companies and
AIG—failed to adequately supervise their safety and soundness, allowing them to
take inordinate risk in activities such as nonprime mortgage securitization and
over-the-counter (OTC) derivatives dealing and to hold inadequate capital and
liquidity.
 15
MARCH 2008:
THE FALL OF BEAR STEARNS

CONTENTS
“I requested some forbearance” ..........................................................................
“We were suitably skeptical”...............................................................................
“Turn into a death spiral” ..................................................................................
“Duty to protect their investors” .........................................................................
“The government would not permit a higher number” ......................................
“It was heading to a black hole”..........................................................................

After its hedge funds failed in July , Bear Stearns faced more challenges in the
second half of the year. Taking out the repo lenders to the High-Grade Fund brought
nearly . billion in subprime assets onto Bear’s books, contributing to a . 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 , a run by these lenders,
hedge fund customers, and derivatives counterparties led to Bear’s having to be taken
over in a government-backed rescue.
Mortgage securitization was the biggest piece of Bear Stearns’s most-profitable di-
vision, its fixed-income business, which generated  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 coun-
try, with a  market share in , trailing Morgan Stanley’s . 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  to . In , it underwrote  billion in collateral-
ized debt obligations of all kinds, more than double its  figure of . billion.


 M A R C H     : T H E FA L L OF BEAR STEARNS 

The total included . billion in CDOs that included mortgage-backed securities,
putting it in the top  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 begin-
ning to falter, as did other firms such as Citigroup and Merrill. As early as May ,
Bear had lost  million relating to defaults on mortgages which occurred within 
days of origination, which had been rare in the decade. But Bear persisted, assuming
the setback would be temporary. In February , Bear even acquired Encore
Credit, its third captive mortgage originator in the United States, doubling its capac-
ity. 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 Commis-
sion 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 deteriora-
tion in collateral performance than anticipated in ex ante models of stress events.”

“I REQUESTED SOME FORBEARANCE”

Vacationing on Nantucket Island when the two Bear-sponsored hedge funds declared
bankruptcy on July , , 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  and  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 ra-
tios, available at the end of each quarter. By November , Bear’s leverage ratio had
reached nearly  to . By the end of , Bear’s Level  assets—illiquid assets diffi-
cult to value and to sell—were  of its tangible common equity; thus, writing
down these illiquid assets by  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 re-
flected this, to some degree: for example, its  annual report said the balance
sheet was approximately  lower than the average month-end balance over the
previous twelve months.
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 —
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

including April  and June —S&P had confirmed Bear’s strong ratings, noting in
April that “Bear’s risk profile is relatively conservative” and “strong senior manage-
ment oversight and a strong culture throughout the firm are the foundation of Bear’s
risk management process.” On June , Moody’s had also confirmed its A rating,
and Fitch had confirmed its “stable” outlook.
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 un-
secured 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 mort-
gage assets and eventually not even against Treasuries.
“I requested some forbearance” from S&P, Upton told the FCIC. He did not get
it. On August , just three days after the two Bear Stearns hedge funds declared bank-
ruptcy, S&P highlighted the funds, Bear’s mortgage-related investments, and its rela-
tively small capital base as it placed Bear on a “negative outlook.”
Asked how he felt about the rating agency’s actions, Jimmy Cayne, Bear’s CEO un-
til , said, “A negative outlook can touch a number of parts of your businesses. . . .
It was like having a beautiful child and they have a disease of some sort that you
never expect to happen and it did. How did I feel? Lousy.”
To reassure investors that no more shoes would drop, Bear invited them on a con-
ference call that same day. The call did not go well. By the end of the day, Bear’s stock
slid , to .,  below its all-time high of ., reached earlier in .

“WE WERE SUITABLY SKEPTICAL”

On Sunday, August , two days after the conference call, Bear had another opportu-
nity 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, respec-
tively, associate director and assistant director of the division of market regulation.
The regulators reviewed Bear’s exposures to the mortgage market, including the 
billion in adjustable-rate mortgages on the firm’s books that were waiting to be secu-
ritized. 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 execu-
tives were being disingenuous. He thought they were just emphasizing the upside.
Alan Schwartz, the co-president who later succeeded Jimmy Cayne as CEO, and
Thomas Marano, head of Global Mortgages and Asset Backed Securities, seemed un-
concerned. But other executives were leery. Wendy de Monchaux, the head of propri-
etary 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  billion in the third quarter of  to . billion in
the fourth quarter, but it was too little too late.
 M A R C H     : T H E FA L L OF BEAR STEARNS 

That summer, the SEC felt Bear’s liquidity was adequate for the immediate future,
but supervisors “were suitably skeptical,” Eichner insisted. After the August  meet-
ing, 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  billion balance sheet,
with specifics on repo and commercial paper. On September , Bear Stearns raised
approximately . billion in unsecured -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’ mort-
gage securities concentration,” despite “aware[ness] that risk management of mort-
gages 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 per-
sonnel 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 de-
crease leverage and sell mortgage-backed securities, as other financial institutions
were doing. Halloran said that as early as the first quarter of , 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 compa-
nies but to protect their customers’ assets.

“TURN INTO A DEATH SPIRAL”

In August, after the rating agencies revised their outlook on Bear, Cayne tried to ob-
tain 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 help-
ing. “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 partici-
pate 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 Octo-
ber  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 , Bear Stearns reduced its unse-
cured commercial paper (from . billion at the end of  to only . billion at
the end of ) and replaced it with secured repo borrowing (which rose from 
billion to  billion). But Bear Stearns’s growing dependence on overnight repo
would create a different set of problems.
The tri-party repo market used two clearing banks, JP Morgan and BNY Mellon.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

During every business day, these clearing banks return cash to lenders; take posses-
sion 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 transac-
tion; 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  billion in average
daily volume in  to . trillion in , . trillion in , and . trillion by
early . It had become a very deep and liquid market. Even though most bor-
rowers 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  was that
JP Morgan and BNY Mellon could face large losses if a counterparty such as Bear de-
faulted 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 -year mortgage, you’ve got a one-week mortgage. If every-
thing’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 mort-
gage. 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.
Often, backing Bear’s borrowing were mortgage-related securities and of these,
. billion—more than Bear’s equity—were Level  assets.
In the fourth quarter of , Bear Stearns reported its first quarterly loss, 
million. Still, the SEC saw “no evidence of any deterioration in the firm’s liquidity po-
sition following the release and related negative press coverage.” The SEC concluded,
“Bear Stearns’ liquidity pool remains stable.”
In the fall of , Bear’s board had commissioned the consultant Oliver Wyman
to review the firm’s risk management. The report, “Risk Governance Diagnostic: Rec-
ommendations and Case for Economic Capital Development,” was presented on Feb-
ruary , , 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
office decisions,” and risk management was “understaffed” and considered a “low pri-
ority.” Schwartz told the FCIC the findings did not indicate substantial deficiencies.
He wasn’t looking for positive feedback from the consultants, because the Wyman re-
 M A R C H     : T H E FA L L OF BEAR STEARNS 

port was meant to provide a road map of what “the gold standard” in risk manage-
ment would be.
In January , before the report was completed, Cayne resigned as CEO, after
receiving . million in compensation from  through . He remained as
non-executive chairman of the board. Some senior executives sharply criticized him
and the board. Thomas Marano told the FCIC that Cayne played a lot of golf and
bridge. Speaking of the board, Paul Friedman, a former senior managing director at
Bear Stearns, said, “I guess because I’d never worked at a firm with a real board, it
never dawned on me that at some point somebody would have or should have gotten
the board involved in all of this,” although he told the FCIC that he made these com-
ments in anger and frustration in the wake of Bear’s failure. In its final report on
Bear, the Corporate Library, which researches and rates firms for corporate gover-
nance, gave the company a “D,” reflecting “a high degree of governance risk” resulting
from “high levels of concern related to the board and compensation.” When asked if
he had made mistakes while at Bear Stearns, Cayne told the FCIC, “I take responsi-
bility 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 re-
stricted 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 accu-
mulation plan for senior managing directors. Cayne told the FCIC he set his own
compensation and the compensation for all five members of the Executive Commit-
tee. According to Cayne, no one, including the board, questioned his decisions.
For , even with its losses, Bear Stearns paid out  of revenues in compensa-
tion. Alix, who sat on the Compensation Committee, told FCIC staff the firm typically
paid  but that the percentage increased in  because revenues fell—if manage-
ment had lowered compensation proportionately, he said, many employees might
have quit. Base salaries for senior managers were capped at ,, with the re-
mainder of compensation a discretionary mix of cash, restricted stock, and options.
From  through , the top five executives at Bear Stearns took home over
. million in cash and over . billion from stock sales, for more than a total of
. billion. This exceeded the annual budget for the SEC. Alan Schwartz, who took
over as CEO after Cayne and had been a leading proponent of investing in the mort-
gage sector, earned more than  million from  to . Warren Spector, the
co-president responsible for overseeing the two hedge funds that had failed, received
more than  million during the same period. Although Spector was asked to re-
sign, Bear never asked him to return any money. In , Cayne, Schwartz, and Spec-
tor each earned more than  times as much as Alix, the chief risk officer.
Cayne was out, Schwartz was in, and Bear Stearns continued hanging on in early
. 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 in-
creased cost would signal to the market that Bear was distressed, which could “make
our problems turn into a death spiral.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

“DUTY TO PROTECT THEIR INVESTORS”

On Wednesday, January , , Treasurer Upton reported an internal accounting
error that showed Bear Stearns to have less than  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 , Bear Stearns had . billion in mortgages, mortgage-
backed securities, and asset-backed securities on its balance sheet, down almost 
billion from November. Nearly  billion were subprime or Alt-A mortgage–backed
securities and CDOs.
The hedge funds that were clients of Bear’s prime brokerage services were particu-
larly 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 ,
but that such inquiries picked up at the beginning of , particularly as the cost in-
creased 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  billion in assets under manage-
ment, down more than  from  billion in January.
Nonetheless, during the week of March , when SEC staff inspected Bear’s liquid-
ity pool, they identified “no significant issues.” The SEC found Bear’s liquidity pool
ranged from  billion to  billion.
Bear opened for business on Monday, March , with approximately  billion
in cash reserves. The same day, Moody’s downgraded  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 “proba-
bly 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 avail-
able up to  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 secu-
rities. The Fed also announced it would extend loans from overnight to  days, giv-
 M A R C H     : T H E FA L L OF BEAR STEARNS 

ing 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 () of the Federal Reserve Act to determine that
there were “unusual and exigent circumstances.” The Fed had not invoked its section
() 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  to allow the Fed to lend
to investment banks. The Fed was taking the unusual step of declaring its willing-
ness to soon open its checkbook to institutions it did not regulate and whose finan-
cial condition it had never examined.
But the Fed would not launch the TSLF until March , more than two weeks
later—and it was not clear that Bear could last that long. The following day, Jim Em-
bersit of the Federal Reserve Board checked on Bear’s liquidity with the SEC. The
SEC said Bear had . billion in cash—down from about  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 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 , Bear
had . trillion in notional exposure on derivatives contracts, compared with .
trillion at  fiscal year-end and . trillion at the end of .
Derivatives counterparties who worried about Bear’s ability to make good on
their payments could get out of their derivative positions with Bear through assign-
ments 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 assign-
ments 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 mort-
gages, had decided to close out a relatively small  million subprime derivative posi-
tion 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 , at :
P.M. The reply  minutes later was unexpected: “GS does not consent to this trade.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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,  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 announce-
ment 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 ,
the SEC noted that Bear paid another . billion for margin calls from  nervous
derivatives counterparties.
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 Mel-
lon, 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  and  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 ex-
ecutives informed the board that the rumors were dissuading counterparties from
doing business with Bear, that Bear was receiving and meeting significant margin
calls, that  billion in repo was not going to roll over, and that “there was a reason-
able 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 counter-
parties continued to run from Bear. By that night, liquidity had dwindled to a mere
 billion (see figure .).
Bear had run out of cash in one week. Executives and regulators continued to be-
lieve the firm was solvent, however. Former SEC Chairman Cox testified before the
FCIC, “At all times during the week of March  to , 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.”
 M A R C H     : T H E FA L L OF BEAR STEARNS 

Bear Stearns Liquidity

In the four days before Bear Stearns collapsed, the company’s
liquidity dropped by $16 billion.
IN BILLIONS OF DOLLARS, DAILY
$25

20

15

10

0
22 23 24 25 26 27 28 29 1 2 3 4 5 6 7 8 9 10 11 12 13
FEBRUARY 2008 MARCH 2008
SOURCE: Securities and Exchange Commission

Figure .

“THE GOVERNMENT
WOULD NOT PERMIT A HIGHER NUMBER”
On Thursday evening, March , 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  billion credit line. Dimon turned him down, citing,
according to Schwartz, JP Morgan’s own significant exposure to the mortgage mar-
ket. Because Bear also had a large, illiquid portfolio of mortgage assets, JP Morgan
would not render assistance without government support. Schwartz spoke with Gei-
thner 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 .
billion loan to Bear Stearns through JP Morgan on the morning of Friday, March .
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 , closing below .
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 be-
fore the Asian markets opened Sunday night or the game would be over. Schwartz,
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Molinaro, Alix, and others spent the weekend in due diligence meetings with JP
Morgan and other potential buyers, 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  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 knowl-
edge let JP Morgan move more quickly.
On Sunday, March , 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 re-
quired under section () of the Federal Reserve Act, agreed to purchase . bil-
lion 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 mortgage-related 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 . billion subordinated loan and the New York Fed lent .
billion. Because of its loan, JP Morgan bore the risk of the first . billion of losses;
the Fed would bear any further losses up to . 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  a share. Minutes of Bear’s board meeting indicate that
JP Morgan had considered  but cut it to  “because the government would not
permit a higher number. . . . The Fed and the Treasury Department would not sup-
port a transaction where [Bear Stearns] equity holders received any significant con-
sideration 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 , Bear Stearns and JP Morgan agreed to increase the
price to . John Chrin, co-head of the financial institutions mergers and acquisi-
tions group at JP Morgan, told the FCIC they increased the price to make Bear share-
holders’ 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 circum-
stances for our shareholders, our , employees, and our creditors.”

“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 . trillion tri-party repo market had “really [begun] to
break down,” Bernanke said. “As the fear increased,” short-term lenders began de-
manding more collateral, “which was making it more and more difficult for the fi-
nancial firms to finance themselves and creating more and more liquidity pressure on
 M A R C H     : T H E FA L L OF BEAR STEARNS 

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.”
“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 in-
volved 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 finan-
cial risk were no longer operative would have triggered substantial further disloca-
tion 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 prob-
lem. “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.”

COMMISSION CONCLUSIONS ON CHAPTER 15

The Commission concludes the failure of Bear Stearns and its resulting govern-
ment-assisted rescue were caused by its exposure to risky mortgage assets, its re-
liance on short-term funding, and its high leverage. These were a result of weak
corporate governance and risk management. Its executive and employee compen-
sation system was based largely on return on equity, creating incentives to use ex-
cessive leverage and to focus on short-term gains such as annual growth goals.
Bear experienced runs by repo lenders, hedge fund customers, and derivatives
counterparties and was rescued by a government-assisted purchase by JP Morgan
because the government considered it too interconnected to fail. Bear’s failure
was in part a result of inadequate supervision by the Securities and Exchange
Commission, which did not restrict its risky activities and which allowed undue
leverage and insufficient liquidity.
 16
MARCH TO AUGUST 2008:
SYSTEMIC RISK CONCERNS

CONTENTS
The Federal Reserve: “When people got scared”.................................................
JP Morgan: “Refusing to unwind . . . would be unforgivable” ............................
The Fed and the SEC: “Weak liquidity position” ................................................
Derivatives: “Early stages of assessing the potential systemic risk” ......................
Banks: “The markets were really, really dicey” ...................................................

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 re-
cession and more about inflation, as the price of oil continued to rise (hitting almost
 per barrel in July). At the beginning of , the stock market had fallen almost
 from its peak in the fall of . Then, in May , the Dow Jones climbed to
,, within  of the record , set in October . 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. “In hindsight, the mar-
kets were surprisingly stable and almost seemed to be neutral a month after Bear
Stearns, leading all the way up to September,” said David Wong, Morgan Stanley’s
treasurer. 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  billion and  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 they knew that the other investment banks shared Bear’s
weaknesses: leverage, reliance on overnight funding, dependence on securitization
markets, and concentrations in illiquid mortgage securities and other troubled assets.
In particular, the run on Bear had exposed the dangers of tri-party repo agreements
and the counterparty risk caused by derivatives contracts.
And the word on the street—despite the assurances of Lehman CEO Dick Fuld at


 MARCH TO A U G U S T     : S YS T E M I C R I S K C O N C E R N S 

an April shareholder meeting that “the worst is behind us”—was that Bear would not
be the only failure.

THE FEDERAL RESERVE: “WHEN PEOPLE GOT SCARED”

The most pressing danger was the potential failure of the repo market—a market that
“grew very, very quickly with no single regulator having a purview of it,” former
Treasury Secretary Henry Paulson would tell the FCIC. Market participants believed
that the tri-party repo market was a relatively safe and durable source of collateral-
ized short-term financing. It was on precisely this understanding that Bear had
shifted approximately  billion of its unsecured funding into repos in . 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 , 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 eye-opening. Market participants and regulators now better appreciated
how the quality of repo collateral had shifted over time from Treasury notes and se-
curities 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  of the total posted. In
April , the Bankruptcy Abuse Prevention and Consumer Protection Act of 
had dramatically expanded protections for repo lenders holding collateral, such as
mortgage-related securities, that was riskier than government or highly rated corpo-
rate debt. These protections gave lenders confidence that they had clear, immediate
rights to collateral if a borrower should declare bankruptcy. Nonetheless, Jamie Di-
mon, 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 bor-
rowers. Despite the bankruptcy provisions in the  act, lenders were reluctant to
risk the hassle of seizing collateral, even good collateral, from a bankrupt borrower.
Steven Meier of State Street testified to the FCIC: “I would say the counterparties are
a first line of defense, and we don’t want to go through that uncomfortable process of
having to liquidate collateral.” William Dudley of the New York Fed told the FCIC,
“At the first sign of trouble, these investors in tri-party repo tend to run rather than
take the collateral that they’ve lent against. . . . So high-quality collateral itself is not
sufficient when and if an institution gets in trouble.”
Moreover, if a borrower in the repo market defaults, money market funds—fre-
quent 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

agency mortgage–backed securities. Typically, if a fund takes possession of such col-

lateral, it liquidates the securities immediately, even—as was the case during the cri-
sis—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, according to Darryll Hendricks, a managing director
and global head of risk methodology at UBS, as well as the head of a private-sector
task force on the repo market organized by the New York Fed.
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 . The TSLF would lend a total of up to  billion of Treasury securi-
ties at any one time to the investment banks and other primary dealers—the securi-
ties 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 
days. The borrowers would trade highly rated securities, including debt in govern-
ment-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—again invoking its au-
thority under () 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  minutes” too late for Bear, Jimmy Cayne, its former CEO,
told the FCIC.
Unlike the TSLF, which would offer Treasuries for  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. “So the idea of the PDCF then was . . . anything that the
dealer couldn’t finance—the securities that were acceptable under the discount win-
dow—if they couldn’t get financing in the market, they could get financing from the
Federal Reserve,” said Seth Carpenter, deputy associate director in the Division of
Monetary Affairs at the Federal Reserve Board. “And that way, you don’t have to
worry. And by providing that support, other lenders know that they’re going to be
able to get their money back the next day.”
By charging the Federal Reserve’s discount rate and adding additional fees for reg-
ular use, the Federal Reserve encouraged dealers to use the PDCF only as a last re-
sort. In its first week of operation, this program immediately provided over 
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
 MARCH TO A U G U S T     : S YS T E M I C R I S K C O N C E R N S 

after April and ceased completely by late July. Because the dealers feared that mar-
kets 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 , the Fed broadened the kinds of collateral allowed in the TSLF to in-
clude 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 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 , the Fed extended both pro-
grams through January , .

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 expo-
sures 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 . A clearing bank had two concerns: First, if repo lenders aban-
doned 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 explained.
To address those risks in , 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 or-
der 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

repo lenders refused to lend as they had in the case of Bear Stearns, but it did not pro-
tect against clearing banks’ refusing exposure to an investment bank during the day.
On July , Fed officials circulated a plan, ultimately never implemented, that ad-
dressed 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 in-
vestment banks, such as Lehman Brothers, with  billion in tri-party repo financ-
ing 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 confi-
dence 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 in-
strument as a nearly risk free, liquid overnight investment.”
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 direc-
tor 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 , 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 signifi-
cant risks. Parkinson noted that even if the Fed lent as much as  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.

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:  to
 for Lehman and Merrill Lynch,  to  for Morgan Stanley, and about 
for Goldman Sachs. Another metric was the reliance on overnight repo (which ma-
ture 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 fund-
ing still exceeded  for all but Goldman Sachs. Comparing the period between
March and May to the period between July and August, Lehman’s percentage fell
 MARCH TO A U G U S T     : S YS T E M I C R I S K C O N C E R N S 

from  to , Merrill Lynch’s fell from  to , Morgan Stanley’s fell from
 to , and Goldman’s fell from  to . Another measure of risk was the
haircuts on repo loans—that is, the amount of excess collateral that lenders de-
manded for a given loan. Fed officials kept tabs on the haircuts demanded of invest-
ment 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 col-
lateral, haircuts increased—doubling for some agency mortgage securities and in-
creasing 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 in-
vestment 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.
Fed Chairman Ben Bernanke would testify before a House committee that the
Fed’s primary role at the investment banks in  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 . The arrival of officials from the Treasury and the Fed created a
full-time 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 includ-
ing 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  billion short of cash in the more stringent Bear
Stearns scenario and  billion short under Bear Stearns Light.
The Fed conducted another liquidity stress analysis in June. While each firm ran
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

different scenarios that matched its risk profile, the supervisors tried to maintain
comparability between the tests. The tests assumed that each firm would lose  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  billion and  billion short of
cash, respectively; each had only  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.”
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 de-
clined 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 communica-
tion was remedied only by a formal memorandum of understanding (MOU) to gov-
ern information sharing. According to former SEC Chairman Christopher Cox,
“One reason the MOU was needed was that the Fed was reluctant to share supervi-
sory 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 , more than three
months after the collapse of Bear Stearns.

DERIVATIVES: “EARLY STAGES OF ASSESSING

THE POTENTIAL SYSTEMIC RISK”
The Fed’s Parkinson advised colleagues in an internal August  email that the sys-
temic 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 col-
lateral. (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 assess-
ing 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
 MARCH TO A U G U S T     : S YS T E M I C R I S K C O N C E R N S 

Notional Amount and Gross Market

Value of OTC Derivatives Outstanding
IN TRILLIONS OF DOLLARS, SEMIANNUAL

Notional Amount Gross Market Value

$800 $40

700 35

600 30

500 25

400 20

300 15

200 10

100 5

0 0
1999 2001 2003 2005 2007 2009
June 2010
SOURCE: Bank for International Settlements

Figure .

the global derivatives market. At the end of June , the notional amount of the
over-the-counter derivatives market was  trillion and the gross market value was
 trillion (see figure .). Adequate information about the risks in this market was
not available to market participants or government regulators like the Federal Re-
serve. Because the market had been deregulated by statute in , market partici-
pants were not subject to reporting or disclosure requirements and no government
agency had oversight responsibility. While the Office of the Comptroller of the Cur-
rency did report information on derivatives positions from commercial banks and
bank holding companies, it did not collect such information from the large invest-
ment banks and insurance companies like AIG, which were also major OTC deriva-
tives 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 relation-
ships 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 unex-
pected 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

cause significant financial harm to its counterparty, which may have offsetting obli-
gations to third parties and depend on prompt payment. Indeed, most OTC deriva-
tives 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 devastating losses in this market could pose a sig-
nificant 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 agree-
ments exposed firms to risk should corporate defaults occur. With urging from
New York Fed President Timothy Geithner, by September ,  major market
participants had significantly reduced the backlog and had ended the practice of as-
signing 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 ,
: . trillion in notional amount for JP Morgan, . trillion for Bank of
America, . trillion for Citigroup, . trillion for Wachovia, and . trillion for
HSBC. Goldman Sachs and Morgan Stanley, which began to report their holdings
only after they became bank holding companies in , held . and . tril-
lion, respectively, in notional amount of OTC derivatives in the first quarter of
. In , 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  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 institutions.
Broad classes of OTC derivatives markets showed stress in . By the summer
of , outstanding amounts of some types of derivatives had begun to decline
sharply. As we will see, over the course of the second half of , the OTC deriva-
tives market would undergo an unprecedented contraction, creating serious prob-
lems for hedging and price discovery.
The Fed was uneasy in part because derivatives counterparties had played an im-
portant 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 back-
 MARCH TO A U G U S T     : S YS T E M I C R I S K C O N C E R N S 

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 guar-
anteed 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, in-
cluding municipal bonds and other securities, necessarily lost some value in the mar-
ket, 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.

BANKS: “THE MARKETS WERE REALLY, REALLY DICEY”

By the fall of , signs of strain were beginning to emerge among the commercial
banks. In the fourth quarter of , commercial banks’ earnings declined to a -
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 meet-
ing 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
, when the economy was coming out of the post-/ recession. Earnings con-
tinued to decline in —at first, more for big banks than small banks, in part be-
cause of write-downs related to their investment banking–type activities, including
the packaging of mortgage-backed securities, CDOs, and collateralized loan obliga-
tions. 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-balance-sheet 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 con-
struction, an industry that virtually went out of business as financing dried up in
mid-. By the end of , the FDIC had  banks, mainly smaller ones, on its
“problem list”; their combined assets totaled . billion. (When large banks
started to be downgraded, in early , 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 mort-
gages that did not meet Fannie Mae’s or Freddie Mac’s underwriting or mortgage size
guidelines) had also vanished in the fourth quarter of . Not only did these non-
conforming 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  for the year, depending on the measure. In the first quarter
of , real estate loans in the banking sector showed the smallest quarterly increase
since . IndyMac reported a  decline in loan production for that quarter
from a year earlier, because it had stopped making nonconforming loans. Washing-
ton Mutual, the largest thrift, discontinued all remaining lending through its sub-
prime mortgage channel in April .
But those actions could not reduce the subprime and Alt-A exposure that these
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

large banks and thrifts already had. And on these assets, the markdowns continued
in . Regulators began to focus on solvency, urging the banks to raise new capital.
In January , Citigroup secured a total of  billion in capital from Kuwait, Sin-
gapore, Saudi Prince Alwaleed bin Talal, and others. In April, Washington Mutual
raised  billion from an investor group led by the buyout firm TPG Capital. Wa-
chovia raised  billion in capital at the turn of the year and then an additional  bil-
lion in April . Despite the capital raises, though, the downgrades by banking
regulators continued.
“The markets were really, really dicey during a significant part of this period,
starting with August ,” Roger Cole, then-director of the Division of Banking Su-
pervision 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
manager 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 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 .”
As the commercial banks’ health worsened in , examiners downgraded even
large institutions that had maintained favorable ratings and required several to fix
their risk management processes. These ratings downgrades and enforcement ac-
tions 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.

Citigroup: “Time to come up with a new playbook”

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 na-
tional bank subsidiary, finally downgraded the company and its main bank to “less
than satisfactory” in April —five months after the firm’s announcement in No-
vember  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 sub-
sidiary CitiFinancial, discussed in an earlier chapter. “The risk management assess-
ment for  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 , , had noted. “During ,
all formal restrictions and enforcement actions between the Federal Reserve and
Citigroup were lifted. Board and senior management remain actively engaged in im-
proving relevant processes.”
But the market disruption had jolted Citigroup’s supervisors. In November ,
 MARCH TO A U G U S T     : S YS T E M I C R I S K C O N C E R N S 

the New York Fed led a team of international supervisors, the Senior Supervisors
Group, in evaluating  of the largest firms to assess lessons learned from the finan-
cial 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  memo describ-
ing meetings with Citigroup management. “Stress tests were not designed for this
type of extreme market event. . . . Management had believed that CDOs and lever-
aged 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 in-
ternal controls with respect to the creation of CDOs. The OCC appears to have iden-
tified some of these issues as early as  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 ac-
tion, 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  that the executives would strive to meet
the OCC’s goals for improving risk management.
In contrast, documents obtained by the FCIC from the New York Fed give no in-
dication 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  Operations Review of
the New York Fed, which covered the previous four years), concluded:

The supervision program for Citigroup has been less than effective. Al-
though 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 . 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 , an OCC review of the breakdown in the CDO business noted
that the risk in the unit had grown rapidly since , after the OCC’s and Fed’s
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

lifting of supervisory agreements associated with various control problems at Citi-

group. In April , the Fed and OCC downgraded their overall ratings of the com-
pany and its largest bank subsidiary from  (satisfactory) to  (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  as an ob-
stacle 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 reg-
ulators across the world; even the securitization businesses were dispersed across sub-
sidiaries with different supervisors—including those from the Fed, OCC, SEC, OTS,
and state agencies.
In May and June , Citigroup entered into memoranda of understanding with
both the New York Fed and OCC to resolve the risk management weaknesses that the
events of  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 , complimented Citigroup on its
assertiveness in executing its regulators’ requests: aggressively replacing manage-
ment, raising capital from investors in late , 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 playbook.”

Wachovia: “The Golden West acquisition was a mistake”

At Wachovia, which was supervised by the OCC as well as the OTS and the Federal
Reserve, a  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 ex-
pected to rise to about  of the portfolio for ; in , losses in this portfolio
had been less than .. It would soon become clear that the higher estimate for
 was not high enough. The company would hike its estimate of the eventual
losses on the portfolio to  by June and to  by September.
Facing these and other growing concerns, Wachovia raised additional capital.
Then, in April, Wachovia announced a loss of  million for the first three months
of the year. Depositors withdrew about  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 second-quarter losses that would be announced in July.
On June , Wachovia’s board ousted CEO Ken Thompson after he had spent 
years at the bank,  of them at its helm. At the end of the month, the bank an-
nounced that it would stop originating Golden West’s Pick-a-Pay products and would
 MARCH TO A U G U S T     : S YS T E M I C R I S K C O N C E R N S 

waive all fees and prepayment penalties associated with them. On July , Wachovia
reported an . billion second-quarter loss. The new CEO, Robert Steel, most re-
cently an undersecretary of the treasury, announced a plan to improve the bank’s fi-
nancial condition: raise capital, cut the stock dividend, and lay off  to  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 “satis-
factory” ratings, downgraded Wachovia to , or “less than satisfactory.” The Fed
noted that  projections showed losses that could wipe out the recently raised
capital:  losses alone could exceed  billion, an amount that could cause a fur-
ther ratings downgrade. The Fed directed Wachovia to reevaluate and update its
capital plans and its liquidity management. Despite having consistently rated Wa-
chovia 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 dis-
ruption, management had minimized exposure to overnight funding markets.
On August , 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 par-
ticularly strong remarks about the acquisition of Golden West, identifying that mort-
gage portfolio 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 mistake.”
The OCC wrote that the market was focused on the company’s weakened condi-
tion and that some large fund providers had already limited their exposure to Wa-
chovia. 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 scram-
ble to find a buyer for the troubled bank.

Washington Mutual: “Management’s persistent lack of progress”

Washington Mutual, often called WaMu, was the largest thrift in the country, with
over  billion in assets at the end of . At the time,  billion of the home
loans on its balance sheet were option ARMs, two times its capital and reserves, with
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

concentrated exposure in California. The reason WaMu liked option ARMs was sim-
ple: in , in combination with other nontraditional mortgages such as subprime
loans, they had generated returns up to  times those on GSE mortgage–backed secu-
rities. But that was then. WaMu was forced to write off . billion for the fourth
quarter of  and another . billion in the first quarter of , mostly related to
its portfolio of option ARMs.
In response to these losses, the Office of Thrift Supervision, WaMu’s regulator, re-
quested 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 con-
stantly nagging (okay, ‘chastising’) through ROE [Reports of Examination] and meet-
ings, since they have not really been adversely impacted in terms of losses,” the OTS’s
lead examiner at the company had commented in a  email. Indeed, the nontradi-
tional mortgage portfolio had been performing very well through  and .
But with WaMu now taking losses, the OTS determined on February , ,
that its condition required a downgrade in its rating from a  to a , or “less than sat-
isfactory.” 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  billion
investment from a consortium led by the Texas Pacific Group, a private equity firm.
But bad news continued for thrifts. On July , the OTS closed IndyMac Bank in
Pasadena, California, making that company the largest-ever thrift to fail. On July ,
, WaMu reported a . billion loss in the second quarter. WaMu’s depositors
withdrew  billion over the next two weeks. And the Federal Home Loan Bank of
San Francisco—which, as noted, had historically served with the other  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 as-
sessment categories, while maintaining the overall rating at .
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 , indicating a “high level of
concern.”
The FDIC expressly disagreed with the OTS’s decision to maintain the  overall
rating, recommending a  instead. Ordinarily,  would have triggered a formal en-
forcement action, but none was forthcoming. In an August  interview, William
Isaac, who was chairman of the FDIC from  until , 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 go-
ing in and letting our [FDIC] examiners do loan-level analysis.”
 MARCH TO A U G U S T     : S YS T E M I C R I S K C O N C E R N S 

The Treasury’s inspector general would later criticize OTS’s supervision of Wash-
ington Mutual: “We concluded that OTS should have lowered WaMu’s composite rat-
ing 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.”

Regulators: “A lot of that pushback”

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 regu-
lation, 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 supervi-
sors’ “risk-focused” approach. The OCC Large Bank Supervision Handbook published
in January  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 force-
fully 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  to  billion a quarter. And that is really hard for a supervi-
sor 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.”
Supervisors also told the FCIC that they feared aggravating a bank’s already-exist-
ing 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
, attributed supervisory reluctance to “a belief that the traditional, nonpublic
(behind-the-scenes) 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 pre-
sumption should be earlier and stronger supervisory follow up.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Douglas Roeder, the OCC’s senior deputy comptroller for Large Bank Supervision
from  to , said that the regulators were hampered by inadequate informa-
tion from the banks but acknowledged that regulators did not do a good job of inter-
vening 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 sound-
ness with the need to let markets work, noting, “We underestimated what systemic
risk would be in the marketplace.”
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 organ-
ization. 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—creat-
ing the potential for both gaps in coverage and problematic overlap. Successive Treas-
ury 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
, , 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 .

COMMISSION CONCLUSIONS ON CHAPTER 16

The Commission concludes that the banking supervisors failed to adequately and
proactively identify and police the weaknesses of the banks and thrifts or their
poor corporate governance and risk management, often maintaining satisfactory
ratings on institutions until just before their collapse. This failure was caused by
many factors, including beliefs that regulation was unduly burdensome, that fi-
nancial institutions were capable of self-regulation, and that regulators should not
interfere with activities reported as profitable.
Large commercial banks and thrifts, such as Wachovia and IndyMac, that had
significant exposure to risky mortgage assets were subject to runs by creditors
and depositors.
The Federal Reserve realized far too late the systemic danger inherent in the
interconnections of the unregulated over-the-counter (OTC) derivatives market
and did not have the information needed to act.
 17
SEPTEMBER 2008: THE TAKEOVER
OF FANNIE MAE AND FREDDIE MAC

CONTENTS
“A good time to buy”...........................................................................................
“The only game in town”....................................................................................
“It’s a time game . . . be cool”...............................................................................
“The idea strikes me as perverse” .......................................................................
“It will increase confidence”................................................................................
“Critical unsafe and unsound practices” ............................................................
“They went from zero to three with no warning in between” .............................
“The worst-run financial institution”.................................................................
“Wasn’t done at my pay grade”...........................................................................

From the fall of  until Fannie Mae and Freddie Mac were placed into conserva-
torship on September , , government officials struggled to strike the right bal-
ance between the safety and soundness of the two government-sponsored enterprises
and their mission to support the mortgage market. The task was critical because the
mortgage market was quickly weakening—home prices were declining, loan delin-
quencies were rising, and, as a result, the values of mortgage securities were plum-
meting. Lenders were more willing to refinance borrowers into affordable mortgages
if these government-sponsored enterprises (GSEs) 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 . trillion of mort-
gages with capital of less than . When interviewed by the FCIC, former Treasury
Secretary Henry Paulson acknowledged that after he was briefed on the GSEs upon
taking office in June , 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 securi-
ties, which by fall  constituted multiples of their reported capital. The GSEs


 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

reported billions of dollars of net losses on these loans and securities, beginning in
the third quarter of .
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 , 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 portfo-
lio caps—limits on the loans and securities they could hold on their books—and a
 capital surplus requirement.
So, even as each company reported billions of dollars in losses in  and ,
their regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), loos-
ened those constraints. “From the fall of , 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  billion—so far.

“A GOOD TIME TO BUY”

In an August , , letter to Lockhart, Fannie Mae CEO Daniel Mudd sought im-
mediate relief from the portfolio caps required by the consent agreement executed in
May  following Fannie’s accounting scandal. “We have witnessed growing evi-
dence of turmoil in virtually all sectors of the housing finance market,” Mudd wrote,
and “the immediate crisis in subprime is indicative of a serious liquidity event im-
pacting the entire credit market, not just subprime.” As demand for purchasing loans
dried up, large lenders like Countrywide kept loans that they normally securitized,
and smaller lenders went under. 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,  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 agree-
ment allowed OFHEO to lift the cap to address “market liquidity issues.” Moreover,
the company had largely corrected its accounting and internal control deficiencies—
the primary condition for removing the cap. Finally, he stressed that the GSEs’ char-
ter 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 returns. Tom Lund, a longtime Fannie Mae executive who led the firm’s
single-family business, told the FCIC that the market moved in Fannie Mae’s favor af-
 S E P T E M B E R    : T H E T A K E O V E R OF FA N N I E M A E AND F R E DDI E M AC 

ter August  as competitors dropped out and prices of loans and securities fell.
Lund told FCIC staff that after the  liquidity shock, Fannie had “more comfort
that the relationship between risk and price was correct.” Robert Levin, the com-
pany’s chief business officer, recalled, “It was a good time to buy.”
On August , OFHEO’s Lockhart notified Fannie that increasing the portfolio
cap would be “premature” but the regulator would keep the request under “active
consideration.” Lockhart wrote that he would not authorize changes, because Fannie
could still guarantee mortgages even if it couldn’t buy them and because Fannie re-
mained a “significant supervisory concern.” In addition, Lockhart noted that Fannie
could not prudently address the problems in the subprime and Alt-A mortgage mar-
ket, and the company’s charter did not permit it to address problems in the market
for jumbo loans (mortgages larger than the GSEs’ loan limit). Although there had
been progress in dealing with the accounting and internal control deficiencies, he ob-
served, much work remained. Fannie still had not filed financial statements for 
or , “a particularly troubling issue in unsettled markets.”
As Lockhart testified to the FCIC, “It became clear by August  that the tur-
moil was too big for the Enterprises [the GSEs] to solve in a safe and sound manner.”
He was worried that fewer controls would mean more losses. “They were fulfilling
their mission,” Lockhart told the FCIC, “but they had no power to do more in a safe
and sound manner. If their mission is to provide stability and lessen market turmoil,
there was nothing in their capital structure” that would allow them to do so.
Lockhart had worried about the financial stability of the two GSEs and about
OFHEO’s ability to regulate the behemoths from the day he became director in May
, and he advocated for more regulatory powers for his largely toothless agency.
Lockhart pushed for the power to increase capital requirements and to limit growth,
and he sought authority over mission goals set by the Department of Housing and
Urban Development, as well as litigation authority independent of the Department of
Justice. His shopping list also included the authority to put Fannie and Freddie into
receivership, a power held by bank regulators over banks, and to liquidate the GSEs if
necessary. As it stood, OFHEO had the authority to place the GSEs in conservator-
ship—in effect, to force a government takeover—but because it lacked funding to op-
erate the GSEs as conservator, that authority was impracticable. The GSEs would
deteriorate even further before Lockhart secured the powers he sought.

“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 , Paulson told the FCIC. And by the spring of , “[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 trade-
off,” Lockhart said in late —a trade-off made all the more difficult by the state of
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

the GSEs’ balance sheets. The value of risky loans and securities was swamping
their reported capital. By the end of , guaranteed and portfolio mortgages with
FICO scores less than  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 re-
ported capital.
In mid-September, OFHEO relented and marginally loosened the GSEs’ portfolio
cap, from about  billion to  billion. It allowed Fannie to increase the amount
of mortgage loans and securities it owned by  per year—a power that Freddie al-
ready had under its agreement with OFHEO. OFHEO ruled out more dramatic in-
creases “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 , they were purchasing  of new
mortgages, nearly twice the  level. With  trillion in mortgages resting on ra-
zor-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 confi-
dence in the Enterprises would have created a self-fulfilling credit crisis.”
In early October, Senator Charles Schumer and Representative Barney Frank in-
troduced similar bills to temporarily lift portfolio limits on the GSEs by  percent,
or approximately  billion, most of which would be designated for refinancing
subprime loans. The measures, which Federal Reserve Chairman Ben Bernanke
called “ill advised,” were not enacted.
In November, Fannie and Freddie reported third-quarter losses of . billion and
 billion, respectively. At the end of December , Fannie reported that it had 
billion of capital to absorb potential losses on  billion of assets and . trillion
of guarantees on mortgage-backed securities; if losses exceeded ., it would be
insolvent. Freddie would be insolvent if losses exceeded .. Moreover, there were
serious questions about the validity of their “reported” capital.

“IT’S A TIME GAME . . . BE COOL”

In the first quarter, real gross domestic product fell . at an annual rate, reflecting
in part the first decline in consumer spending since the early s. The unemploy-
ment rate averaged  in the first three months of , up from a low of . in
spring of . 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 pur-
chase, among other measures.
The push to get OFHEO to loosen requirements on the GSEs also continued.
Schumer pressed OFHEO to justify or lower the  capital surcharge; such a strin-
gent requirement, he wrote Lockhart on February , hampered Fannie’s ability to
provide financing to homeowners.
 S E P T E M B E R     : T H E TA K E O V E R OF FA N N I E M A E AND F R E DDI E M AC 

Two days later, Fannie CEO Mudd reported losses in the fourth quarter of ,
acknowledging that Fannie was “working through the toughest housing and mort-
gage markets in a generation.” The company had issued . billion of preferred
stock, had completed all  requirements of the consent agreement with OFHEO,
and was discussing with OFHEO the possibility of reducing the  capital surplus
requirement. The next day, Freddie also reported losses and said the company had
raised  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, Lockhart an-
nounced that OFHEO would remove the portfolio caps on March , . He also
said OFHEO would consider gradually lowering the  capital surplus require-
ment, because both companies had made progress in satisfying their consent agree-
ments 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 , , the day after OFHEO lifted the growth limits, a New York
Fed analyst noted to Treasury that the  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 be-
lieve that we are nearing a tipping point; . . . lack of transparency on pricing for vir-
tually 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 recog-
nized 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 “encour-
aging” conversations with Senator Richard Shelby, the ranking member of the Senate
Committee on Banking, Housing, and Urban Affairs, and Representative 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  email to Fannie chief business officer Levin, Mudd
suggested that the  capital surplus requirement might be reduced without any
trade: “It’s a time game . . . whether they need us more . . . or if we hit the capital wall
first. Be cool.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

On the next day, March , Treasury and White House officials received additional
information about Fannie’s condition. The White House economist Jason Thomas
sent Steel an email enclosing an alarming analysis: it claimed that in reporting its
 financial results, Fannie was masking its insolvency through fraudulent ac-
counting practices. The analysis, which resembled one offered in a March  Barron’s
article, stated:

Any realistic assessment of Fannie Mae’s capital position would show

the company is currently insolvent. Accounting fraud has resulted in
several asset categories (non-agency securities, deferred tax assets, low-
income partnership investment) being overstated, while the guarantee
obligation liability is understated. These accounting shenanigans add up
to tens of billions of exaggerated net worth.
Yet, the impact of a tsunami of mortgage defaults has yet to run
through Fannie’s income statement and further annihilate its capital.
Such grim results are a logical consequence of Fannie’s dual mandate to
serve the housing market while maximizing shareholder returns. In try-
ing to do both, Fannie has done neither well. With shareholder capital
depleted, a government seizure of the company is inevitable.

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 , , 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.”

“THE IDEA STRIKES ME AS PERVERSE”

Regulators at OFHEO and the Treasury huddled with GSE executives to discuss low-
ering capital requirements if the GSEs would raise more capital. “The entire mort-
gage market was at risk,” Lockhart told the FCIC. The pushing and tugging
continued. Paulson told the FCIC that personal commitments from Mudd and Fred-
die Mac CEO Richard Syron to raise capital cinched the deal. Just days earlier, on
March , Syron had announced in a quarterly call to investors that his company
would not raise new capital. Fannie and Freddie executives prepared a draft press re-
lease before a discussion with Lockhart and Steel. It announced a reduction in the
capital surcharge from  to . Lockhart was not pleased; the draft lacked a com-
 S E P T E M B E R     : T H E TA K E O V E R OF FA N N I E M A E AND F R E DDI E M AC 

mitment to raise additional capital, stating instead that the GSEs planned to raise it
“over time as needed.” It looked as if the GSEs were making the deal with their fin-
gers crossed. In an email to Steel and the CEOs of both entities, Lockhart wrote: “The
idea strikes me as perverse, and I assume it would seem perverse to the markets that
a regulator would agree to allow a regulatee to increase its very high mortgage credit
risk leverage (not to mention increasing interest rate risk) without any new capital.”
The initial negotiations had the GSEs raising  of capital for each  of reduction in
the surplus. Lockhart wrote in frustration, “We seem to have gone from  to  right
through  to  to now  to .”
Despite Lockhart’s reservations, OFHEO announced the deal, unaltered in any
material way, on March . OFHEO agreed to ease the capital restraint from  to
; Fannie and Freddie pledged to “begin the process to raise significant capital,”
giving no concrete commitment. Paulson told the FCIC that the agreement, which
included a promise to raise capital, was “a no-brainer,” and that he had no memory of
Lockhart ever having called it “perverse.”
The market analyst Joshua Rosner panned the deal. “We view any reduction [in
capital] as a comment not only on the GSEs but on the burgeoning panic in Wash-
ington,” he wrote. “If this action results in the destabilizing of the GSEs, OFHEO
will go from being the only regulator that prevented its charges from getting into
trouble, to a textbook example of why regulators should be shielded from outside
political pressure.”
Fannie would keep its promise by raising . billion in preferred stock. Freddie
reneged. Executive Vice President Donald Bisenius offered two reasons why, in hind-
sight, Fannie Mae did not raise additional capital. First was protecting the assets of
existing shareholders. “I’m sure [Fannie’s] investors are not very happy,” Bisenius told
the FCIC. “Part two is . . . if you actually fundamentally believe you have enough cap-
ital to withstand even a fairly significant downturn in house prices, you wouldn’t
raise capital.”
Similarly, CEO Syron spoke of the downside of raising capital on August , :
“Raising a lot more capital at these kinds of prices could be quite dilutive to our
shareholders, so we have to balance the interest of our shareholders.” But Lockhart
saw it differently; in his view, Syron’s public comments put “a good face on Freddie’s
inability to raise capital.” He speculated that Syron was masking a different concern:
lawsuits. “[Syron] was getting advice from his attorneys about the high risk of raising
capital before releasing [quarterly earnings] . . . and our lawyers could not disagree
because we know about their accounting issues,” Lockhart told the FCIC.

“IT WILL INCREASE CONFIDENCE”

In May, the two companies announced further losses in the first quarter. Even as the
situation deteriorated, on June  OFHEO rewarded Fannie Mae for raising . bil-
lion in new capital by further lowering the capital surcharge, from  to . In
June, Fannie’s stock fell ; Freddie’s, . The price of protection on  million in
Fannie’s debt through credit default swaps jumped to , in June, up from
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

, in May; between  and , it had typically been about ,. In Au-
gust, they both reported more losses for the second quarter.
Even after both Fannie and Freddie became public companies owned by share-
holders, 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 . 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
s, and it came through in the mid-s for another GSE in duress, the Farm
Credit System. In the mid-s, even a GSE-type organization, the Financing Cor-
poration, 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 
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 , the spread
had risen  over the  level; by September , just before regulators parachuted
in, the spread had nearly doubled from its  level to just under , 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 dra-
matically declined. For example, the price of the FNCI index—an index of Fannie
mortgage–backed securities with an average coupon of —increased from  in
January  to  on September , , two days prior to the conservatorship. As
another example, the price of the FNCI index—Fannie securities with an average
coupon of —increased from  to  during the same time period.
In July and August , Fannie suffered a liquidity squeeze, because it was un-
able to borrow against its own securities to raise sufficient cash in the repo market.
Its stock price dove to less than  a share. Fannie asked the Fed for help. A senior
adviser in the Federal Reserve Board’s Division of Banking Supervision and Regula-
tion 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 pro-
vide it.”
On July , 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 fi-
nancial markets.” Fannie and Freddie would never tap the Fed for that funding.
Also on July , 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 receiver-
ship. Paulson told the Senate that regulators needed “a bazooka” at their disposal.
 S E P T E M B E R     : T H E TA K E O V E R OF FA N N I E M A E AND F R E DDI E M AC 

“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 confi-
dence 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 , 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
-page bill also strengthened regulation of the GSEs by creating FHFA, an inde-
pendent 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  billion to . 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 Fed and the OCC discovered that the problems were worse than their suspi-
cions 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 be-
low 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 un-
til they were delinquent for two years, a head-in-the-sand approach. Banks are re-
quired to charge off loans once they are  days delinquent. For these and numerous
other errors and flawed methodologies, Fannie and Freddie earned rebukes. “Given
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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, produc-
tive analysis, and comprehensive reporting. Instead they appear to significantly lag
the industry in all respects.”

“CRITICAL UNSAFE AND UNSOUND PRACTICES”

Paulson told the FCIC that although he learned of the Fed and OCC findings by Au-
gust , it took him three weeks to convince Lockhart and FHFA that there was a cap-
ital shortfall, that the GSEs were not viable, and that they should be placed under
government control. On August , FHFA informed both Mudd and Syron that their
firms were “adequately capitalized” under the regulations, a judgment based on finan-
cial information that was “certified and represented as true and correct by [GSE] man-
agement.” But FHFA also emphasized that it was “seriously concerned about the
current level of Fannie Mae’s capital” if the housing market decline continued.
Fannie’s prospects for increasing capital grew gloomier. Fannie informed Treasury
on August —and repeatedly told FHFA—that raising capital was infeasible and
that the company was expecting additional losses. Even Fannie’s “base-case earnings
forecast” pointed to substantial pressure on solvency, and a “stressed” forecast indi-
cated that “capital resources will continue to decline.”
By September , Lockhart and FHFA agreed with Treasury that the GSEs needed
to be placed into conservatorship. That day, Syron and Mudd received blistering
midyear reviews from FHFA. The opening paragraph of each letter informed the
CEOs that their companies had been downgraded to “critical concerns,” and that “the
critical unsafe and unsound practices and conditions that gave rise to the Enterprise’s
existing condition, the deterioration in overall asset quality and significant earnings
losses experienced through June , as well as forecasted future losses, likely re-
quire recapitalization of the Enterprise.” A bad situation was expected to worsen.
The -page report sent to Fannie identified sweeping concerns, including fail-
ures by the board and senior management, a significant drop in the quality of mort-
gages and securities owned or guaranteed by the GSE, insufficient reserves, the
almost exclusive reliance on short-term funding, and the inability to raise additional
capital. FHFA admonished management and the board for their “imprudent deci-
sions” to “purchase or guarantee higher risk mortgage products.” The letter faulted
Fannie for purchasing high-risk loans to “increase market share, raise revenue and
meet housing goals,” and for attempting to increase market share by competing with
Wall Street firms that purchased lower-quality securities. FHFA, noting “a conflict
between prudent credit risk management and corporate business objectives,” found
that these purchases of higher-risk loans were predicated on the relaxing of under-
writing and eligibility standards. Using models that underestimated this risk, the
GSE then charged fees even lower than what its own deficient models suggested
were appropriate. FHFA determined that these lower fees were charged because “fo-
cus was improperly placed on market share and competing with Wall Street and
[Freddie Mac].”
 S E P T E M B E R    : T H E T A K E O V E R OF FA N N I E M A E AND F R E DDI E M AC 

Even after internal reports pointed to market problems, Fannie kept buying and
guaranteeing riskier loan products, FHFA said. “Despite signs in the latter half of
 and  of emerging problems, management continued activity in risky pro-
grams, and maintained its higher eligibility program for Alt-A loans without estab-
lishing limits.” The company also bought private-label securities backed by Alt-A
and subprime loans. Losses were likely to be higher than the GSEs had estimated,
FHFA found.
FHFA also noted “increasing questions and concerns” regarding Fannie’s account-
ing. The models it used to forecast losses had not been independently validated or
updated for several years. FHFA judged that in an up-to-date model, estimated losses
would likely show a “material increase.” In addition, Fannie had overvalued its de-
ferred tax assets. Applying more reasonable projections of future performance, FHFA
found this benefit to be significantly overstated.
The -page report delivered to Freddie included similarly harsh assessments of
that GSE’s safety and soundness, but more severe criticisms of its management and
board. In particular, the report noted a significant lack of market confidence, which
had “eliminated the ability to raise capital.” FHFA, for its part, “lost confidence in the
Board of Directors and the executive management team,” holding them accountable
for losses stemming from “a series of ill-advised and poorly executed decisions and
other serious misjudgments.” According to the regulator, they therefore could not be
relied on, particularly in light of their widespread failures to resolve regulatory issues
and address criticisms. In addition, FHFA said that Freddie’s failure to raise capital
despite its assurances “invite[d]” the conclusion that the board and CEO had not ne-
gotiated “in good faith” about the capital surcharge reduction.
As in its assessment of Fannie, FHFA found that Freddie’s unsafe and unsound
practices included the purchase and guarantee of higher-risk loan products in 
and  in a declining market. Even after being told by the regulator in  that its
purchases of subprime private-label securities had outpaced its risk management abil-
ities, Freddie bought  billion of subprime securities in each subsequent quarter.
FHFA also found that “aggressive” accounting cast doubt on Freddie’s reported
earnings and capital. Despite “clear signals” that losses on mortgage assets were likely,
Freddie waited to record write-downs until the regulator threatened to issue a cease
and desist order. Even then, one write-down was reversed “just prior to the issuance
of the second quarter financial statements.” The regulator concluded that rising
delinquencies and credit losses would “result in a substantial dissipation of earnings
and capital.”

“THEY WENT FROM ZERO

TO THREE WITH NO WARNING IN BETWEEN”
Mudd told the FCIC that its regulator had never before communicated the kind of
criticisms leveled in the September  letter. He said the regulator’s “chronicling of the
situation” then was “inconsistent with what you would consider better regulatory
practice to be—like, first warning: fix it; second warning: fix it; third warning: you’re
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

out of here. Instead, they went from zero to three with no warning in between.” A
review of the examination reports and other documents provided by FHFA to the
FCIC largely supports Mudd’s view on this specific point. While OFHEO’s examina-
tion reports noted concerns about increasing credit risk and slow remediation of de-
ficiencies required by the May  consent agreement, they do not include the
sweeping criticisms contained in the September  letter.
Two days after their two companies were designated “critical concerns,” Mudd at
Fannie and Syron at Freddie faced a government takeover. On September , FHFA
Acting Deputy Director Chris Dickerson sent separate memos to Lockhart recom-
mending that FHFA be appointed conservator for each GSE.
Still, conservatorship was not a foregone conclusion. Paulson, Lockhart, and
Bernanke met with Mudd, Syron, and their boards to persuade them to cede con-
trol. Essentially the GSEs faced a Hobson’s choice: take the horse offered or none at
all. “They had to voluntarily agree to a consent agreement,” Lockhart told the FCIC.
The alternative, a hostile action, invited trouble and “nasty lawsuits,” he noted. “So we
made a . . . very strong case so the board of directors did not have a choice.” Paulson
reminded the GSEs that he had authority to inject capital, but he would not do so un-
less they were in conservatorship.
Mudd was “stunned and angry,” according to Paulson. Tom Lund, who ran Fan-
nie Mae’s single-family business, told the FCIC that conservatorship came as a sur-
prise to everyone. Levin told the FCIC that he never saw a government seizure
coming. He never imagined, he said, that Fannie Mae was or might become insol-
vent. Interviewed in , Mudd told the FCIC: “I did not think in any way it was
fair for the government to have been in a position of being in the chorus for the com-
pany to add capital, and then to inject itself in the capital structure.” The conserva-
torship memoranda reiterated all the damning evidence presented in the letters two
days earlier. Losses at Fannie Mae for the year were estimated to be between  bil-
lion and  billion. Freddie Mac’s memorandum differed only in the details. Its
losses, recorded at  billion in the first six months of , were projected to end up
between  and  billion by the end of the year.
Although the boards had a choice, the only realistic option was assent. “We were go-
ing to agree to go in a conservatorship anyway,” Syron told the FCIC. “There was a very
clear message that the [September ] letter was there as a mechanism to bring about a
result.” Mudd agreed, observing that “the purpose of the letter was really to force con-
servatorship.” The boards of both companies voted to accept conservatorship.
Both CEOs were ousted, but the fundamental problems persisted. As promised,
the Treasury was prepared to take two direct steps to support solvency. First, it would
buy up to  billion of senior preferred stock from the GSEs and extend them
short-term secured loans. In addition, it pledged to buy GSE mortgage–backed secu-
rities from Wall Street firms and others until the end of . Up front, Treasury
bought from each GSE  billion in preferred stock with a  dividend. Each GSE
also gave Treasury warrants to purchase common stock representing . of shares
outstanding. Existing common and preferred shareholders were effectively wiped
out. The decline in value of the preferred stock caused losses at many banks that held
 S E P T E M B E R     : T H E TA K E O V E R OF FA N N I E M A E AND F R E DDI E M AC 

these securities, contributing to the failure of  institutions and to the downgrading

of  to less than “well capitalized” by their regulators.
Paulson told the FCIC that he was “naive” enough to believe that the action would
halt the crisis because it “would put a floor under the housing market decline, and
provide confidence to the market.” He realized he was wrong on the next day, when,
as he told the FCIC, “Lehman started to go.” Former Treasury Assistant Secretary
Neel Kashkari agreed. “We thought that after we stabilized Fannie and Freddie that
we bought ourselves some time. Maybe a month, maybe three months. But they were
such profound interventions, stabilizing such a huge part of the financial markets,
that would buy us some time. We were surprised that Lehman then happened a week
later, that Lehman had to be taken over or it would go into bankruptcy.”
The firms’ failure was a huge event and increased the magnitude of the crisis, ac-
cording to Fed Governor Kevin Warsh and New York Fed General Counsel Tom Bax-
ter. Warsh also told the FCIC that the events surrounding the GSE takeover led to “a
massive, underreported, underappreciated jolt to the system.” Then, according to
Warsh, when the market grasped that it had misunderstood the risks associated with
the GSEs, and that the government could have conceivably let them fail, it “caused in-
vestors to panic about the value of every asset, to reassess every portfolio.”
FHFA Director Lockhart described the decision to put the GSEs into conservator-
ship in the context of Lehman’s failure. Given that the investment bank’s balance
sheet was about one-fifth the size of Fannie Mae’s, he felt that the fallout from
Lehman’s bankruptcy would have paled in comparison to a GSE failure. He said,
“What happened after Lehman would have been very small compared to these .
trillion institutions failing.” Major holders of GSE securities included the Chinese
and Russian central banks, which, between them, owned more than half a trillion
dollars of these securities, and U.S. financial firms and investment funds had even
more extensive holdings. A  Fed study concluded that U.S. banks owned more
than  trillion in GSE debt and securities—more than  of the banks’ Tier  cap-
ital and  of their total assets at the time.
Testifying before the FCIC, Mudd claimed that failure was all but inevitable. “In
, the companies had no refuge from the twin shocks of a housing crisis followed
by a financial crisis,” he said. “A monoline GSE structure asked to perform multiple
tasks cannot withstand a multiyear  home price decline on a national scale, even
without the accompanying global financial turmoil. The model allowed a balance of
business and mission when home prices were rising. When prices crashed far beyond
the realm of historical experience, it became ‘The Pit and the Pendulum,’ a choice be-
tween horrible alternatives.”

“THE WORSTRUN FINANCIAL INSTITUTION”

When interviewed by the FCIC, FHFA officials were very critical of Fannie’s manage-
ment. John Kerr, the FHFA examiner (and an OCC veteran) in charge of Fannie ex-
aminations, minced no words. He labeled Fannie “the worst-run financial
institution” he had seen in his  years as a bank regulator. Scott Smith, who became
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

associate director at FHFA after that agency replaced OFHEO, concurred; in his view,
Fannie’s forecasting capabilities were not particularly well thought out, and lacked a
variety of stress scenarios. Both officials noted Fannie’s weak forecasting models,
which included hundreds of market simulations but scarcely any that contemplated
declines in house prices. To Austin Kelly, an OFHEO examination specialist, there
was no relying on Fannie’s numbers, because their “processes were a bowl of
spaghetti.” Kerr and a colleague said that that they were struck that Fannie Mae, a
multitrillion-dollar company, employed unsophisticated technology: it was less tech-
savvy than the average community bank.
Nonetheless, OFHEO’s communications with Fannie prior to September  did
not fully reflect these criticisms. FHFA officials conceded that they had made mis-
takes in their oversight of Fannie and Freddie. They paid too much attention to fix-
ing operational problems and did not react to Fannie’s increasing credit risk.
Lockhart told the FCIC that more resources should have been dedicated to assessing
credit risk of their mortgage assets and guarantees. Current FHFA Acting Director
Edward DeMarco told the FCIC that it would not pass the “reasonable person test”
to deny that OFHEO took its eye off the ball by not paying sufficient attention to
credit risk and instead focused on operational risk, accounting and lack of audited
results.
To Mudd and others, OFHEO’s mistakes were not surprising. Mudd told the
FCIC that the regulators’ skill levels were “developing but below average.” Henry
Cisneros, a former housing and urban development secretary, expressed a similar
view. “OFHEO,” Cisneros told the FCIC, “was puny compared to what Fannie Mae
and Freddie Mac could muster in their intelligence, their Ivy League educations, their
rocket scientists in their place, their lobbyists, their ability to work the Hill.”
The costs of the bailouts have been enormous and are expected to increase. From
January , , through the third quarter of , the two companies lost  bil-
lion, wiping out  billion of combined capital that they had reported at the end of
 and the  billion of capital raised by Fannie in . Treasury narrowed the
gap with  billion in support. FHFA has estimated that costs through  will
range from  billion to  billion. The Congressional Budget Office has pro-
jected that the economic cost of the GSEs’ downfall, including the total financial
cost of government support as well as actual dollar outlays, could reach  billion
by .

“WASN’ T DONE AT MY PAY GRADE”

Fannie’s two most senior executives were asked at an FCIC hearing how their charter
could have been changed to make the company more sound, and to avoid the multi-
billion-dollar bailout. Mudd, who made approximately  million from  to
, testified that “the thing that would have made the institution more sound or
have produced a different outcome would have been for it to have become over time
a more normal financial institution able to diversify, able to allocate capital, able to be
 S E P T E M B E R    : T H E T A K E O V E R OF FA N N I E M A E AND F R E DDI E M AC 

long or short in the market, able to operate internationally. And if the trade for that
would have been, you know, a cut in the so-called implicit ties with the government, I
think that would have—that would have been a better solution.” Chief Business Of-
ficer Levin, who received approximately  million from  to , answered
only that making such decisions “wasn’t done at my pay grade.”

COMMISSION CONCLUSIONS ON CHAPTER 17

The Commission concludes that the business model of Fannie Mae and Freddie
Mac (the GSEs), as private-sector, publicly traded, profit-making companies with
implicit government backing and a public mission, was fundamentally flawed. We
find that the risky practices of Fannie Mae—the Commission’s case study in this
area—particularly from  on, led to its fall: practices undertaken to meet Wall
Street’s expectations for growth, to regain market share, and to ensure generous
compensation for its employees. Affordable housing goals imposed by the De-
partment of Housing and Urban Development (HUD) did contribute marginally
to these practices. The GSEs justified their activities, in part, on the broad and
sustained public policy support for homeownership. Risky lending and securiti-
zation resulted in significant losses at Fannie Mae, which, combined with its ex-
cessive leverage permitted by law, led to the company’s failure.
Corporate governance, including risk management, failed at the GSEs in part
because of skewed compensation methodologies. The Office of Federal Housing
Enterprise Oversight (OFHEO) lacked the authority and capacity to adequately
regulate the GSEs. The GSEs exercised considerable political power and were suc-
cessfully able to resist legislation and regulatory actions that would have strength-
ened oversight of them and restricted their risk-taking activities.
In early , the decision by the federal government and the GSEs to increase
the GSEs’ mortgage activities and risk to support the collapsing mortgage market
was made despite the unsound financial condition of the institutions. While these
actions provided support to the mortgage market, they led to increased losses at
the GSEs, which were ultimately borne by taxpayers, and reflected the conflicted
nature of the GSEs’ dual mandate.
GSE mortgage securities essentially maintained their value throughout the
crisis and did not contribute to the significant financial firm losses that were cen-
tral to the financial crisis.
 18
SEPTEMBER 2008:
THE BANKRUPTCY OF LEHMAN

CONTENTS
“Get more conservatively funded” ......................................................................
“This is not sounding good at all”.......................................................................
“Spook the market” ............................................................................................
“Imagination hat” ..............................................................................................
“Heads of family” ...............................................................................................
“Tell those sons of bitches to unwind”.................................................................
“This doesn’t seem like it is going to end pretty”..................................................
“The only alternative was that Lehman had to fail”...........................................
“A calamity” .......................................................................................................

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 af-
ternoon of Friday, September , , experts from the country’s biggest commer-
cial 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 -
year-old firm was solvent.
Only two days earlier, Lehman had reported shareholder equity—the measure of
solvency—of  billion at the end of August. Over the previous nine months, the
bank had lost  billion but raised more than  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 offi-
cials 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  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 rele-
vant 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


 SE P T E M B E R     : T H E BA N K RU P TC Y OF LEHMAN 

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  bil-
lion 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  billion in equity would be gone. In a
fire sale, some might sell for even less than half their stated value.
“What does solvent mean?” JP Morgan CEO Jamie Dimon responded when the
FCIC asked if Lehman had been solvent. “The answer is, I don’t know. I still could
not answer that question.” JP Morgan’s Chief Risk Officer Barry Zubrow testified be-
fore the FCIC that “from a pure accounting standpoint, it was solvent,” although “it
obviously was financing its assets on a very leveraged basis with a lot of short-term fi-
nancing.”
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 . 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 Paul-
son, 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 illiq-
uid.” Others, such as Bank of America CEO Ken Lewis, who that week considered
acquiring Lehman with government support, had no doubts either. He told the FCIC
that Lehman’s real estate and other assets had been overvalued by  to  bil-
lion—a message he had delivered to Paulson a few days before Lehman declared
bankruptcy.
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 philo-
sophical 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.”

“GET MORE CONSERVATIVELY FUNDED”

After the demise of Bear Stearns in March , 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 “con-
sumed” 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
, the day after JP Morgan announced its acquisition of Bear Stearns, the market
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

(through credit default swaps on Lehman’s debt) put the cost of insuring  million
of Lehman’s five-year senior debt at , annually; for Merrill Lynch, the cost
was ,; and for Goldman Sachs, ,.
The chief concerns were Lehman’s real estate–related investments and its reliance
on short-term funding sources, including . billion of commercial paper and 
billion of repos at the end of the first quarter of . There were also concerns about
the firm’s more than , derivative contracts with a myriad of counterparties.
As they did for all investments banks, the Fed and SEC asked: Did Lehman have
enough capital—real capital, after possible asset write-downs? And did it have suffi-
cient 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 cur-
tail 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 securi-
ties firms, but the Fed, as a consequence of its banking mandate, had more of an em-
phasis 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 ,
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 overreliant
on the PDCF for cash, which would signal funding problems.
Lehman built up its liquidity to  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 .
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  bil-
lion to  billion at the end of May and to  billion at the end of the summer. Sec-
ond, it raised new capital and longer-term debt—a total of . billion of preferred
stock and senior and subordinated debt from April through June .
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 ru-
mors and a liquidity crisis of confidence,” Fuld told the FCIC. “Immediately there-
 SE P T E M B E R     : T H E BA N K RU P TC Y OF LEHMAN 

after, 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 col-
lapse of Bear and Lehman or of the difficulties faced by other investment banks dur-
ing the fall of .” The SEC to date has not brought short selling charges related to
the failure of these investment banks.
On March , Lehman reported better-than-expected earnings of  million
for the first quarter of . Its stock jumped nearly , to .. But investors and
analysts quickly raised questions, especially concerning the reported value of
Lehman’s real estate assets. Portfolio.com 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 es-
tate loans and said, “There is good reason to question Lehman’s fair value calcula-
tions. . . . 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 , a grade it downgraded to F in September . On June , Lehman
announced a preliminary . billion loss for its second quarter—the first loss since it
became a public company in . The share price fell to . Three days later
Lehman announced it was replacing Chief Operating Officer Joseph Gregory and
Chief Financial Officer Erin Callan. The stock slumped again, to ..

“THIS IS NOT SOUNDING GOOD AT ALL”

After Lehman reported its final second-quarter results on June , 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 se-
cured 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 experi-
enced a full blown liquidity crisis,” he wrote.
Just one week after the earnings release, Harlow reported that Lehman was in-
deed having funding difficulties. Four financial institutions had “trading issues”
with Lehman and had reduced their exposure to the firm, including Natixis, a
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 Citi-
group requested a  to  billion “comfort deposit” to cover its exposure to
Lehman, settling later for  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, sen-
ior adviser in the Federal Reserve’s banking supervision and regulation division, was
short and direct: “This is not sounding good at all.”
On June , results from the regulators’ most recent stress test showed that
Lehman would need  billion more than the  billion in its liquidity pool to sur-
vive 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  billion at the end of November  to  billion at the end of May
. And it was reliant on repo funding, particularly the portions that matured
overnight and were collateralized by illiquid assets. As of mid-June,  of
Lehman’s liquidity was dependent on borrowing against nontraditional securities,
such as illiquid mortgage-related securities—which could not be financed with the
PDCF and of which investors were becoming increasingly wary.
On July , 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 Fed-
erated would “no longer pursue additional business with Lehman,” because JP Mor-
gan 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.

“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 Geith-
ner told Fuld was “gimmicky” and “[could not] solve a liquidity/capital problem.” A
proposal by the Fed’s Dudley followed the Bear Stearns model:  billion of
Lehman’s assets would be held by a new special-purpose vehicle, financed by  bil-
lion of Lehman’s equity and a  billion loan from the Fed. This proposal would re-
move 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  email to colleagues at the Federal Re-
serve and Treasury, Patrick Parkinson, then the deputy director of the Federal Re-
serve Board’s Division of Research and Statistics, described a “game plan” that would
() identify activities of Lehman that could significantly harm financial markets and
the economy if it filed for chapter  bankruptcy protection, () gather information
 SE P T E M B E R     : T H E BA N K RU P TC Y OF LEHMAN 

to more accurately assess the potential effects of its failure, and () identify risk miti-
gation actions for areas of serious potential harm.
As they now realized, regulators did not know nearly enough about over-the-
counter derivatives activities at Lehman and other investment banks, which were ma-
jor OTC derivatives dealers. Investment banks disclosed the total number of OTC
derivative contracts they had, the total exposures of the contracts, and their esti-
mated 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 impor-
tant to analyze the possible impact of a Lehman bankruptcy on derivatives counter-
parties and the financial markets.
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 private-sector 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 , Parkinson emailed New York Fed officials that he was worried that no
sensible game plan could be formulated without more information. He was in-
formed that New York Fed officials had just met with Lehman two days earlier to ob-
tain 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, be-
cause such a request would send a “huge negative signal.” The formation of the in-
dustry group seemed “less provocative,” wrote a New York Fed official, but could still
“spook the market.” Parkinson believed that the information was important, but at-
tempting 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 , Treasury’s Steve Shafran informed Parkinson that Secretary Paul-
son agreed on the need to collect information on OTC derivatives. It just had to be
done in a way that minimized disruptions. On September , 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 re-
port, to form an industry group to advise on information needed from a troubled in-
vestment 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 moot.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

On September , 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 . billion loss would reflect “significant asset
write-downs.” The firm was also considering several steps to bolster capital, includ-
ing an investment by Korea Development Bank or others, the sale of Lehman’s invest-
ment 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.
On Monday, September , more than  New York Fed officials were notified of a
meeting the next morning “to continue the discussion of near-term options for deal-
ing with a failing nonbank.” They received a list documenting Lehman’s tri-party
repo exposure at roughly  billion. Before its collapse, Bear Stearns’s exposure had
been only  to  billion. The documentation further noted that  counterpar-
ties provided  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 , news there would be no investment from Ko-
rea Development Bank shook the market. Lehman’s stock plunged  from the day
before, closing at .. To prepare for an afternoon call with Bernanke, Geithner di-
rected 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 : P.M., Paulson convened a call with Cox, Geithner, Bernanke, and Treasury
staff “to deal with a possible Lehman bankruptcy.” At : 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 . 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 re-
quested the collateral because of its growing exposure as a derivatives trading coun-
terparty to Lehman. Steven Black, JP Morgan’s president, said he requested 
billion from Lehman, which agreed to post . billion. He did not believe the re-
quest 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
 SE P T E M B E R     : T H E BA N K RU P TC Y OF LEHMAN 

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 pur-
chase 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 prean-
nouncing its third-quarter earnings at : the next morning. The amendments re-
quired 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 stop extending credit and clearing if the September
Agreements were not executed before the markets opened on [Wednesday,] Septem-
ber , .”
Before the market opened on Wednesday, Lehman announced its . billion
third-quarter loss, including a . 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] lines.”
“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 deci-
sions 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  billion from
over  billion the previous Friday; according to Fidelity’s response to an FCIC sur-
vey of market participants, in the week prior to Bear’s demise in March, Fidelity had
pulled its entire . billion repo line to that company.

“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 pri-
vate 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: () find a buyer at any price,
() wind down Lehman’s affairs, or () force it into bankruptcy. Regarding option ,
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 .” Option ,
bankruptcy, would be “[a] mess on every level, but fixes the moral hazard problem.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

On Wednesday night, a New York Fed official circulated a “Liquidation Consor-

tium” 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 (Sun-
day night, New York time) to devise a credible plan. The game plan stated that “we
should have in mind a maximum number of how much we are willing to finance be-
fore the meeting starts, but not divulge our willingness to do so to the consortium.”
Indeed, Paulson would tell the consortium when it met two days later that the gov-
ernment was willing to let Lehman fail.
Former Bank of America CEO Ken Lewis told the FCIC that Treasury Secretary
Paulson had called him on Wednesday, September , and asked him to take another
look at acquiring Lehman, assuring him that Fuld was ready to deal. 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 as-
sets were overvalued, and Lewis told Paulson there would be no deal without govern-
ment 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 , Lewis called Paulson to
repeat his assessment—no government support, no deal. Apparently Fuld had been
kept out of the loop, and began to call Lewis at home. Lewis’s wife told Fuld that
Lewis would not come to the phone and to stop calling.
On Thursday September , an email time-stamped : A.M. from Susan Mc-
Cabe, a Goldman Sachs executive, to Dudley and others set the tone for the day: “It is
not pretty, This is getting pretty scary and ugly again. . . . They [Lehman] have much
bigger counter-party risk than Bear did, especially in Derivatives market, so [t]he
market is getting very spooked, nervous. Also have Aig, Wamu concerns. This is just
spinning out of control again. Just fyi, this is shaping up as going to be a rough day.”
Bernanke was informed that if Lehman failed, “it would be a much more complex
proposition to unwind their positions than it would have been to unwind the posi-
tions held by Bear Stearns,” because Lehman was “nearly twice the size of Bear
Stearns.”
Some believed government action was required. At : 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 funda-
mental problem, which is too many bad assets that need to get off too many balance
sheets.”
 SE P T E M B E R     : T H E BA N K RU P TC Y OF LEHMAN 

At : P.M., Fed officials circulated the outline of a plan to create a “Lehman De-
fault 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 com-
mon valuation method. A little before midnight on Thursday, Boesky notified col-
leagues 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  to , where  is Bear-Stearns-week-panic, I would
put sentiment today at a .”
At almost the same time, JP Morgan demanded that Lehman post another  bil-
lion in cash “by the opening of business tomorrow in New York”; if it didn’t, JP Mor-
gan 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  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 . So
Lehman “delivered the  billion in cash only by pulling virtually every unencum-
bered asset it could deliver.”
JP Morgan’s Zubrow saw it differently. He told the FCIC that the previously
posted . billion of collateral by Lehman was “inappropriate” because it was “illiq-
uid” and “could not be reasonably valued.” Moreover, Zubrow said the potential col-
lateral shortfall was greater than  billion. Lehman’s former CEO, Fuld, told the
FCIC that he agreed to post the  billion because JP Morgan said it would be re-
turned to Lehman at the close of business the following day. The Lehman bank-
ruptcy estate made the same allegation. This dispute is now the subject of litigation;
the Lehman bankruptcy estate is suing JP Morgan to retrieve the  billion—and the
original . billion.

“HEADS OF FAMILY”
Should Lehman be allowed to go bankrupt? Within the government, sentiments var-
ied. On Friday morning, as Secretary Paulson headed to New York to “sort through
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 Gover-
nor 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 fam-
ily”—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 bank-
ruptcy. 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, re-
sulting in collateral calls and reduced liquidity: that is, systemic risk. He could not of-
fer the prospect of containing the damage if the executives were unable to fashion an
orderly resolution of the situation, as had been done in  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 ex-
traordinary 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 diffi-
cult 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 Co-
hen’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 as-
sistance 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 Lehman.”

“TELL THOSE SONS OF BITCHES TO UNWIND”

What would happen if JP Morgan refused to provide intraday credit for Lehman in
the tri-party repo market on Monday, September ? 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-
 SE P T E M B E R     : T H E BA N K RU P TC Y OF LEHMAN 

dealer to live 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 week-
end 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 facil-
ity. 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 ex-
ecutives reviewing Lehman’s assets had estimated that they were overvalued by any-
where from  to  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  per share, payable in Bank of America stock.
On Saturday afternoon, Lehman’s counsel provided the Fed with a document de-
scribing 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 partici-
pated 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, be-
cause 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 re-
sult from a Lehman bankruptcy had been avoided. An agreement apparently had
been reached. Barclays would purchase Lehman, excluding  to  billion of as-
sets 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 completed.

“THIS DOESN’T SEEM LIKE IT IS GOING TO END PRETTY”

But on Sunday, things went terribly wrong. At : 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 obliga-
tions 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 share-
holder vote, which could take  to  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.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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.”
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 re-
ject 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 re-
quired, because JP Morgan had to provide the same type of guarantee when it ac-
quired 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 obliga-
tions 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 gov-
ernment assistance: “No way [government] money is coming in. . . . I’m here writing
the usg coms [United States government communications] plan for orderly un-
wind . . . 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 winddown unless bar-
clays 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 trans-
action: “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 chil-
dren 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 Bar-
clays to accept the guarantee, which could have a grave impact on the British econ-
omy, 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 Ameri-
can bank,’ which in effect meant the British taxpayer was underwriting an Ameri-
can bank.”
Following that decision in London, Lehman Brothers was, for all practical pur-
poses, 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 presi-
 SE P T E M B E R     : T H E BA N K RU P TC Y OF LEHMAN 

dent 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 : 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 pro-
gram. 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 Lehman to provide the ex-
panded 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 : P.M. on that Sunday, September , 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  board meeting show that the Fed rejected
Lehman’s request for an even broader range of collateral to be eligible for PDCF fi-
nancing 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 , the New York Fed informed Lehman Sen-
ior Vice President Robert Guglielmo that the broker-dealer could finance expanded
types of collateral with the PDCF, but that letter was not sent until : A.M. on Sep-
tember —after Lehman had filed for bankruptcy. The Lehman broker-dealer
borrowed  to  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 plan-
ning 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.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

“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  to  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 be-
lieved 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 con-
vince 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 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—

it was like a scene from [the  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 hun-
dreds 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 gov-
ernment 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 gov-
 SE P T E M B E R     : T H E BA N K RU P TC Y OF LEHMAN 

ernment’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 bank-
ruptcy. The company filed at : A.M. on Monday morning.

“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
short-term 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.

“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 cor-
porations 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
occurred.”
On the day that Lehman filed for bankruptcy, the Dow plummeted more than 
points;  billion in value from retirement plans, government pension funds, and
other investment portfolios disappeared.
As for Lehman itself, the bankruptcy affected about , subsidiaries and affiliates
with  billion in assets and liabilities, the firm’s more than , creditors, and
about , employees. Its failure triggered default clauses in derivatives contracts,
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

allowing its counterparties to have the option of seizing its collateral and terminating
the contracts. After the parent company filed, about  insolvency proceedings of its
subsidiaries in  foreign countries followed. In the main bankruptcy proceeding,
about , claims—exceeding  billion—have been filed against Lehman as of
September . 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  bil-
lion; 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 be-
hind 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 capi-
tal or to make guarantees.” A Sunday afternoon email from Bernanke to Fed Gov-
ernor Warsh indicated that more than  billion in capital assistance would have
been needed to prevent Lehman’s failure. “In case I am asked: How much capital in-
jection would have been needed to keep LEH alive as a going concern? I gather B
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 () 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 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 provid-
ing assistance to Lehman was not the explanation he offered days after the bank-
ruptcy—at that time, he said that he believed the market was prepared for the
event. On September , , he testified: “The failure of Lehman posed risks. But
the troubles at Lehman had been well known for some time, and investors clearly rec-
ognized—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 pos-
sibility. Thus, we judged that investors and counterparties had had time to take pre-
cautionary 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 (), the au-
thority 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
 SE P T E M B E R     : T H E BA N K RU P TC Y OF LEHMAN 

bank.” Indeed, in March , Federal Reserve General Counsel Scott Alvarez con-
cluded that requiring loans under () to be fully secured would “undermine the
very purpose of section (), which was to make credit available in unusual and ex-
igent circumstances to help restore economic activity.”
To CEO Fuld and others, the Fed’s emergency lending powers under section ()
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 (). Fuld asserted to the FCIC
that in fact, “Lehman had adequate financeable collateral. . . . [O]n September , 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 Sun-
day 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 , , two
weeks prior to the bankruptcy filing, Lehman had . . . . billion in equity capital.
Positive equity of . billion is very different from the negative  or  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.”
During the September , , meeting of the Fed’s Federal Open Market Com-
mittee, 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 disor-
derly failure of a key firm could have a broad and disruptive effect on financial mar-
kets 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 fi-
nancial 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 rec-
ollection 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 dif-
ferent 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 un-
folded 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 repay-
ment—this hearing and other hearings would have only been about how we wasted
the taxpayers’ money.”
 SE P T E M B E R     : T H E BA N K RU P TC Y OF LEHMAN 

COMMISSION CONCLUSIONS ON CHAPTER 18

The Commission concludes the financial crisis reached cataclysmic proportions
with the collapse of Lehman Brothers.
Lehman’s collapse demonstrated weaknesses that also contributed to the failures
or near failures of the other four large investment banks: inadequate regulatory
oversight, risky trading activities (including securitization and over-the-counter
(OTC) derivatives dealing), enormous leverage, and reliance on short-term fund-
ing. While investment banks tended to be initially more vulnerable, commercial
banks suffered from many of the same weaknesses, including their involvement in
the shadow banking system, and ultimately many suffered major losses, requiring
government rescue.
Lehman, like other large OTC derivatives dealers, experienced runs on its de-
rivatives operations that played a role in its failure. Its massive derivatives posi-
tions greatly complicated its bankruptcy, and the impact of its bankruptcy
through interconnections with derivatives counterparties and other financial in-
stitutions contributed significantly to the severity and depth of the financial crisis.
Lehman’s failure resulted in part from significant problems in its corporate
governance, including risk management, exacerbated by compensation to its ex-
ecutives and traders that was based predominantly on short-term profits.
Federal government officials decided not to rescue Lehman for a variety of
reasons, including the lack of a private firm willing and able to acquire it, uncer-
tainty about Lehman’s potential losses, concerns about moral hazard and political
reaction, and erroneous assumptions that Lehman’s failure would have a manage-
able impact on the financial system because market participants had anticipated
it. After the fact, they justified their decision by stating that the Federal Reserve
did not have legal authority to rescue Lehman.
The inconsistency of federal government decisions in not rescuing Lehman af-
ter having rescued Bear Stearns and the GSEs, and immediately before rescuing
AIG, added to uncertainty and panic in the financial markets.
 19
SEPTEMBER 2008:
THE BAILOUT OF AIG

CONTENTS
“Current liquidity position is precarious” ...........................................................
“Spillover effect” .................................................................................................
“Like a gnat on an elephant” ..............................................................................

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 ,
they were almost certain  billion in cash could not keep the company alive through
the next week. The AIG corporate empire held more than  trillion in assets, but
most of the liquid assets, including cash, were held by regulated insurance sub-
sidiaries 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  billion on hand.
On Friday, September , , AIG was facing challenges on a number of fronts.
It had to fund . billion of its own commercial paper on that day because tradi-
tional investors—for example, money market funds—no longer wanted even short-
term unsecured exposure to AIG; and the company had another . billion coming
due the following week. On another front, the repo lenders—who had the comfort
of holding collateral for their loans to AIG (. billion in mostly overnight fund-
ing)—were nonetheless becoming skittish about the perceived weakness of the com-
pany 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 , counterparties were demanding
. billion, and AIG had posted . billion. By September , the calls had
soared to . billion, and AIG had paid . billion—. 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 down-
grades to AIG’s credit rating, which, if they happened, would lead to an estimated
 billion in new collateral calls. A downgrade would also trigger liquidity puts that


 SE P T E M B E R     : T H E BA I LOU T OF A IG 

AIG had written on commercial paper, requiring AIG to come up with another  to
 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
 and  of the market value of the securities they lent. As borrowers began
questioning AIG’s stability, the company had to accept below-market terms—some-
times accepting cash equal to only  of the value of the securities. Furthermore,
AIG had invested this cash in mortgage-related assets, whose value had fallen. Since
September , state regulators had worked with AIG to reduce exposures of the se-
curities 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 , AIG had invested  billion in cash in
mortgage-related securities, which had declined in value to . billion. By late Au-
gust , the parent company had to provide . billion to its struggling securities
lending subsidiary, and counterparties were demanding  billion to offset the
shortfall between the cash collateral provided and the diminished value of the securi-
ties. According to Dinallo, the collateral call disputes between AIG and its credit de-
fault swap counterparties hindered an orderly wind down of the securities lending
business, and in fact accelerated demands from securities lending counterparties.
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 Timo-
thy 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 emergency meeting regarding another beleaguered American institution. “Bot-
tom line,” the New York Fed later reported of that meeting, “[AIG’s] Treasurer esti-
mates that parent and [Financial Products] have – days before they are out of
liquidity.”
AIG posed a simple question: how could it obtain an emergency loan under the
Federal Reserve’s () authority? Without a solution, there was no way this con-
glomerate, despite more than  trillion in assets, would survive another week.

“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 effec-
tively opened its discount window—traditionally available only to depository institu-
tions—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 emer-
gency collateralized funding to even more large institutions that were systemically
important. That led the regulators to look closely at two trillion-dollar holding com-
panies, AIG and GE Capital. Both were large participants in the commercial paper
market: AIG with  billion in outstanding paper, GE Capital with  billion. In
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

August, the New York Fed set up a team to study the two companies’ funding and liq-
uidity risk.
On August , 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
, , Kevin Coffey, an analyst from the Financial Sector Policy and Analysis unit,
wrote that despite raising  billion earlier in the year, “AIG is under increasing cap-
ital 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: () AIG’s significant losses on investments, primarily
because of securities lending activities; () . billion in mark-to-market losses on
AIG Financial Products’ credit default swap book and related margin calls, for which
AIG had posted . billion in collateral by mid-August; () significant near-term
liabilities; () commitments to purchase collateralized debt obligations due to out-
standing liquidity puts; () ratings-based triggers in derivative contracts that could
cause significant additional collateral calls if AIG were downgraded; and () 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 
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, Capi-
tal Raise on the Horizon,” warned that “we foresee – 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 uni-
verse, and foresee outcomes similar in nature but on a much larger scale.” Goldman
appeared to be referring to Bear Stearns. Ira Selig, a manager at the New York Fed,
emailed the Goldman report to Coffey and others. “The bottom line: large scale cash
outflows and posting of collateral could substantially weaken AIG’s balance sheet,”
the manager wrote.
On September , the New York Fed’s Danielle Vicente noted the situation had
worsened: “AIG’s current liquidity position is precarious and asset liability manage-
ment appears inadequate given the substantial off balance sheet liquidity needs.” Liq-
uidating an  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 fund-
ing sources made the firm vulnerable to runs. Off-balance-sheet commitments—in-
cluding collateral calls, contract terminations, and liquidity puts—could be as high as
 SE P T E M B E R     : T H E BA I LOU T OF A IG 

 billion if AIG was downgraded. Yet AIG had only  billion of revolving credit
facilities in addition to the  to  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. In-
deed, Goldman’s August  report on AIG concluded that the firm itself and the rat-
ing agencies were in denial about impending losses.
By early September, management was no longer in denial. At the Friday, Septem-
ber , 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 , would trigger bil-
lions of dollars in collateral calls, liquidity puts, and other liquidity needs. AIG’s
stock had fallen significantly (shares hit an intraday low of . Friday, down from
a . close the day before) and credit default swap spreads had reached  dur-
ing the day, indicating that protection on  million of AIG debt would cost ap-
proximately . million per year. AIG reported it was having problems with its
commercial paper, able to roll only . billion of the . billion that matured on
September . In addition, some banks were pulling away and even refusing to pro-
vide repo funding. Assets were illiquid, their values had declined, borrowing was
restricted, and raising capital was not viable.

“SPILLOVER EFFECT”
The New York Fed knew that a failure of AIG would have dramatic, far-reaching con-
sequences. By the evening of September , 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 expo-
sure 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 take-
away is that they are potentially facing a severe run on their liquidity over the course
of the next several (approx. ) days if they are downgraded. . . . Their risk exposures
are concentrated among the  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 failure.”
New York Fed officials met on Saturday morning, and gathered additional infor-
mation about AIG’s financial condition, but according to New York Fed General
Counsel Tom Baxter, it “seemed clear that the private sector solution would material-
ize for AIG.” Indeed, Christopher Flowers, head of J. C. Flowers & Co., a private eq-
uity firm, had spoken to AIG CEO Robert Willumstad the prior Thursday, and the
two had called Warren Buffett to discuss a possible deal. Willumstad told the FCIC
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

that he was in contact with about a dozen private equity firms over the weekend.
AIG executives also worked with then-Superintendent Eric Dinallo to help craft a
deal that would have allowed AIG’s regulated subsidiaries to essentially lend money
to the parent company. Fed officials reported to AIG executives during a conference
call on Saturday that “they should not be particularly optimistic [about financial as-
sistance], given the hurtles [sic] and history of [the Fed’s] - lending [authority].”
And by the end of the day on Saturday, AIG appeared to the Fed to be pursuing pri-
vate-sector leads. “It was clear from the conversation that Flowers [is] actively in-
volved in working with everything (AIG, regulators, bankers, etc) in putting together
both the ‘term sheet’ with AIG, and providing analysis to NYSID on liquidity profile
of the parent company,” Patricia Mosser, a senior vice president at the New York Fed,
wrote to LaTorre and others.
On Sunday morning, September , Adam Ashcraft of the New York Fed circu-
lated a memo, “Comment on Possible - 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 giv-
ing [AIG] access to the discount window, and avoid making otherwise hard but vi-
able options: sell or hedge the CDO risk (little to no impact on capital), sell
subsidiaries, or raise capital.”
Before a : 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
B 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 . trillion over-the-counter derivatives portfolio of which 
trillion was concentrated in  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 - 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 LaTorre referred to had hit a wall, however. By Sunday
afternoon, Flowers had been “summarily dismissed” by AIG’s board. Flowers told the
FCIC that under his proposal, his firm and Allianz, the giant insurance company,
would have each invested  billion in exchange for the stock of AIG subsidiaries. With
 SE P T E M B E R     : T H E BA I LOU T OF A IG 

approval from the NYSID, the subsidiaries would “upstream”  billion to the parent
company, and the parent company would get access to bridge financing from the Fed.
Then, Allianz would take control of AIG almost immediately. Flowers said that he was
surprised by AIG’s unwillingness to negotiate. “I’m not saying it would have worked or
that it was perfect as written, but it was astounding to me that given what happened,
nobody bothered to check this [deal] out,” he said. Willumstad referred to the Flowers
deal as a “so-called offer”—he did not consider it to be a “serious effort,” and so it was
“dismissed immediately.” With respect to the other potential investors AIG spoke with
over the weekend, Willumstad said that negotiations were unsuccessful because every
potential deal would have required government assistance—something Willumstad
had been assured by the “highest levels” would not be forthcoming.
On Monday morning—after Lehman had declared bankruptcy, and with no pri-
vate-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  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 A and A,
respectively. The downgrades triggered an additional  billion in cash collateral
calls on AIG Financial Products’ credit default swaps. Goldman Sachs alone requested
. billion. Demands hit  billion, and AIG’s payouts increased to . billion.
The company’s stock plummeted  to . from the closing price of . the
previous Friday—a fraction of its all-time high of ..
The syndicate of banks did not agree on a deal, despite the expectations of Fed of-
ficials. “Once Lehman filed [for bankruptcy] on the morning of the th, everyone
decided that, ‘we’ve got to protect our own balance sheet,’ and the banks that were go-
ing to provide the  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.
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 () 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 brand-name 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 is-
sues. In addition, the staff noted that money market funds had even broader expo-
sure to AIG than to Lehman and that the parent company could run out of money
quite soon, even within days.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

On Tuesday morning, the Fed put a number on the table: it would loan  billion
so that AIG could meet its immediate obligations. The collateral would be the assets
of the parent company and its primary nonregulated subsidiaries, plus the stock of al-
most 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
.. The previous eight years’ profits of  billion would be dwarfed by the .
billion loss for this one year, .
But  billion would soon prove insufficient. Treasury added . billion under
its Troubled Asset Relief Program (TARP). Ultimately, according to the Congres-
sional Oversight Panel, taxpayer funds committed to AIG reached  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 De-
partment 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.”

“LIKE A GNAT ON AN ELEPHANT”

The Office of Thrift Supervision has acknowledged failures in its oversight of AIG. In
a March , , 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 , 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 ig-
nored the OTS’s responsibilities under the European Union’s Financial Conglomer-
ates Directive (FCD)—responsibilities 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 , the OTS worked
to persuade the European Union that it was capable of serving as AIG’s “home coun-
try consolidated supervisor.” In  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 Fi-
nancial Products, which he said had slipped through a regulatory gap.
 SE P T E M B E R     : T H E BA I LOU T OF A IG 

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  to November , 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 – period. After a limited review in July —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 . The agency’s stated reason was
its limited time and staff resources.
In February , AIG reported billions of dollars in losses and material weak-
nesses 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 —ten days before
AIG went to the Fed seeking a rescue—completing the review on October , more
than a month after AIG failed. It was, former OTS director of Conglomerate Opera-
tions Brad Waring admitted, “in hindsight, a bad choice.”
Reich told the FCIC that before , AIG had not been a great concern. He also
acknowledged that the OTS had never fully understood the Financial Products unit,
and thus couldn’t regulate it. “At the simplest level, . . . an organization like OTS can-
not supervise AIG, GE, Merrill Lynch, and entities that have worldwide offices. . . . I
would be the first to say that for an organization like OTS to pretend that it has total
responsibility over AIG and all of its subsidiaries . . . it’s like a gnat on an elephant—
there’s no way.” Reich said that for the OTS to think it could regulate AIG was “totally
impractical and unrealistic. . . . I think we thought we could grow into that responsi-
bility. . . . But I think that was sort of pie in the sky dreaming.”
Geithner agreed, and told Reich so bluntly. Reich told the FCIC about a phone call
from Geithner after the rescue. “About all I can remember is the foul language that I
heard on the other end of the line,” Reich said. He recalled Geithner telling him.
“‘You guys have handed me a bag of sh*t.’ I just listened.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

COMMISSION CONCLUSIONS ON CHAPTER 19

The Commission concludes AIG failed and was rescued by the government prima-
rily because its enormous sales of credit default swaps were made without putting
up initial collateral, setting aside capital reserves, or hedging its exposure—a pro-
found failure in corporate governance, particularly its risk management practices.
AIG’s failure was possible because of the sweeping deregulation of over-the-
counter (OTC) derivatives, including credit default swaps, which effectively elim-
inated federal and state regulation of these products, including capital and margin
requirements that would have lessened the likelihood of AIG’s failure. The OTC
derivatives market’s lack of transparency and of effective price discovery exacer-
bated the collateral disputes of AIG and Goldman Sachs and similar disputes be-
tween other derivatives counterparties. AIG engaged in regulatory arbitrage by
setting up a major business in this unregulated product, locating much of the
business in London, and selecting a weak federal regulator, the Office of Thrift
Supervision (OTS).
The OTS failed to effectively exercise its authority over AIG and its affiliates: it
lacked the capability to supervise an institution of the size and complexity of AIG,
did not recognize the risks inherent in AIG’s sales of credit default swaps, and did
not understand its responsibility to oversee the entire company, including AIG
Financial Products. Furthermore, because of the deregulation of OTC derivatives,
state insurance supervisors were barred from regulating AIG’s sale of credit de-
fault swaps even though they were similar in effect to insurance contracts. If they
had been regulated as insurance contracts, AIG would have been required to
maintain adequate capital reserves, would not have been able to enter into con-
tracts requiring the posting of collateral, and would not have been able to provide
default protection to speculators; thus AIG would have been prevented from act-
ing in such a risky manner.
AIG was so interconnected with many large commercial banks, investment
banks, and other financial institutions through counterparty credit relationships
on credit default swaps and other activities such as securities lending that its po-
tential failure created systemic risk. The government concluded AIG was too big
to fail and committed more than  billion to its rescue. Without the bailout,
AIG’s default and collapse could have brought down its counterparties, causing
cascading losses and collapses throughout the financial system.
 20
CRISIS AND PANIC

CONTENTS
Money market funds: “Dealers weren’t even picking up their phones” ...............
Morgan Stanley: “Now we’re the next in line”.....................................................
Over-the-counter derivatives: “A grinding halt” .................................................
Washington Mutual: “It’s yours”.........................................................................
Wachovia: “At the front end of the dominoes as other dominoes fell”.................
TARP: “Comprehensive approach” ....................................................................
AIG: “We needed to stop the sucking chest wound in this patient”.....................
Citigroup: “Let the world know we will not pull a Lehman”...............................
Bank of America: “A shotgun wedding” .............................................................

September , —the date of the bankruptcy of Lehman Brothers and the
takeover of Merrill Lynch, followed within  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 sus-
pected 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 ac-
cess to the federal government’s safety net.
John Mack, CEO of Morgan Stanley during the crisis, told the FCIC, “In the imme-
diate wake of Lehman’s failure on September , Morgan Stanley and similar institu-
tions experienced a classic ‘run on the bank,’ as investors lost confidence in financial
institutions and the entire investment banking business model came under siege.”
“The markets were very bad, the volatility, the illiquidity, some things couldn’t
trade at all, I mean completely locked, the markets were in terrible shape,” JP Morgan
CEO Jamie Dimon recalled to the FCIC. He thought the country could face  un-
employment. “We could have survived it in my opinion, but it would have been terri-
ble. I would have stopped lending, marketing, investing . . . and probably laid off
, people. And I would have done it in three weeks. You get companies starting
to take actions like that, that’s what a Great Depression is.”
Treasury Secretary Timothy Geithner told the FCIC, “You had people starting to
take their deposits out of very, very strong banks, long way removed in distance and


 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

risk and business from the guys on Wall Street that were at the epicenter of the prob-
lem. And that is a good measure, classic measure of incipient panic.” In an interview
in December , Geithner said that “none of [the biggest banks] would have sur-
vived a situation in which we had let that fire try to burn itself out.”
Fed Chairman Ben Bernanke told the FCIC, “As a scholar of the Great Depres-
sion, I honestly believe that September and October of  was the worst financial
crisis in global history, including the Great Depression. If you look at the firms that
came under pressure in that period . . . only one . . . was not at serious risk of fail-
ure. . . . So out of maybe the ,  of the most important financial institutions in the
United States,  were at risk of failure within a period of a week or two.”
As it had on the weekend of Bear’s demise, the Federal Reserve announced new
measures on Sunday, September , 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. By the end of September, Morgan Stanley was getting by on
. billion of Fed-provided life support; Goldman was receiving . billion.
But the new measures did not quell the market panic. Among the first to be di-
rectly affected were the money market funds and other institutions that held
Lehman’s  billion in unsecured commercial paper and made loans to the company
through the tri-party repo market. Investors pulled out of funds with known expo-
sure to that jeopardy, including the Reserve Management Company’s Reserve Pri-
mary Fund and Wachovia’s Evergreen Investments.
Other parties with direct connections to Lehman included the hedge funds, in-
vestment banks, and investors who were on the other side of Lehman’s more than
, over-the-counter derivatives contracts. For example, Deutsche Bank, JP
Morgan, and UBS together had more than , outstanding trades with Lehman
as of May . The Lehman bankruptcy caused immediate problems for these OTC
derivatives counterparties. They had the right under U.S. bankruptcy law to termi-
nate their derivatives contracts with Lehman upon its bankruptcy, and to the extent
that Lehman owed them money on the contracts they could seize any Lehman collat-
eral that they held. However, any additional amount owed to them had to be claimed
in the bankruptcy proceeding. If they had posted collateral with Lehman, they would
have to make a claim for the return of that collateral, and disputes over valuation of
the contracts would still have to be resolved. These proceedings would delay payment
and most likely result in losses. Moreover, any hedges that rested on these contracts
were now gone, increasing risk.
Investors also pulled out of funds that did not have direct Lehman exposure. The
managers of these funds, in turn, pulled  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 de-
 CRISIS AND PA N I C 

Cost of Interbank Lending

As concerns about the health of bank counterparties spread, lending banks
demanded higher interest rates to compensate for the risk. The one-month LIBOR-
OIS spread measures the part of the interest rates banks paid other banks that is due
to this credit risk. Strains in the interbank lending markets appeared just after the
crisis began in 2007 and then peaked during the fall of 2008.
IN PERCENT, DAILY
4%

0
2005 2006 2007 2008 2009

NOTE: Chart shows the spread between the one-month London Interbank Offered Rate (LIBOR) and the
overnight index swap rate (OIS), both closely watched interest rates.
SOURCE: Bloomberg

Figure .

pended on those markets. “When the commercial paper market died, the biggest
corporations in America thought they were finished,” Harvey Miller, the bankruptcy
attorney for the Lehman estate, told the FCIC.
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 Mor-
gan). Hedge funds withdrew tens of billions of dollars of assets held in custody at the re-
maining 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
Morgan, Credit Suisse, Deutsche Bank), because the commercial banks had more di-
verse sources of liquidity than the investment banks as well as large bases of insured de-
posits. 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 an-
other; the cost of interbank lending rose to unprecedented levels (see figure .).
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

On Monday, September , the Dow Jones Industrial Average fell more than 
points, or , the largest single-day point drop since the / terrorist attacks.
These drops would be exceeded on September —the day that the House of Repre-
sentatives initially voted against the  billion Troubled Asset Relief Program
(TARP) proposal to provide extraordinary support to financial markets and firms—
when the Dow Jones fell  and financial stocks fell . For the month, the S&P
 would lose  billion of its value, a decline of —the worst month since
September .
And specific institutions would take direct hits.

MONEY MARKET FUNDS:

“DEALERS WEREN’ T EVEN PICKING UP THEIR PHONES”
When Lehman declared bankruptcy, the Reserve Primary Fund had  million in-
vested in Lehman’s commercial paper. The Primary Fund was the world’s first money
market mutual fund, established in  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 , the fund had advised investors that it had “slightly underper-
formed” its rivals, owing to a “more conservative and risk averse manner” of invest-
ing—“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  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 fastest-growing money market fund complex in the United States in
, , and —doubling in the first eight months of  alone.
Earlier in , 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 days, Primary
Fund Portfolio Manager Michael Luciano told the FCIC. But after the government-
assisted rescue of Bear, Luciano, like many other professional investors, said he as-
sumed 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 sys-
temic risks, ran into trouble. These firms, Luciano said, were too big to fail.
On September , when Lehman declared bankruptcy, the Primary Fund’s
Lehman holdings amounted to . of the fund’s total assets of . billion. That
morning, the fund was flooded with redemption requests totaling . 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 : 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
 CRISIS AND PA N I C 

committed to maintaining a . net asset value, investors requested an additional

 billion later on Monday and Tuesday, September .
Meanwhile, on Monday, the fund’s board had determined that the Lehman paper
was worth  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 :PM New York time today.” As a result,
the fund broke the buck. Four days later, the fund sought SEC permission to offi-
cially suspend redemptions.
Other funds suffering similar losses were propped up by their sponsors. On Mon-
day, Wachovia’s asset management unit, Evergreen Investments, announced that it
would support three Evergreen mutual funds that held about  million in
Lehman paper. On Wednesday, BNY Mellon announced support for various funds
that held Lehman paper, including the  billion Institutional Cash Reserves fund
and four of its trademark Dreyfus funds. BNY Mellon would take an after-tax charge
of  million because of this decision. Over the next two years,  money market
funds— based in the United States,  in Europe—would receive such assistance
to keep their funds from breaking the buck.
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 expo-
sure 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.”
“We were really cognizant of the fact that there weren’t backstops in the system
that were resilient at that time,” the Fed’s Michael Palumbo said. “Liquidity crises, by
their nature, invoke rapid, emergent episodes—that’s what they are. By their nature,
they spread very quickly.”
An early and significant casualty was Putnam Investments’  billion Prime
Money Market Fund, which was hit on Wednesday with a wave of redemption re-
quests. The fund, unable to liquidate assets quickly enough, halted redemptions. One
week later, it was sold to Federated Investors.
Within a week, investors in prime money market funds—funds that invested in
highly rated securities—withdrew  billion; within three weeks, they withdrew
another  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 (see figure .). As a result of the un-
precedented demand for Treasuries, the yield on four-week Treasuries fell close to
, 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. “We heard
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Investments in Money Market Funds

In a flight to safety, investors shifted from prime money market funds to
money market funds investing in Treasury and agency securities.

IN TRILLIONS OF DOLLARS, DAILY

$2

1.5 Prime
Treasury and
government
1

.5

0
AUG. 2008 SEPT. OCT.
SOURCE: Crane Data

Figure .

anecdotally that the dealers weren’t even picking up their phones. The funds had to
get rid of their paper; they didn’t have anyone to give it to,” McCabe said.
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  billion to  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 pa-
per 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  (see figure .).
“You had a broad-based run on commercial paper markets,” Geithner told the
FCIC. “And so you faced the prospect of some of the largest companies in the world
and the United States losing the capacity to fund and access those commercial paper
markets.” Three decades of easy borrowing for those with top-rated credit in a very
liquid market had disappeared almost overnight. The panic threatened to disrupt the
payments system through which financial institutions transfer trillions of dollars in
 CRISIS AND PA N I C 

Cost of Short-Term Borrowing

During the crisis, the cost of borrowing for lower-rated nonfinancial firms spiked.
IN PERCENT, DAILY
7%

0
2007 2008 2009
 
    
           
!   
   "# $%           
     &
'() * ( + ,  - . + 

Figure .

cash and assets every day and upon which consumers rely—for example, to use their
credit cards and debit cards. “At that point, you don’t need to map out which particu-
lar mechanism—it’s not relevant anymore—it’s become systemic and endemic and it
needs to be stopped,” Palumbo said.
The government responded with two new lending programs on Friday, Septem-
ber . Treasury would guarantee the  net asset value of eligible money market
funds, for a fee paid by the funds. And the Fed would provide loans to banks to pur-
chase high-quality-asset-backed commercial paper from money market funds. In
its first two weeks, this program loaned banks  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  banks, insurance companies, and securities firms.
This action, taken on September , 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  financial stocks in order to protect them from “un-
lawful manipulation.”
Meanwhile, Treasury Secretary Henry Paulson and other senior officials had de-
cided they needed a more systematic approach to dealing with troubled firms and
troubled markets. Paulson started seeking authority from Congress for TARP. “One
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

thing that was constant about the crisis is that we were always behind. It was always
morphing and manifesting itself in ways we didn’t expect,” Neel Kashkari, then assis-
tant secretary of the treasury, told the FCIC. “So we knew we’d get one shot at this au-
thority and it was important that we provided ourselves maximum firepower and
maximum flexibility. We specifically designed the authority to allow us basically to
do whatever we needed to do.” Kashkari “spent the next two weeks basically living on
Capitol Hill.” As discussed below, the program was a tough sell.

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 , the annual cost of protecting  million in
Morgan Stanley debt through credit default swaps jumped to ,—from
, 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  billion—Goldman’s was 
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 Wong well knew that rumors about derivatives counterpar-
ties fleeing through novations had contributed to the demise of Bear and Lehman.
Repo lenders, primarily money market funds, likewise did not panic immediately.
On Monday, only a few of them requested slightly more collateral.
But the relative stability was fleeting. Morgan Stanley immediately became the
target of a hedge fund run. Before the financial crisis, it had typically been prime bro-
kers like Morgan Stanley who were worried about their exposures to hedge fund
clients. Now the roles were reversed. The Lehman episode had revealed that because
prime brokers were able to reuse clients’ assets to raise cash for their own activities,
clients’ assets could be frozen or lost in bankruptcy proceedings.
To protect themselves, hedge funds pulled billions of dollars in cash and other as-
sets 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. For example, “Most [hedge funds] request cash move-
ment from [prime brokers] primarily through a fax,” the hedge fund manager
Jonathan Wood told the FCIC. “What tends to happen in very stressful times is those
 CRISIS AND PA N I C 

faxes tend to get lost. I’m not sure that’s just coincidental . . . that was collateral for
whatever lending [prime brokers] had against you and they didn’t want to give it
[away].”
Soon, hedge funds would suffer unprecedented runs by their own investors. Ac-
cording to an FCIC survey of hedge funds that survived, investor redemption requests
averaged  of client funds in the fourth quarter of . This pummeled the mar-
kets. Money invested in hedge funds totaled . trillion, globally, at the end of ,
but because of leverage, their market impact was several times larger. Widespread re-
demptions forced hedge funds to sell extraordinary amounts of assets, further de-
pressing market prices. Many hedge funds would halt redemptions or collapse.
On Monday, hedge funds requested about  billion from Morgan Stanley.
Then, on Tuesday morning, Morgan Stanley announced a profit of . billion for the
three months ended August , , 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 preannounc-
ing earnings a day early was a sign of weakness. So I guess it was, because people cer-
tainly 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. Wong said, “We
were managing our funding . . . but really there were other things that were happen-
ing as a result of the Lehman bankruptcy that were beginning to affect, really ripple
through and affect some of our clients, our more sophisticated clients.”
The hedge fund run became a  billion torrent on Wednesday, the day after
AIG was bailed out and the day that “many of our sophisticated clients started to liq-
uefy,” as Wong put it. Many of the hedge funds now sought to exercise their con-
tractual capability to borrow more from Morgan Stanley’s prime brokerage without
needing to post collateral. Morgan Stanley borrowed  billion from the Fed’s
PDCF on Tuesday,  billion on Wednesday, and . billion on Friday.
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. On Sunday of the Lehman weekend, the Fed had low-
ered the bar on the collateral that it would take for overnight lending through the
PDCF. But the PDCF was not designed to take the place of the intraday funding pro-
vided by JP Morgan and BNY Mellon, and neither of them wanted to accept for their
intraday loans the lower-quality collateral that the Fed was accepting for its overnight
loans. They would not make those loans to the three investment banks without re-
quiring bigger haircuts, which translated into requests for more collateral.
“Big intraday issues at the clearing banks,” the SEC’s Matt Eichner informed New
York Fed colleagues in an early Wednesday email. “They don’t want exposure and are
asking for cash/securities. . . . Lots of desk level noise around [Morgan Stanley] and
[Merrill Lynch] and taking the name. Not pretty.”
“Taking the name” is Wall Street parlance for accepting a counterparty on a trade.
On Thursday, BNY Mellon requested  billion in collateral from Morgan Stanley.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

And New York Fed officials reported that JP Morgan was “thinking” about requesting
. billion on top of a . billion on deposit. According to a Fed examiner at Citi-
group, a banker from that firm had said that “Morgan [Stanley] is the ‘deer in the
headlights’ and having significant stress in Europe. It’s looking like Lehman did a few
weeks ago.”
Commercial paper markets also seized up for Morgan Stanley. From Friday, Sep-
tember , to the end of September, the amount of the firm’s outstanding commercial
paper had fallen nearly , and it had rolled over only  million. By comparison,
on average Morgan Stanley rolled over about  million every day in the last two
weeks of August.
On Saturday, Morgan Stanley executives briefed the New York Fed on the situa-
tion. By this time, the firm had a total of . billion in PDCF funding and . bil-
lion in TSLF funding from the Fed. Morgan Stanley’s liquidity pool had dropped
from  billion to  billion in one week. Repo lenders had pulled out  billion
and hedge funds had taken  billion out of Morgan Stanley’s prime brokerage. That
run had vastly exceeded the company’s most severe scenario in stress tests adminis-
tered only one month earlier.
During the week, Goldman Sachs had encountered a similar run. Its liquidity
pool had fallen from about  billion on the previous Friday to  billion on
Thursday. At the end of the week, its Fed borrowing totaled  billion from the
PDCF and . billion from the TSLF. Lloyd Blankfein, Goldman’s CEO, told the
FCIC,

We had tremendous liquidity through the period. But there were sys-
temic events going on, and we were very nervous. If you are asking me
what would have happened but for the considerable government inter-
vention, I would say we were in—it was a more nervous position than
we would have wanted [to be] in. We never anticipated the government
help. We weren’t relying on those mechanisms. . . . I felt good about it,
but we were going to bed every night with more risk than any responsi-
ble manager should want to have, either for our business or for the sys-
tem as a whole—risk, not certainty.

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 them-
selves 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 ac-
cess the Fed’s facilities, increasing its PDCF borrowing to a high of  billion in Oc-
tober and its TSLF borrowing to a high of . billion in December.
On Sunday, September , both Morgan Stanley and Goldman Sachs applied to
the Fed to become bank holding companies. “In my -year history, [Goldman and
 CRISIS AND PA N I C 

Morgan Stanley] had consistently opposed Federal Reserve supervision—[but after

Lehman,] those franchises saw that they were next unless they did something drastic.
That drastic thing was to become bank holding companies,” Tom Baxter, the New
York Fed’s general counsel, told the FCIC. The Fed, in tandem with the Department
of Justice, approved the two applications with extraordinary speed, waiving the stan-
dard five-day antitrust waiting period. Morgan Stanley instantly converted its 
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 
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 dis-
count window for terms of up to  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 go-
ing to survive.”
In a show of confidence, Warren Buffett invested  billion in Goldman Sachs,
and Mitsubishi UFJ invested  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 con-
tinued. “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.”
By the end of September, Morgan Stanley’s liquidity pool would be  billion.
But Morgan Stanley’s liquidity depended critically on borrowing from two Fed pro-
grams,  billion from the PDCF and  billion from the TSLF. Goldman Sachs’s
liquidity pool had recovered to about  billion, backed by . billion from the
PDCF and  billion from the TSLF.

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.
“The OTC derivatives markets came to a grinding halt, jeopardizing the viability
of every participant regardless of their direct exposure to subprime mortgage-backed
securities,” the hedge fund manager Michael Masters told the FCIC. “Furthermore,
when the OTC derivatives markets collapsed, participants reacted by liquidating
their positions in other assets those swaps were designed to hedge.” This market was
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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. Firms had
come to rely on the prices of derivatives contracts reflected in the ABX indices to
value their nonprime mortgage assets. The ABX.HE.BBB- -, whose decline in
 had been an early bellwether for the market crisis, had been trading around 
cents on the dollar since May. But trading on this index had become so thin, falling
from an average of about  transactions per week from January  to September
 to fewer than  transactions per week in October , that index values
weren’t informative. So, what was a valid price for these assets? Price discovery was
a guessing game, even more than it had been under normal market conditions.
The contraction of the OTC derivatives market had implications beyond the valu-
ation 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 , 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 dis-
covery, 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 de-
clined. Since its deregulation by federal statute in December , this market had
increased more than sevenfold. From June ,  to the end of the year, however,
outstanding notional amounts of OTC derivatives fell by more than . This de-
cline 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 . Moreover, it occurred during a period of great volatility in the fi-
nancial markets. At such a time, firms usually turn to the derivatives market to hedge
their increased risks—but now they fled the market.
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 be-
tween 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
 CRISIS AND PA N I C 

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 uncreditworthy counterpar-
ties. 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 in-
creased. The cost of risk management rose just when the risks themselves had risen.
Meanwhile, outstanding credit derivatives contracted by  between December
, when they reached their height of . trillion in notional amount, and the
latest figures as of June , when they had fallen to . trillion.
In sum, the sharp contraction in the OTC derivatives market in the fall of 
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 sys-
tem made risk management a top priority.

WASHINGTON MUTUAL: “IT’S YOURS”

In the eight days after Lehman’s bankruptcy, depositors pulled . 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 down-
graded WaMu’s senior unsecured debt to Baa, the lowest-tier investment-grade rat-
ing, in July, and then to junk status on September , 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 , , appointing the Federal Deposit Insurance
Corporation as receiver; many unsecured creditors suffered losses. With assets of 
billion as of June , , WaMu thus became the largest insured depository institu-
tion in U.S. history to fail—bigger than IndyMac, bigger than any bank or thrift failure
in the s and s. JP Morgan paid . billion to acquire WaMu’s banking oper-
ations from the FDIC on the same day; on the next day, WaMu’s parent company (now
minus the thrift) filed for Chapter  bankruptcy protection.
FDIC officials told the FCIC that they had known in advance of WaMu’s troubles and
thus had time to arrange the transaction with JP Morgan. JP Morgan CEO Jamie Dimon
said that his bank was already examining WaMu’s assets for purchase when FDIC Chair-
man Sheila Bair called him and asked, “Would you be prepared to bid on WaMu?” “I
said yes we would,” Dimon told the FCIC. “She called me up literally the next day and
said—‘It’s yours.’ . . . I thought there was another bidder, by the way, the whole time,
otherwise I would have bid a dollar—not [. billion], but we wanted to win.”
The FDIC insurance fund came out of the WaMu bankruptcy whole. So did the
uninsured depositors, and (of course) the insured depositors. But the FDIC never
contemplated using FDIC funds to protect unsecured creditors, which it could have
done by invoking the “systemic risk exception” under the FDIC Improvement Act of
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

. (Recall that FDICIA required that failing banks be dismantled at the least cost
to the FDIC unless the FDIC, the Fed, and Treasury agree that a particular company’s
collapse poses a risk to the entire financial system; it had not been tested in  years.)
Losses among those creditors created panic among the unsecured creditors of other
struggling banks, particularly Wachovia—with serious consequences. Nevertheless,
FDIC Chairman Bair stood behind the decision. “I absolutely do think that was the
right decision,” she told the FCIC. “WaMu was not a well-run institution.” She char-
acterized the resolution of WaMu as “successful.”
The FDIC’s decision would be hotly debated. Fed General Counsel Scott Alvarez
told the FCIC that he agreed with Bair that “there should not have been intervention
in WaMu.” But Treasury officials felt differently: “We were saying that’s great, we can
all be tough, and we can be so tough that we plunge the financial system into the
Great Depression,” Treasury’s Neel Kashkari told the FCIC. “And so, I think, in my
judgment that was a mistake. . . . [A]t that time, the economy was in such a perilous
state, it was like playing with fire.”

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. Con-
cerns about Wachovia—then the fourth-largest bank holding company—had also
been escalating for some time. On September , the Merrill analyst Ed Najarian
downgraded the company’s stock to “underperform,” pointing to weakness in its op-
tion ARM and commercial loan portfolios. On September , 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 be-
lieved that Wachovia’s cash position was strong and that the requested relief was a
“want” rather than a “need.”
But they changed their minds after the Lehman bankruptcy, immediately launch-
ing daily conference calls to discuss liquidity with Wachovia management. Depositor
outflows increased. On September , the Fed supported the company’s request to
use insured deposits to provide liquidity to the holding company. On September , a
Saturday, Wells Fargo Chairman Richard M. Kovacevich told Robert Steel, Wa-
chovia’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. The
same day, Fed Governor Kevin Warsh suggested that Steel also talk to Goldman. As a
former vice chairman of Goldman, Steel could easily approach the firm, but the ensu-
ing conversations were short; Goldman was not interested.
Throughout the following week, it became increasingly clear that Wachovia
needed to merge with a stronger financial institution. Then, WaMu’s failure on Sep-
tember  “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 acceler-
ated the withdrawal of significant amounts from their accounts,” Alvarez said. “In ad-
 CRISIS AND PA N I C 

dition, wholesale funds providers withdrew liquidity support from Wachovia. It ap-
peared likely that Wachovia would soon become unable to fund its operations.” Steel
said, “As the day progressed, some liquidity pressure intensified as financial institu-
tions began declining to conduct normal financing transactions with Wachovia.”
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 , 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 . billion of deposits and . bil-
lion 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— billion to  billion. Wa-
chovia “did not have to pay all these funds from a contractual basis (they had not ma-
tured), but would have difficulty [borrowing from these lenders] going forward given
the reluctance to repay early,” Richard Westerkamp, the Richmond Fed’s lead exam-
iner at Wachovia, told the FCIC.
In one day, the value of Wachovia’s -year bonds fell from  cents to  cents on
the dollar, and the cost of buying protection on  million of Wachovia debt jumped
from , to almost ,, annually. Wachovia’s stock fell , wiping out
 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 , without a deal in place. “Markets were already under con-
siderable strain after the events involving Lehman Brothers, AIG, and WaMu,” the
Fed’s Alvarez told the FCIC. “There were fears that the failure of Wachovia would
lead investors to doubt the financial strength of other organizations in similar situa-
tions, making it harder for those institutions to raise capital.”
Wells Fargo had already expressed interest in buying Wachovia; by Friday, Citi-
group had as well. Wachovia entered into confidentiality agreements with both com-
panies on Friday and the two suitors immediately began their due diligence
investigations.
The key question was whether the FDIC would provide assistance in an acquisi-
tion. 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 ex-
ception under FDICIA. Over the weekend, federal officials hurriedly considered the
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

systemic risks if the FDIC did not intervene and if creditors and uninsured deposi-
tors suffered losses.
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 
billion of additional cash outflows the following week—including, most prominently,
 billion of further deposit outflows, as well as  billion from corporate deposit
accounts and  billion from retail brokerage customers. Yet Wachovia had only 
billion in cash and cash equivalents. While the FDIC and OCC estimated that the
company could use its collateral to raise another  billion through the Fed’s dis-
count window, the repo market, and the Federal Home Loan Banks, even those ef-
forts would bring the amount on hand to only  billion to cover the potential
 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  bil-
lion of Wachovia debt, which Richmond Fed staff concluded represented “signifi-
cant systemic consequences”; and investment banks, “already weak and exposed to
low levels of confidence,” owned  billion of Wachovia’s  billion debt and de-
posits. These firms were in danger of becoming “even more reliant on Federal Re-
serve 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 “be-
come even less willing to lend to businesses and households. . . . [T]hese effects
would contribute to weaker economic performance, higher unemployment, and re-
duced wealth.” Secretary Paulson had recused himself from the decision because of
his ties to Steel, but other members of Treasury had “vigorously advocated” saving
Wachovia. White House Chief of Staff Josh Bolten called Bair on Sunday to express
support for the systemic risk exception.
At about : P.M. on Sunday, September , Wells’s Kovacevich told Steel that he
wanted more time to review Wachovia’s assets, particularly its commercial real estate
holdings, and could not make a bid before Monday if there were to be no FDIC assis-
tance. So Wells and Citigroup came to the table with proposals predicated on such as-
sistance. Wells offered to cover the first  billion of losses on a pool of  billion
worth of assets as well as  of subsequent losses, if they grew large enough, cap-
ping the FDIC’s losses at  billion. Citigroup wanted the FDIC to cover losses on a
different, and larger, pool of  billion worth of assets, but proposed to cover the
first  billion of losses and an additional  billion a year for three years, while giv-
ing the FDIC  billion in Wachovia preferred stock and stock warrants (rights to
buy stock at a predetermined price) as compensation; the FDIC would cover any ad-
ditional losses above  billion.
FDIC staff expected Wachovia’s losses to be between  billion and  billion.
On the basis of that analysis and the particulars of the offers, they estimated that the
 CRISIS AND PA N I C 

Wells proposal would cost the FDIC between . billion and . billion, whereas
the Citigroup proposal would cost the FDIC nothing. Late Sunday, Wachovia submit-
ted 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 : A.M. on Mon-
day, September , to decide Wachovia’s fate before the markets opened. FDIC As-
sociate Director Miguel Browne hewed closely to the analysis prepared by the
Richmond Fed: Wachovia’s failure carried the risk of knocking down too many domi-
noes 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 inter-
vene in private financial markets but ultimately agreed. “Well, I think this is, you
know . . . one option of a lot of 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 com-
fortable with it but we need to move forward with something, clearly, because this in-
stitution 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 gov-
ernment 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 . 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  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 exe-
cuted 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 , 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 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 manag-
ing problems at large institutions and that subsequently, through the process of regu-
latory reform, we might develop good resolution mechanisms and decisively address
the issues of financial concentration and too big to fail.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Citigroup and Wachovia immediately began working on the deal—even as Wa-

chovia’s stock fell . to . on September , the day that TARP was initially re-
jected 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 , Wells Fargo returned to the table and made a compet-
ing bid to buy all of Wachovia for  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 pro-
posal, particularly given IRS Notice -. 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  billion in the first
year following the acquisition rather than by  billion per year for three years. How-
ever, Wells said this “was itself not a major factor” in its decision to bid for Wachovia
without direct 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 , three days after accepting Citigroup’s federally assisted
offer, Wachovia’s board convened an emergency : P.M. session to discuss Wells’s
revised bid. The Wachovia board voted unanimously in favor.
At about : 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 pre-
pared 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  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 unsta-
ble 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 , Citigroup filed suit to enjoin Wells Fargo’s acquisition of
 CRISIS AND PA N I C 

Wachovia, but without success. The Wells Fargo deal would close at midnight on De-
cember , for  per share.
IRS Notice - was repealed in . 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 re-
moving 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  bil-
lion of tax revenues over  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.

TARP: “COMPREHENSIVE APPROACH”

Ten days after the Lehman bankruptcy, the Fed had provided nearly  billion to
investment banks and commercial banks through the PDCF and TSLF lending facili-
ties, 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  to . trillion.
But the Fed was running out of options. In the end, it could only make collateral-
ized 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 resort.
On Thursday, September , the Fed and Treasury proposed what Secretary Paul-
son 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 , as Gold-
man 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  billion to purchase toxic assets
from financial institutions.
The initial reaction was not promising. For example, Senate Banking Committee
Chairman Christopher Dodd said on Tuesday, “This proposal is stunning and un-
precedented 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
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 , as bankers and regulators hammered
out Wachovia’s rescue, congressional negotiators had agreed on the outlines of a deal.
Senator Mel Martinez, a former HUD secretary and then a member of the Bank-
ing Committee, told the FCIC about a meeting with Paulson and Bernanke that
Sunday:

I just remember thinking, you know, Armageddon. The thing that was
the most frightening about it is that even with them asking for extraor-
dinary powers, that they were not at all assured that they could prevent
the kind of financial disaster that I think really was greater than the
Great Depression. . . . And obviously to a person like myself I think you
think, “Wow, if these guys that are in the middle of it and hold the titles
that they hold believe this to be as dark as they’re painting it, it must be
pretty darned dark.”

Nevertheless, on Monday, September , just hours after Citigroup had an-
nounced its proposed government-assisted acquisition of Wachovia, the House re-
jected TARP by a vote of  to . The markets’ response was immediate: the Dow
Jones Industrial Average quickly plunged  points, or almost .
To broaden the bill’s appeal, TARP’s supporters made changes, including a tempo-
rary increase in the cap on FDIC’s deposit insurance coverage from , to
, per customer account. On Wednesday evening, the Senate voted in favor
by a margin of  to . On Friday, October , the House agreed,  to , and
President George W. Bush signed the law, which had grown to  pages. TARP’s
stated goal was to restore liquidity and confidence in financial markets by providing
“authority for the Federal Government to purchase and insure certain types of trou-
bled 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  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 , the Dow closed
below , for the first time in four years; by the end of the week it was down al-
 CRISIS AND PA N I C 

most , points, or , below its peak in October . 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  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 ,
the Fed created yet another emergency program, the Commercial Paper Funding Fa-
cility, to purchase secured and unsecured commercial paper directly from eligible is-
suers. 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 cumu-
lative  billion over time), Dexia ( billion), and Barclays ( billion). Other
financial firms included GE Capital ( billion), Prudential Funding (. billion),
and Toyota Motor Credit Corporation (. billion). Nonfinancial firms that partici-
pated included Verizon (. billion), Harley-Davidson (. billion), McDonald’s,
( million) and Georgia Transmission ( 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 de-
termine 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 un-
derstood 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 pur-
chases necessary to promote financial market stability. However, the new proposal
would pose a host of new problems. By injecting capital in these firms, the govern-
ment would become a major shareholder in the private financial sector.
On Sunday, October , after agreeing to the terms of the capital injections, Paul-
son, Bernanke, Bair, Dugan, and Geithner selected a small group of major financial
institutions to which they would immediately offer capital: the four largest commer-
cial 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  trillion in assets, or
about  of all assets in U.S. banks.
Paulson summoned the firms’ chief executives to Washington on Columbus Day,
October . Along with Bernanke, Bair, Dugan, and Geithner, Paulson explained
that Treasury had set aside  billion from TARP to purchase equity in financial
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

institutions under the newly formed Capital Purchase Program (CPP). Specifically,
Treasury would purchase senior preferred stock that would pay a  dividend for
the first five years; the rate would rise to  thereafter to encourage the companies
to pay the government back. Firms would also have to issue stock warrants to Treas-
ury and agree to abide by certain standards for executive compensation and corpo-
rate governance.
The regulators had already decided to allocate half of these funds to the nine firms
assembled that day:  billion each to Citigroup, JP Morgan, and Wells;  billion
to Bank of America;  billion each to Merrill, Morgan Stanley, and Goldman; 
billion to BNY Mellon; and  billion to State Street.
“We didn’t want it to look or be like a nationalization” of the banking sector, Paul-
son 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 im-
portance 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 argu-
ment 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 FCIC.
To further reassure markets that it would not allow the largest financial institu-
tions 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, Gold-
man Sachs had  billion in debt backed by the FDIC outstanding in January ,
and  billion at the end of , according to public filings; Morgan Stanley had
 billion at the end of  and  billion at the end of . GE Capital, one of
the heaviest users of the program, had  billion of FDIC-backed debt outstanding
at the end of  and  billion at the end of . Citigroup had  billion of
FDIC guaranteed debt outstanding at the end of  and  billion at the end of
; JPMorgan Chase had  billion outstanding at the end of  and  billion
at the end of .
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 sys-
temic 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 PA N I C 

“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 divi-
dends 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  billion in financial institutions under TARP’s Capi-
tal Purchase Program by the end of ; ultimately, it would invest  billion in
 financial institutions.
In the ensuing months, Treasury would provide much of TARP’s remaining 
billion to specific financial institutions, including AIG ( billion plus a  billion
lending facility), Citigroup ( billion plus loss guarantees), and Bank of America
( billion). On December , it established the Automotive Industry Financing
Program, under which it ultimately invested  billion of TARP funds to make in-
vestments in and loans to automobile manufacturers and auto finance companies,
specifically General Motors, GMAC, Chrysler, and Chrysler Financial. On January
, , President Bush notified Congress that he intended not to access the second
half of the  billion in TARP funds, so that he might “‘ensure that such funds are
available early’ for the new administration.”
As of September —two years after TARP’s creation—Treasury had allocated
 billion of the  billion authorized. Of that amount,  billion had been re-
paid,  billion remained outstanding, and . billion in losses had been in-
curred. About  billion of the outstanding funds were in the Capital Purchase
Program. Treasury still held large stakes in GM ( of common stock), Ally Finan-
cial (formerly known as GMAC; ), and Chrysler (). Moreover, . billion of
TARP funds remained invested in AIG in addition to . billion of loans from the
New York Fed and a  billion non-TARP equity investment by the New York Fed in
two of AIG’s foreign insurance companies. By December , 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 to-
taling 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  billion and  billion, respectively.
Its money market funding peaked at  billion in January , and its Commer-
cial Paper Funding Facility peaked at  billion, also in January . When it
was introduced, the FDIC’s program to guarantee senior debt for all FDIC-insured
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

institutions stood ready to backstop as much as  billion in bank debt. The Fed’s
largest program, announced in November , purchased . trillion in agency
mortgage–backed securities.

AIG: “WE NEEDED TO STOP

THE SUCKING CHEST WOUND IN THIS PATIENT”
AIG would be the first TARP recipient that was not part of the Capital Purchase Pro-
gram. It still had two big holes to fill, despite the  billion loan from the New York
Fed. Its securities-lending business was underwater despite payments in September
and October of  billion that the Fed loan had enabled; and it still needed  bil-
lion to pay credit default swap (CDS) counterparties, despite earlier payments of 
billion.
On November , the government announced that it was restructuring the New
York Fed loan and, in the process, Treasury would purchase  billion in AIG pre-
ferred 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 compensation.
That day, the New York Fed created two off-balance-sheet entities to hold AIG’s
bad assets associated with securities lending (Maiden Lane II) and CDS (Maiden
Lane III). Over the next month, the New York Fed loaned Maiden Lane II . bil-
lion so that it could purchase mortgage-backed securities from AIG’s life insurance
company subsidiaries. This enabled those subsidiaries to pay back their securities-
lending counterparties, bringing to . billion the total payments AIG would make
with government help. These payments are listed in figure ..
Maiden Lane III was created with a . billion loan from the New York Fed and
an AIG investment of  billion, supported by the Treasury investment. That money
went to buy CDOs from  of AIG Financial Products’ CDS counterparties. The
CDOs had a face value of . billion, which AIG Financial Products had guaran-
teed through its CDS. Because AIG had already posted  billion in collateral to
its counterparties, Maiden Lane III paid . billion to those counterparties, provid-
ing them with the full face amount of the CDOs in return for the cancellation of their
rights under the CDS. A condition of this transaction was that AIG waive its legal
claims against those counterparties. These payments are listed in figure ..
Goldman Sachs received  billion in payments from Maiden Lane III related to
the CDS it had purchased from AIG. During the FCIC’s January , , hearing,
Goldman CEO Lloyd Blankfein testified that Goldman Sachs would not have lost any
money if AIG had failed, because his firm had purchased credit protection to cover
the difference between the amount of collateral it demanded from AIG and the
amount of collateral paid by AIG. Documents submitted to the FCIC by Goldman
after the hearing do show that the firm owned . billion of credit protection in the
form of CDS on AIG, although much of that protection came from financially unsta-
ble companies, including Citibank (. million), which itself had to be propped
up by the government, and Lehman (. million), which was bankrupt by the
 CRISIS AND PA N I C 

Payments to AIG Counterparties

Payments to AIG Securities Payments to AIG Credit Default

Lending Counterparties Swap Counterparties

IN BILLIONS OF DOLLARS IN BILLIONS OF DOLLARS

Sept. 18 to Dec. 12, 2008 As of Nov. 17, 2008
Maiden Collateral
Lane III payments
Barclays $7.0 payment from AIG
Deutsche Bank 6.4 Société Générale $6.9 $9.6
BNP Paribas 4.9 Goldman Sachs 5.6 8.4
Goldman Sachs 4.8 Merrill Lynch 3.1 3.1
Bank of America 4.5 Deutsche Bank 2.8 5.7
HSBC 3.3 UBS 2.5 1.3
Citigroup 2.3 Calyon 1.2 3.1
Dresdner Kleinwort 2.2 Deutsche Zentral-Genossenschaftsbank 1.0 0.8
Merrill Lynch 1.9 Bank of Montreal 0.9 0.5
UBS 1.7 Wachovia 0.8 0.2
ING 1.5 Barclays 0.6 0.9
Morgan Stanley 1.0 Bank of America 0.5 0.3
Société Générale 0.9 Royal Bank of Scotland 0.5 0.6
AIG International 0.6 Dresdner Bank AG 0.4 0.0
Credit Suisse 0.4 Rabobank 0.3 0.3
Paloma Securities 0.2 Landesbank Baden-Wuerttemberg 0.1 0.0
Citadel 0.2 HSBC Bank USA 0.0 0.2
TOTAL $43.7 TOTAL $27.1 $35.0

NOTE: Amounts may not add due to rounding.

Of this total, $19.5 billion came
SOURCE: Special Inspector General for TARP
from Maiden Lane II, $17.2
billion came from the Federal
Reserve Bank of New York, and
$7 billion came from AIG.

Figure .

time AIG was rescued. In an FCIC hearing, Goldman CFO David Viniar said that
those counterparties had posted collateral.
Goldman also argued that the  billion of CDS protection that it purchased
from AIG was part of Goldman’s “matched book,” meaning that Goldman sold 
billion in offsetting protection to its own clients; it provided information to the FCIC
indicating that the  billion received from Maiden Lane III was entirely paid to its
clients. Without the federal assistance, Goldman would have had to find the 
billion some other way.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Goldman also produced documents to the FCIC that showed it received . bil-
lion from AIG related to credit default swaps on CDOs that were not part of Maiden
Lane III. Of that . billion, . billion was received after, and thus made possible
by, the federal bailout of AIG. And most—. billion—of the total was for propri-
etary trades (that is, trades made solely for Goldman’s benefit rather than on behalf of
a client) largely relating to Goldman’s Abacus CDOs. Thus, unlike the  billion re-
ceived from AIG on trades in which Goldman owed the money to its own counter-
parties, this . billion was retained by Goldman.
That AIG’s counterparties did not incur any losses on their investments—because
AIG, once it was backed by the government, paid claims to CDS counterparties at
 of face value—has been widely criticized. In November , SIGTARP faulted
the New York Fed for failing to obtain concessions. The inspector general said that
seven of the top eight counterparties had insisted on  coverage and that the New
York Fed had agreed because efforts to obtain concessions from all counterparties
had little hope of success.
SIGTARP was highly critical of the New York Fed’s negotiations. From the outset,
it found, the New York Fed was poorly prepared to assist AIG. To prevent AIG’s fail-
ure, the New York Fed had hastily agreed to the  billion bailout on substantially
the same terms that a private-sector group had contemplated. SIGTARP blamed
the Fed’s own negotiating strategy for the outcome, which it described as the transfer
of “billions of dollars of cash from the Government to AIG’s counterparties, even
though senior policy makers contend that assistance to AIG’s counterparties was not
a relevant consideration.”
In June , TARP’s Congressional Oversight Panel criticized the AIG bailout
for having a “poisonous” effect on capital markets. The report said the government’s
failure to require “shared sacrifice” among AIG’s creditors effectively altered the rela-
tionship between the government and the markets, signaling an implicit “too big to
fail” guarantee for certain firms. The report said the New York Fed should have in-
sisted on concessions from counterparties.
Treasury and Fed officials countered that concessions would have led to an instant
ratings downgrade and precipitated a run on AIG. New York Fed officials told the
FCIC that they had very little bargaining power with counterparties who were pro-
tected by the terms of their CDS contracts. And, after providing a  billion loan,
the government could not let AIG fail. “Counterparties said ‘we got the collateral, the
contractual rights, you’ve been rescued by the Fed, Uncle Sam’s behind you, why
would we let you out of a contract you agreed to?” New York Fed General Counsel
Tom Baxter told the FCIC. “And then the question was, should we use our regulatory
power to leverage counterparties. From my view, that would have been completely
inappropriate, an abuse of power, and not something we were willing to even con-
template.”
Sarah Dahlgren, who was in charge of the Maiden Lane III transaction at the New
York Fed, said the government could not have threatened bankruptcy. “There was a
financial meltdown,” she told the FCIC. “The credibility of the United States govern-
ment was on the line.” SIGTARP acknowledged that the New York Fed “felt ethi-
 CRISIS AND PA N I C 

cally restrained from threatening an AIG bankruptcy because it had no actual plans
to carry out such a threat” and that it was “uncomfortable interfering with the sanc-
tity of the counterparties’ contractual rights with AIG,” which were “certainly valid
concerns.”
Geithner has said he was confident that full reimbursement was “absolutely” the
right decision. “We did it in a way that I believe was not just least cost to the taxpayer,
best deal for the taxpayer, but helped avoid much, much more damage than would
have happened without that.”
New York Fed officials told the FCIC that threats to AIG’s survival continued after
the  billion loan on September . “If you don’t fix the [securities] lending or
the CDOs, [AIG would] blow through the  billion. So we needed to stop the suck-
ing chest wound in this patient,” Dahlgren said. “It wasn’t just AIG—it was the finan-
cial markets. . . . It kept getting worse and worse and worse.”
Baxter told the FCIC that Maiden Lane III stopped the “hemorrhage” from AIG
Financial Products, which was paying collateral to counterparties by drawing on the
 billion government loan. In addition, because Maiden Lane III received the
CDOs underlying the CDS, “as value comes back in those CDOs, that’s value that is
going to be first used to pay off the Fed loan; . . . the likely outcome of Maiden Lane
III is that we’re going to be paid in full,” he said.
In total, the Fed and Treasury had made available over  billion in assistance
to AIG to prevent its failure. As of September , , the total outstanding assis-
tance has been reduced to . billion, primarily through the sale of AIG business
units.

CITIGROUP: “LET THE WORLD KNOW

THAT WE WILL NOT PULL A LEHMAN”
The failed bid for Wachovia reflected badly on Citigroup. Its stock fell  on Octo-
ber , , the day Wachovia announced that it preferred Wells’s offer, and another
 within a week. “Having agreed to do the deal was a recognition on our part that
we needed it,” Edward “Ned” Kelly III, vice chairman of Citigroup, told the FCIC.
“And if we needed it and didn’t get it, what did that imply for the strength of the firm
going forward?”
Roger Cole, then head of banking supervision at the Federal Reserve Board, saw
the failed acquisition as a turning point, the moment “when Citi really came under
the microscope.” “It was regarded [by the market] as an indication of bad manage-
ment at Citi that they lost the deal, and had it taken away from them by a smarter,
more astute Wells Fargo team,” Cole told the FCIC. “And then here’s an organization
that doesn’t have the core funding [insured deposits] that we were assuming that they
would get by that deal.”
Citigroup’s stock rose  the day after the Columbus Day announcement that it
would receive government capital, but the optimism did not last. Two days later, Citi-
group announced a . billion net loss for the third quarter, concentrated in sub-
prime and Alt-A mortgages, commercial real estate investments, and structured
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

investment vehicle (SIV) write-downs. The bank’s stock fell  in the following
week and, by November , hit single digits for the first time since .
The market’s unease was heightened by press speculation that the company’s
board had lost confidence in senior management, Kelly said. On November , the
company announced that the value of the SIVs had fallen by . billion in the
month since it had released third-quarter earnings. Citigroup was therefore going to
bring the remaining . billion in off-balance-sheet SIV assets onto its books. In-
vestors clipped almost another  off the value of the stock, its largest single-day
drop since the October  stock market crash. Two days later, the stock closed at
.. Credit defaults swaps on Citigroup reached a steep , annually to pro-
tect  million in Citigroup debt against default. According to Kelly, these devel-
opments threatened to make perceptions become a reality for the bank: “[Investors]
look at those spreads and say, ‘Is this some place I really want to put my money?’ And
that’s not just in terms of wholesale funding, that’s people who also have deposits
with us at various points.”
The firm’s various regulators watched the stock price, the daily liquidity, and the
CDS spreads with alarm. On Friday, November , the United Kingdom’s Financial
Services Authority (FSA) imposed a . billion cash “lockup” to protect Citigroup’s
London-based broker-dealer. FDIC examiners knew that this action would be “very
damaging” to the bank’s liquidity and worried that the FSA or other foreign regula-
tors might impose additional cash requirements in the following week. By the close
of business Friday, there was widespread concern that if the U.S. government failed to
act, Citigroup might not survive; its liquidity problems had reached “crisis propor-
tions.” Among regulators at the FDIC and the Fed, there was no debate. Fed Chair-
man Bernanke told the FCIC, “We were looking at this firm [in the fall of ] and
saying, ‘Citigroup is not a very strong firm, but it’s only one firm and the others are
okay,’ but not recognizing that that’s sort of like saying, ‘Well, four out of your five
heart ventricles are fine, and the fifth one is lousy.’ They’re all interconnected, they all
connect to each other; and, therefore, the failure of one brings the others down.”
The FDIC’s Arthur Murton emailed his colleague Michael Krimminger on No-
vember : “Given that the immediate risk is liquidity, the way to address that is by
letting counterparties know that they will be protected both at the bank and holding
company level. . . . [T]he main point is to let the world know that we will not pull a
Lehman.” Krimminger, special adviser to the FDIC chairman, agreed: “At this stage, it
is probably appropriate to be clear and direct that the US government will not allow
Citi to fail to meet its obligations.”
Citigroup’s own calculations suggested that a drop in deposits of just . would
wipe out its cash surplus. If the trend of recent withdrawals continued, the company
could expect a  outflow of deposits per day. Unless Citigroup received a large and
immediate injection of funds, its coffers would be empty before the weekend. Mean-
while, Citigroup executives remained convinced that the company was sound and
that the market was simply panicking. CEO Pandit argued, “This was not a funda-
mental situation, it was not about the capital we had, not about the funding we had at
that time, but with the stock price where it was . . . perception becomes reality.” All
 CRISIS AND PA N I C 

that was needed, Citigroup contended, was for the government to expand access to
existing liquidity facilities. “People were questioning what everything was worth at
the time. . . . [T]here was a flight not just to quality and safety, but almost a flight to
certainty,” Kelly, then Pandit’s adviser, told the FCIC.
The FDIC dismissed Citigroup’s request that the government simply expand its
access to existing liquidity programs, concluding that any “incremental liquidity”
could be quickly eliminated as depositors rushed out the door. Officials also believed
the company did not have sufficient high-quality collateral to borrow more under the
Fed’s mostly collateral-based liquidity programs. In addition to the  billion from
TARP, Citigroup was already getting by on substantial government support. As of
November , it had . billion outstanding under the Fed’s collateralized liquidity
programs and  million under the Fed’s Commercial Paper Funding Facility. And
it had borrowed  billion from the Federal Home Loan Banks. In December, Citi-
group would have a total of  billion in senior debt guaranteed by the FDIC under
the debt guarantee program.
On Sunday, November , FDIC staff recommended to its board that a third sys-
temic risk exception be made under FDICIA. As they had done previously, regula-
tors decided that a proposed resolution had to be announced over the weekend to
buttress investor confidence before markets opened Monday. The failure of Citigroup
“would significantly undermine business and household confidence,” according to
FDIC staff. Regulators were also concerned that the economic effects of a Citi-
group failure would undermine the impact of the recently implemented Capital Pur-
chase Program under TARP.
Treasury agreed to provide Citigroup with an additional  billion in TARP
funds in exchange for preferred stock with an  dividend. This injection of cash
brought the company’s TARP tab to  billion. The bank also received . billion
in capital benefits related to its issuance of preferred stock and the government’s
guarantee of certain assets. Under the guarantee, Citigroup and the government
would identify a  billion pool of assets around which a protective “ring fence”
would be placed. In effect, this was a loss-sharing agreement between Citigroup and
the federal government. “There was not a huge amount of science in coming to that
[ billion] number,” Citigroup’s Kelly told the FCIC. He said the deal was struc-
tured to “give the market comfort that the catastrophic risk has been taken off the
table.” When its terms were finalized in January , the guaranteed pool, which
contained mainly loans and residential and commercial mortgage–backed securities,
was adjusted downward to  billion.
Citigroup assumed responsibility for the first . billion in losses on the ring-
fenced assets. The federal government would assume responsibility for  of all
losses above that amount. Should these losses actually materialize, Treasury would
absorb the first  billion using TARP funds, the FDIC would absorb the next 
billion from the Deposit Insurance Fund (for which it had needed to approve the sys-
temic risk exception), and the Fed would absorb the balance. In return, Citigroup
agreed to grant the government  billion in preferred stock, as well as warrants that
gave the government the option to purchase additional shares. After analyzing the
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

quality of the protected assets, FDIC staff projected that the Deposit Insurance Fund
would not incur any losses.
Once again, the FDIC Board met late on a Sunday to determine the fate of a strug-
gling institution. Brief dissent on the  P.M. conference call came from OTS Director
John Reich, who questioned why similar relief had not been extended to OTS-super-
vised thrifts that failed earlier. “There isn’t any doubt in my mind that this is a sys-
temic situation,” he said. But he added,

In hindsight, I think there have been some systemic situations prior to

this one that were not classified as such. The failure of IndyMac pointed
the focus to the next weakest institution, which was WaMu, and its fail-
ure pointed to Wachovia, and now we’re looking at Citi and I wonder
who’s next. I hope that all of the regulators, all of us, including Treasury
and the Fed, are looking at these situations in a balanced manner, and I
fear there has been some selective creativity exercised in the determina-
tion of what is systemic and what’s not and what’s possible for the gov-
ernment to do and what’s not.

The FDIC Board approved the proposal unanimously. The announcement beat
the opening bell, and the markets responded positively: Citigroup’s stock price soared
almost , closing at .. The ring fence would stay in place until December
, at which time Citigroup terminated the government guarantee in tandem with
repaying  billion in TARP funds. In December , Treasury announced the sale
of its final shares of Citigroup’s common stock.

BANK OF AMERICA: “A SHOTGUN WEDDING”

With Citigroup stabilized, the markets would quickly shift focus to the next domino:
Bank of America, which had swallowed Countrywide earlier in the year and, on Sep-
tember , had announced it was going to take on Merrill Lynch as well. The merger
would create the world’s largest brokerage and reinforce Bank of America’s position
as the country’s largest depository institution. Given the share prices of the two com-
panies at the time, the transaction was valued at  billion.
But the deal was not set to close until the first quarter of the following year. In the
interim, the companies continued to operate as independent entities, pending share-
holder and regulatory approval. For that reason, Merrill CEO John Thain and Bank
of America CEO Ken Lewis had represented their companies separately at the
Columbus Day meeting at Treasury. Treasury would invest the full  billion in
Bank of America only after the Merrill acquisition was complete.
In October, Merrill Lynch reported a net loss for the third quarter of . billion.
In its October  earnings press release, Merrill Lynch described write-downs related
to its CDO positions and other real estate–related securities and assets affected by the
“severe market dislocations.” Thain told investors on the conference call that Merrill’s
strategy was to clean house. It now held less than  billion in asset-backed-security
 CRISIS AND PA N I C 

CDOs and no Alt-A positions at all. “We’re down to  million in subprime on our
trading books,” Thain said. “We cut our non-U.S. mortgage business positions in
half.”
The Fed approved the merger on November , noting that both Bank of America
and Merrill were well capitalized and would remain so after the merger, and that
Bank of America “has sufficient financial resources to effect the proposal.” Share-
holders of both companies approved the acquisition on December .
But then Bank of America executives began to have second thoughts, Lewis told
the FCIC. In mid-November, Merrill Lynch’s after-tax losses for the fourth quarter
had been projected to reach about  billion; the projection grew to about  billion
by December ,  billion by December , and  billion by December . Lewis
said he learned only on December  that Merrill’s losses had “accelerated pretty dra-
matically.” Lewis attributed the losses to a “much, much, higher deterioration of the
assets we identified than we had expected going into the fourth quarter.”
In a January conference call, Lewis and CFO Joe Price told investors that the bank
had not been aware of the extent of Merrill’s fourth-quarter losses at the time of the
shareholder vote. “It wasn’t an issue of not identifying the assets,” Ken Lewis said. “It
was that we did not expect the significant deterioration, which happened in mid- to
late December that we saw.” Merrill’s Thain contests that version of events. He told
the FCIC that Merrill provided daily profit and loss reports to Bank of America and
that bank executives should have known about losses as they occurred. The SEC
later brought an enforcement action against Bank of America, charging the company
with failing to disclose about . billion of known and expected Merrill Lynch losses
before the December  shareholder vote. According to the SEC’s complaint, these in-
sufficient disclosures deprived shareholders of material information that was critical
to their ability to fairly evaluate the merger. In February , Bank of America
would pay  million to settle the SEC’s action.
On December , Lewis called Treasury Secretary Paulson to inform him that
Bank of America was considering invoking the material adverse change (MAC)
clause of the merger agreement, which would allow the company to exit or renegoti-
ate the terms of the acquisition. “The severity of the losses were high enough that we
should at least consider a MAC,” Lewis told the FCIC. “The acceleration, we thought,
was beyond what should be happening. And then secondly, you had a major hole be-
ing created in the capital base with the losses—that dramatically reduced [Merrill
Lynch’s] equity.”
That afternoon, Lewis flew from North Carolina to Washington to meet at the Fed
with Paulson and Fed Chairman Bernanke. The two asked Lewis to “stand down” on
invoking the clause while they considered the situation.
Paulson and Bernanke concluded that an attempt by Bank of America to invoke
the MAC clause “was not a legally reasonable option.” They believed that Bank of
America would be ultimately unsuccessful in the legal action, and that the attendant
litigation would likely result in Bank of America still being contractually bound to ac-
quire a considerably weaker Merrill Lynch. Moreover, Bernanke thought the market
would lose faith in Bank of America’s management, given that review, preparation,
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

and due diligence had been ongoing for “ months.” The two officials also believed
that invoking the clause would lead to a broader systemic crisis that would result in
further deterioration at the two companies.
Neither Merrill nor its CEO, John Thain, was informed of these deliberations at
Bank of America. Lewis told the FCIC that he didn’t contact Merrill Lynch about the
situation because he didn’t want to create an “adversarial relationship” if it could be
avoided. When Thain later found out that Bank of America had contemplated put-
ting the MAC clause into effect, he was skeptical about its chances of success: “One of
the things we negotiated very heavily was the Material Adverse Change clause. [It]
specifically excluded market moves . . . [and] pretty much nothing happened to Mer-
rill in the fourth quarter other than the market move.”
On Sunday, December , Paulson informed Lewis that invoking the clause
would demonstrate a “colossal loss of judgment” by the company. Paulson reminded
Lewis that the Fed, as its regulator, had the legal authority to replace Bank of Amer-
ica’s management and board if they embarked on a “destructive” strategy that had “no
reasonable legal basis.” Bernanke later told his general counsel: “Though we did
not order Lewis to go forward, we did indicate that we believed that going forward
[with the clause] would be detrimental to the health (safety and soundness) of his
company.” Congressman Edolphus Towns of New York would later refer to the Bank
of America and Merrill Lynch merger as “a shotgun wedding.”
Regulators began to discuss a rescue package similar to the one for Citigroup, in-
cluding preferred shares and an asset pool similar to Citigroup’s ring fence. The
staff ’s analysis was essentially the same as it had been for Citigroup. Meanwhile,
Lewis decided to “deescalate” the situation, explaining that when the secretary of the
treasury and the chairman of the Fed say that invoking the MAC would cause sys-
temic risk, “then it obviously gives you pause.” At a board meeting on December
, Lewis told his board that the Fed and Treasury believed that a failed acquisition
would pose systemic risk and would lead to removal of management and the board at
the insistence of the government, and that the government would provide assistance
“to protect [Bank of America] against the adverse impact of certain Merrill Lynch as-
sets,” although such assistance could not be provided in time for the merger’s close on
January , .
The board decided not to exercise the MAC and to proceed as planned, with the
understanding that the government’s assistance would be “fully documented” by the
time fourth-quarter earnings were announced in mid-January. “Obviously if [the
MAC clause] actually would cause systemic risk to the financial system, then that’s
not good for Bank of America,” Lewis told the FCIC. “Which is finally the conclusion
that I came to and the board came to.”
The merger was completed on January , , with no hint of government assis-
tance. By the time the acquisition became official, the purchase price of  billion
announced in September had fallen to  billion, thanks to the decline in the stock
prices of the two companies over the preceding three months. On January , Bank of
America received the  billion in capital from TARP that had been allocated to
Merrill Lynch, adding to the  billion it had received in October.
 CRISIS AND PA N I C 

In addition to those TARP investments, at the end of  Bank of America and
Merrill Lynch had borrowed  billion under the Fed’s collateralized programs (
billion through the Term Auction Facility and  billion through the PDCF and
TSLF) and  billion under the Fed’s Commercial Paper Funding Facility. (During
the previous fall, Bank of America’s legacy securities arm had borrowed as much as
 billion under TSLF and as much as  billion under PDCF.) Also at the end of
, the bank had issued . billion in senior debt guaranteed by the FDIC under
the debt guarantee program. And it had borrowed  billion from the Federal
Home Loan Banks. Yet despite Bank of America’s recourse to these many supports, the
regulators worried that it would experience liquidity problems if the fourth-quarter
earnings were weak.
The regulators wanted to be ready to announce the details of government sup-
port in conjunction with Bank of America’s disclosure of its fourth-quarter per-
formance. They had been working on the details of that assistance since late
December, and had reason to be cautious: for example,  of Bank of America’s
repo and securities-lending funding, a total of  billion, was rolled over every
night, and Merrill “legacy” businesses also funded  billion overnight. A one-
notch downgrade in the new Bank of America’s credit rating would contractually
obligate the posting of  billion in additional collateral; a two-notch downgrade
would require another  billion. Although the company remained adequately capi-
talized from a regulatory standpoint, its tangible common equity was low and, given
the stressed market conditions, was likely to fall under . Low levels of tangible
common equity—the most basic measure of capital—worried the market, which
seemed to think that in the midst of the crisis, regulatory measures of capital were
not informative.
On January , the Federal Reserve and the FDIC, after “intense” discussions,
agreed on the terms: Treasury would use TARP funds to purchase  billion of
Bank of America preferred stock with an  dividend. The bank and the three perti-
nent government agencies—Treasury, the Fed, and the FDIC—designated an asset
pool of  billion, primarily from the former Merrill Lynch portfolio, whose losses
the four entities would share. The pool was analogous to Citigroup’s ring fence. In
this case, Bank of America would be responsible for the first  billion in losses on
the pool, and the government would cover  of any additional losses. Should the
government losses materialize, Treasury would cover , up to a limit of . bil-
lion, and the FDIC , up to a limit of . billion. Ninety percent of any additional
losses would be covered by the Fed.
The FDIC Board had a conference call at  P.M. on Thursday, January , and
voted for the fourth time, unanimously, to approve a systemic risk exception under
FDICIA.
The next morning, January , Bank of America disclosed that Merrill Lynch had
recorded a . billion net loss on real estate-related write-downs and charges. It
also announced the  billion TARP capital investment and  billion ring fence
that the government had provided. Despite the government’s support, Bank of Amer-
ica’s stock closed down almost  from the day before.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Over the next several months Bank of America worked with its regulators to iden-
tify the assets that would be included in the asset pool. Then, on May , Bank of
America asked to exit the ring fence deal, explaining that the company had deter-
mined that losses would not exceed the  billion that Bank of America was required
to cover in its first-loss position. Although the company was eventually allowed to ter-
minate the deal, it was compelled to compensate the government for the benefits it
had received from the market’s perception that the government would insure its as-
sets. On September , Bank of America agreed to pay a  million termination fee:
 million to Treasury,  million to the Fed, and  million to the FDIC.

COMMISSION CONCLUSIONS ON CHAPTER 20

The Commission concludes that, as massive losses spread throughout the finan-
cial system in the fall of , many institutions failed, or would have failed but
for government bailouts. As panic gripped the market, credit markets seized up,
trading ground to a halt, and the stock market plunged. Lack of transparency
contributed greatly to the crisis: the exposures of financial institutions to risky
mortgage assets and other potential losses were unknown to market participants,
and indeed many firms did not know their own exposures.
The scale and nature of the over-the-counter (OTC) derivatives market cre-
ated significant systemic risk throughout the financial system and helped fuel the
panic in the fall of : millions of contracts in this opaque and deregulated
market created interconnections among a vast web of financial institutions
through counterparty credit risk, thus exposing the system to a contagion of
spreading losses and defaults. Enormous positions concentrated in the hands of
systemically significant institutions that were major OTC derivatives dealers
added to uncertainty in the market. The “bank runs” on these institutions in-
cluded runs on their derivatives operations through novations, collateral de-
mands, and refusals to act as counterparties.
A series of actions, inactions, and misjudgments left the country with stark
and painful alternatives—either risk the total collapse of our financial system or
spend trillions of taxpayer dollars to stabilize the system and prevent catastrophic
damage to the economy. In the process, the government rescued a number of fi-
nancial institutions deemed “too big to fail”—so large and interconnected with
other financial institutions or so important in one or more financial markets that
their failure would have caused losses and failures to spread to other institutions.
The government also provided substantial financial assistance to nonfinancial
corporations. As a result of the rescues and consolidation of financial institutions
through failures and mergers during the crisis, the U.S. financial sector is now
more concentrated than ever in the hands of a few very large, systemically signifi-
cant institutions. This concentration places greater responsibility on regulators
for effective oversight of these institutions.
 PART V

The Aftershocks
 21
THE ECONOMIC FALLOUT

CONTENTS
Households : “I’m not eating. I’m not sleeping”...................................................
Businesses: “Squirrels storing nuts” ....................................................................
Commercial real estate: “Nothing’s moving”.......................................................
Government: “States struggled to close shortfalls” ..............................................
The financial sector: “Almost triple the level of three years earlier”.....................

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.” In-
deed, 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  months, and reported unemployment hit . at its peak in October .
As the housing bubble deflated, families that had counted on rising housing val-
ues 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 al-
most 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 to-
day, 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 proper-
ties, returning the keys to the banks—an action that would destroy families’ credit for


 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 communi-
ties 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 im-
pact of the crisis has been severe. From  to , for example, banks in Sacra-
mento 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 , when the FCIC held its Sacramento hearing, that region’s
once-robust construction industry was still languishing. “Unless we begin to turn
around demand, unless we begin to turn around the business situation, the employ-
ment is not going to increase here in the Sacramento area, and housing is critical to it.
It is a vicious circle,” Williams testified.
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.

HOUSEHOLDS: “I’M NOT EATING. I’M NOT SLEEPING”

The recession officially began in December . 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 . million jobs in —the largest annual plunge since record keep-
ing began in . By December , the United States had lost another . million
jobs. Through November , the economy had regained nearly  million jobs, put-
ting 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
. in December  to . in December , reaching . in October
. This was the highest level since calculations for that labor category were first
made in . As of November , the underemployment rate stood at . The
average length of time individuals spent unemployed spiked from . weeks in June
 to . weeks in June , and . weeks in June . Fifty-nine percent of
 T H E E C O N O M I C FA L L O U T 

all job seekers, according to the most recent government statistics, searched for work
for at least  weeks.
The labor market is daunting across the board, but it is especially grim among
African American workers, whose jobless rate is ., about  percentage points
above the national average; workers between the ages of  and  years old, at
.; and Hispanics, at .. And the impact has been especially severe in certain
professions: unemployment in construction, for instance, climbed to an average of
. in , and averaged . during the first  months of .
Real gross domestic product, the nation’s measure of economic output adjusted
for inflation, fell at an annual rate of  in the third quarter of  and . in the
fourth quarter. After falling again in the first half of  and then modestly growing
in the second half, average GDP for the year was . lower than in , the biggest
drop since .
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  prevented firms from investing in the way that they oth-
erwise would, and I think that slows the rehiring of workers and still continues to be
a problem in labor markets.”
In June , the nation officially emerged out of the recession that had begun 
months earlier. The good news still had not reached many of the . million Ameri-
cans who were out of work, who could not find full-time work, or who had stopped
looking for work as of November . 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 full-
time job since .
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  trillion lost from
 to the first quarter of  in household net wealth—the difference between
what households own and what they owe—about . trillion was due to declining
house prices, with much of the remainder due to the declining value of financial as-
sets. As a point of reference, GDP in  was . trillion. And, as a separate point,
the amount of wealth lost in the dot-com crash early in the decade was . trillion,
with far fewer repercussions for the economy as a whole. The painful drop in real es-
tate and financial asset values followed a . trillion run-up in household debt from
 to . Aided by the gains in home prices and, to a lesser degree, stock prices,
households’ net wealth had reached a peak of  trillion in the second quarter of
. 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 . As of the third quarter of , despite firmer stock and housing prices
and a decline in household borrowing, household net worth totaled . trillion, a
. drop-off from its pinnacle just three years earlier (see figure .).
Nationwide, home prices dropped  from their peak in  to their low point
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Household Net Worth

The crisis wiped out much more wealth than other recent events such as the
bursting of the dot-com bubble in 2000.

IN TRILLIONS OF DOLLARS
$70

60

50
$54.9
40

30

20

10

0
1952 1960 1970 1980 1990 2000 2010

NOTE: Net worth is assets minus liabilities for U.S. households.

SOURCE: Federal Reserve Flow of Funds Report

Figure .

early in . The homeownership rate declined from its peak of . in  to
. as of the fall of . 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  miles into the mountains to a rental house to help her hus-
band’s fragile health. Their old home was put up for sale and languished on the mar-
ket, 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  days or more or
homes in the foreclosure process—have spread since the crisis. Among regions, the
 T H E E C O N O M I C FA L L O U T 

eastern states in the Midwest (Ohio, Indiana, Illinois, Wisconsin, and Michigan) had
the highest delinquency rate, topping  in . By fall , this rate had risen to
.. Other regions also endured high rates—especially the so-called sand states,
where the housing crisis was the worst. The third quarter  serious delinquency
rate for Florida was .; Nevada, .; Arizona, .; and California, ..
The data company CoreLogic identified the  housing markets with the worst
records of “distressed” sales, which include short sales and sales of foreclosed proper-
ties. Las Vegas led the list in mid-, with distressed sales accounting for more
than  of all home sales. “The state was overbuilt and some , jobs were
predicated on a level of growth and consumer spending that seemed to evaporate al-
most overnight,” Jeremy Aguero, an economic and marketing analyst who follows the
Nevada economy, testified to the Commission.
The performance of the stock market in the wake of the crisis also reduced
wealth. The Standard and Poor’s  Index fell by a third in —the largest single-
year decline since —as big institutional investors moved to Treasury securities
and other 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 calcu-
lation, assets in retirement accounts such as (k)s lost . trillion, or about a third
of their value, between September  and December . While the stock mar-
ket has recovered somewhat, the S&P  as of December , , was still about
 below where it was at the start of . Similarly, stock prices worldwide plum-
meted more than  in  but rebounded by  in , according to the MSCI
World Index stock fund (which represents a collection of , 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  billion, unaddressed, could cause the Public Employees Re-
tirement Association plan—which covers , public workers and teachers—to
go bust in two decades. The state cut retiree benefits to adjust for the losses. Mon-
tana’s public pension funds lost  billion, or a fourth of their value, in the six months
following the  downturn, in part because of investments in complex Wall Street
securities.
Even before the fall of , consumer confidence had been on a downward slope
for months. The Conference Board reported in May  that its measure of con-
sumer confidence fell to the lowest point since late . By early , 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 ap-
praiser 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  billion at the end of . Almost two years later, that total had fallen
, to  billion. The actions of banks have also played an important role: since
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

, they have tightened lending standards, reduced lines of credit on credit cards,
and increased fees and interest rates. In the third quarter of ,  of banks im-
posed standards on credit cards that were tighter than those in place in the previous
quarter. In the fourth quarter,  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 . Only in the latest surveys have even a small num-
bers of banks begun to loosen them. Faced with financial difficulties, over . mil-
lion households declared bankruptcy in , up from approximately . million
in .
Together, the decline in households’ financial resources, banks’ tightening of lend-
ing 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 . in the second half of  and then fell
again in the first half of . Gains since then have been modest. Spending on cars
and trucks fell by an extraordinary  between the end of  and the spring of
, in part because consumer financing was less available as well as because of job
and wage losses.

BUSINESSES: “SQUIRRELS STORING NUTS”

When the financial panic hit in September , 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 execu-
tive at Devon Energy Corporation, told the FCIC that had the government not sup-
ported the commercial paper market, “We would have been eating grasshoppers and
living in tents. Things could have been that bad.” While his expression was hyper-
bolic, the fear was very real. The lack of credit and the sharp drop in demand took its
toll on businesses. In , just under , U.S. companies filed for bankruptcy
protection. That figure more than tripled to nearly , in . 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- 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 , , 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, in-
hibiting growth and reducing their potential for improving productivity. A survey of
chief financial officers found that  of U.S. companies were somewhat or very af-
fected by credit constraints, leading to decisions to make cuts in capital investment,
 T H E E C O N O M I C FA L L O U T 

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 compa-
nies such as Merck and Wyeth; and tech companies alike laid off employees as the re-
cession took hold. Some businesses struggled to cover payrolls and the financing of
inventory.
The introduction in October  of the Commercial Paper Funding Facility, un-
der 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  of banks tightened credit standards
and lending in the fourth quarter of . And small businesses particularly felt the
squeeze. Because they employ nearly  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 . Unlike the larger firms,
which had come to rely on capital markets for borrowing, these companies had gen-
erally obtained their credit from traditional banks, other financial institutions, nonfi-
nancial 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 ,  of respondents called credit “harder to get.” That figure compares with
 in  and a previous peak, at around , during the credit crunch of .
Fed Chairman Ben Bernanke said in a July  speech that getting a small busi-
ness loan was still “very difficult.” He also noted that banks’ loans to small businesses
had dropped from more than  billion in the second quarter of  to less than
 billion in the first quarter of .
Another factor—hesitancy to take on more debt in an anemic economy—is cer-
tainly 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, cus-
tomers 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  percentage point premium over their funding costs on business loans,
but that premium had hit  points by year-end  and had continued to rise in
, raising the costs of borrowing.
Small businesses’ access to credit also declined when the housing market col-
lapsed. 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 em-
ployers with a mortgage refinanced it specifically to capitalize their businesses. As
housing prices declined, their ability to use this option was reduced or blocked alto-
gether by the lenders. Jerry Jost told the FCIC he borrowed against his home to help
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 busi-
nesses, also became more stringent. In the Fed’s April  Senior Loan Officer Sur-
vey, 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 . But the July  update of the Fed survey showed the first positive
signs since the end of  that banks were easing up on underwriting standards for
small businesses.
In an effort to assist small business lenders, the Federal Reserve in March 
created the Term Asset-Backed Securities Loan Facility (TALF), a program to aid se-
curitization 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  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 pay-
ing bills, and bankruptcies and loan defaults rose. Defaults on small business loans
increased to  in , from  in . Overall, the current state of the small
business sector is a critical factor in the struggling labor market: ailing small busi-
nesses have laid people off in large numbers, and stronger small businesses are not
hiring additional workers.
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 . 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 . 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 , it regis-
tered to borrow up to  billion in commercial paper through one government pro-
gram and issued . billion in long-term debt and . billion in commercial
paper under another program. That GE Capital had trimmed commercial paper be-
fore the crisis to less than  of its total debt, or about  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.
 T H E E C O N O M I C FA L L O U T 

The firm put more than  billion in cash on its balance sheet, with  billion in
back-up bank lines of credit, if needed.
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 col-
lapsed in nearly every major trading country. The decline in exports shaved more
than  percentage points off GDP growth in the third and fourth quarters of .
Recently, exports have begun to recover, and as of the fall of  they are back near
precrisis levels.

COMMERCIAL REAL ESTATE: “NOTHING’S MOVING”

Commercial real estate—offices, stores, warehouses—also took a pounding, an indi-
cator 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 de-
mand, 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  and .
In fall , commercial vacancy rates were still sky-high, with  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
, compared with their low of  midway through . Vacancies in retail com-
mercial space in Las Vegas top , compared with historical vacancy rates of  to
. The economic downturn tugged national-brand retailers into bankruptcy, emp-
tying out the 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 . Lehman’s bankruptcy meant that Monday Properties
came up short in its efforts to build a  million, -story glass office tower in Ar-
lington, 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 ten-
ants. “It’s a bit of a cart-and-horse situation,” said CEO Anthony Westreich, who in
October  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 overex-
tended banks suddenly pulled out of commercial construction loans. And when banks
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

failed and were taken over by the Federal Deposit Insurance Commission, the com-
mercial landlords overnight lost major bank tenants and the long-term leases that
went with them. In California, at least  banks have failed since .
Almost half of commercial real estate loans were underwater as of February ,
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 re-
gional banks. Some commercial mortgages were also securitized, and by August
, the delinquency rate on these packaged mortgages neared —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 , the default rate had been ..
Near the end of , 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-
. About half of the decline between  and  has been recovered, accord-
ing to Mike Kirby, Green Street’s director of research. “Nevertheless,” Kirby added,
“values remain roughly  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 de-
tected some signs of a pickup in the spring and fall of , 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 pro-
jected for  and beyond, according to a report issued by the Congressional Over-
sight Panel. And, looking forward, nearly  billion in commercial real estate
debt will come due from  through .

GOVERNMENT: “STATES STRUGGLED TO CLOSE SHORTFALLS”

State and local government finances
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 wel-
fare, in addition to local assistance for mental health care, for children, and for the
homeless. “At least  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 tank.
“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
 T H E E C O N O M I C FA L L O U T 

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  fiscal year alone, which started
July , states must come up with  billion in savings or new revenue to balance
their budgets, one study estimated. By the fall of , 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  report, the National Conference of State Legislatures de-
clared that the states “are waiting to see if the economy will sustain this nascent rev-
enue 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 pressures.”
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 , New Jersey Governor Chris Christie proposed chopping 
billion—or a quarter—of the state budget to eliminate a deficit. California officials
struggled through the summer and fall to close a  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 
billion— billion in the  billion budget for this year and  billion in the fis-
cal year commencing in June . As people lost jobs, many also lost their health
insurance, helping to drive . million Americans into the Medicaid program in
 alone, an  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 en-
rollment increase: in nine states it was greater than ; in Nevada and Wisconsin,
greater than .
States share the cost of Medicaid with the federal government. Congress included
 billion in the stimulus package to help them with this expense, and it has ex-
tended the assistance through June  at a reduced level. If the economy has not
improved by then, Kaiser predicts, paying for this program will be another huge po-
tential 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 effects of a depressed real estate market, low levels of consumer confidence,
and high levels of unemployment will likely play out in cities through ,  and
beyond,” the survey of  cities reported. The authors of the survey projected that
revenue would fall  in , and cities’ budgets would shrink another , the
largest cutbacks in the  years for which the group has published the report.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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. Mu-
nicipalities in Florida, the state with the third-highest rate of home foreclosures, saw
borrowing costs rise when they sold  million in bonds in September .

Impact at the federal level

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, inef-
fective or both.”
The government’s fiscal initiatives began soon after the recession started: the Eco-
nomic Stimulus Act of , signed into law in February, provided roughly  bil-
lion in tax rebates for households and tax incentives for businesses. In October ,
at the height of the crisis, the  billion TARP was enacted; and in early , the
American Recovery and Reinvestment Act of  was enacted to stimulate the weak-
ening economy, costing another  billion in tax cuts and government spending.
Beginning with the rate cuts in mid- through the implementation of the
TALF in early , the Federal Reserve provided support to the economy through-
out the crisis. Aside from its emergency lending programs put in place during the fi-
nancial crisis, the Fed put about . trillion into the economy from September 
to October —primarily by buying financial assets such as mortgages-backed se-
curities and Treasury bonds, a process known as “quantitative easing.” And in No-
vember , officials announced another  billion in easing, designed to keep
long-term and short-term interest rates down.
In October , the Treasury Department reported that the TARP program
would cost far less than the  billion that Congress had appropriated in the fall of
, because banks had begun to repay the Treasury in . In fact, Treasury said,
TARP would wind up costing about  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 
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 out-
lays, could reach  billion by .
Overall, as spending increased and revenues declined during the recession, the
federal deficit grew from  billion in  to . trillion in . And it is esti-
mated to have risen to . trillion in .

THE FINANCIAL SECTOR:

“ALMOST TRIPLE THE LEVEL OF THREE YEARS EARLIER”
While the overall economy has struggled, the story for the financial sector is some-
what different. Like other sectors of the economy, the financial industry has cut
 T H E E C O N O M I C FA L L O U T 

jobs. After growing steadily for years, employment in the financial sector fell by
, in , , in , and another , in . Areas dependent on
the financial industry, such as Charlotte, North Carolina, have been hit hard. The un-
employment rate in the Charlotte area rose from . in  to a recent peak of
. in February .
Between January  and December ,  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  in the second quarter of  to  in the third
quarter, the largest number since March . Though a number of large financial
institutions failed or nearly failed during the crisis, on the whole they have done bet-
ter since the fall of . Total financial sector profits peaked at  billion in 
and then fell to  billion in , the lowest level since the early s. They have
since rebounded in  and , boosted by low interest rates and access to low-
cost government borrowing. Financial sector profits were  billion in  and
reached an annual rate of  billion in the fall of .
Within the financial sector, commercial bank profits rose from . billion in the
first quarter of  to . billion in the first quarter of . The gains were con-
centrated among the larger banks. For banks with assets greater than  billion,
profits more than doubled, from . billion to . billion, from the first quarter of
 to the first quarter of . For commercial banks with less than  billion in
assets, profits rose only , from less than  billion to . 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 secu-
rities firms in  were . billion, up  from the year before, with “average
compensation [rising] by  percent to more than ,.” After reporting 
billion of losses during  and , the New York State Comptroller reported that
in , “industry profits reached a record . billion—almost triple the level of
three years earlier.”
 22
THE FORECLOSURE CRISIS

CONTENTS
Foreclosures on the rise: “Hard to talk about any recovery” ...............................
Initiatives to stem foreclosures: “Persistently disregard” ......................................
Flaws in the process: “Speculation and worst-case scenarios” ............................
Neighborhood effects: “I’m not leaving”..............................................................

FORECLOSURES 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  million and more than 
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 , the foreclosure rate was historically less than . But the trend
since the housing market collapsed has been dramatic: In , . of all houses, or
 out of , received at least one foreclosure filing. In the fall of ,  in every 
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.
Returning to the , borrowers whose loans were pooled into CMLTI -
NC: by September , many had moved or refinanced their mortgages; by that
point, , had entered foreclosure (mostly in Florida and California), and  had
started loan modifications. Of the , still active loans then,  were seriously
past due in their payments or currently in foreclosure. 
The causes of foreclosures have been analyzed by many academics and govern-
ment agencies. Two events are typically necessary for a mortgage default. First,
monthly payments become unaffordable owing to unemployment or other financial


 THE FORECLOSURE CRISIS 

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.
“The evidence is irrefutable,” Laurie Goodman, a senior managing director with
Amherst Securities, told Congress in : “Negative equity is the most important
predictor of default. When the borrower has negative equity, unemployment acts as
one of many possible catalysts, increasing the probability of default.”
After falling  from their peak in  to the spring of , home prices have
rebounded somewhat, but improvements are uneven across regions. Nationwide,
. million households, or . of those with mortgages, owe more on their mort-
gages than the market value of their house (see figure .). In Nevada,  of homes
with mortgages are under water, the highest rate in the country; in California, the
rate is .
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 , three states particularly hard hit by foreclosures—California,
Florida, and Nevada—reported some recent improvement in the initiation of foreclo-
sures, but in November Nevada’s rate was still five times higher than the national av-
erage. Foreclosure starts climbed in  states from their levels a year earlier, with the
largest increases in Washington State (which has . unemployment), Indiana
(. unemployment), and South Carolina (. 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 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 , foreclosures in
. 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 Commission.
In a spring  survey,  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, , said they expected the fore-
closure problems to stay the same or worsen in their cities over the next year.
“There has been no meaningful decline in the inventory of distressed properties
found in the housing market,” Guy Cecala, the chief executive and publisher of Inside
Mortgage Finance Publications, told a congressional panel overseeing the Troubled
Asset Relief Program in October . “It is hard to talk about any recovery of the
housing market when the share of distressed property transactions remains close to
 percent.”
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

“Underwater” Mortgages
Many mortgage holders find themselves underwater; that is, owing more
than their homes are worth. This is particularly true in Arizona, California,
Florida, Michigan, and Nevada.
SHARE OF LOANS WITH NEGATIVE EQUITY, THIRD QUARTER 2010

>50%
30–49
WA 15–29
0–14 ME
MT
ND NA
OR
VT
ID MN NH
SD WI NY MA
WY CT
MI
RI
NV PA NJ
IA
NE OH DE
UT
CA IL IN DC
CO WV MD
KS MO VA
KY
NC
AZ TN
NM OK
AR SC

MS AL GA
U.S. average
TX LA
23%
FL
AK

HI

SOURCE: CoreLogic

Figure .

“There was a fundamental change in our financial services sector that really is the
reason we’re in this crisis, this economic crisis, and is the reason we’re seeing and will
see in total probably before we’re done, between  and  million foreclosure filings
in this country,” John Taylor, the president and CEO of the National Community
Reinvestment Coalition, explained to the FCIC. “And by the way, a few hundred
thousand people, even a million people going into foreclosure, you can kind of blame
and say, ‘Well they should have known better.’ But  [or]  million American fami-
lies can’t all be wrong. They can’t all be greedy and they can’t all be stupid.”
 THE FORECLOSURE CRISIS 

INITIATIVES TO STEM FORECLOSURES:

“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, includ-
ing 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  to 
million families targeted for help by the end of . (The program’s resources come
from the federal TARP funds.) As of December , HAMP has resulted in the per-
manent modification of only , mortgages. Meanwhile, the banks report that
they have independently approved . million loan alterations of various kinds, al-
though many of these modifications simply roll missed payments into a new mort-
gage and thus result in higher monthly payments.
The effectiveness of state mortgage modification and foreclosure assistance pro-
grams is unclear. Some are just getting started. New Jersey, for instance, will begin a
 million “HomeKeeper Program” in , to offer some residents who face foreclo-
sure 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.
Kirsten Keefe, a senior staff attorney with the Empire Justice Center in Albany, New
York, brought this issue to regulators’ attention in March . Speaking to the Fed-
eral Reserve Board’s Consumer Advisory Council in Washington, Keefe identified
trends among borrowers in New York who tried to qualify for the government’s
HAMP program. “We are also routinely hearing that folks who have a lot of equity
are . . . being denied HAMP modifications,” she said. Diane Thompson, from the
National Consumer Law Center, testified to the United States Senate Committee on
Banking, Housing, and Urban Affairs in November  about the challenges of the
program. She stated, “Only a very few of the potentially eligible borrowers have been
able to obtain permanent modifications. Advocates continue to report that borrowers
are denied improperly for HAMP . . . and that some servicers persistently disregard
HAMP applications.”
Competing incentives may encourage banks to view foreclosure as quicker,
cleaner, and often cheaper than modifying the terms of existing mortgages.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

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 guid-
ing a mortgage through the foreclosure process, creating an incentive to deny a
modification.
Frequently, there’s another complication to attempting a foreclosure or modifi-
cation: 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  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 sec-
ond mortgages could be much less than their  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 obliga-
tions. According to Laurie Goodman, for mortgage modifications to work, the hold-
ers of the second mortgages will have to accept some losses—a potentially expensive
proposition.
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 high-
est-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 mod-
ification, 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 borrow-
ers, 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.
 THE FORECLOSURE CRISIS 

FLAWS IN THE PROCESS:

“SPECULATION AND WORSTCASE SCENARIOS”
In , additional issues have come to the fore, as problems with individual foreclo-
sures have revealed systemic flaws in how lenders documented and processed mort-
gages 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  of the nation’s state attorneys general banded together in the fall of  to
investigate foreclosure irregularities, identify possible solutions, and explore poten-
tial 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 about mortgages that they did not actually know to be true. One such “robo-
signer,” Jeffrey Stephan of GMAC, said that he signed , affidavits in a month—
roughly  per minute, in a -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 signa-
tures, backdated mortgage paperwork, and failure to demonstrate having legal stand-
ing to foreclose—that is, being the entity with the right to repossess a home.
The problem of legal standing arose because the rapid growth of mortgage securi-
tization outpaced the ability of the legal and financial system to accurately record
who owns the mortgage. During the securitization process, loans were sold multiple
times. To speed up processing, the financial industry created Mortgage Electronic
Registration Systems, Inc. (MERS), an organization made up of , mortgage
lenders. It tracks changes in servicing rights and ownership interests in mortgage
loans. MERS is designated as the “mortgagee of record” on behalf of its members, a
status that is meant to give it the legal right to foreclose if the borrower fails to pay the
loan. MERS has registered  million mortgages since launching in  and had 
million loans outstanding as of November .
The standing of MERS or its designees to foreclose has been called into question
by courts and academics, however. In a hearing before the House Judiciary Com-
mittee on the foreclosure crisis, New York State Supreme Court Justice F. Dana
Winslow testified that “standing has become such a pervasive issue that I frequently
use the term ‘presumptive mortgagee in foreclosure’” to describe MERS. Because of
“multiple unrecorded transfers of the legal ownership of the [m]ortgage,” it is unclear
whether MERS continued to be the mortgagee after subsequent sales of the loan, ac-
cording to Winslow. Moreover, courts have held that MERS does not own the un-
derlying note and therefore cannot transfer the note or the deed of trust, or foreclose
upon the property.
Winslow also highlighted other deficiencies in MERS’ standing, many involving
sloppy paperwork: the failure to produce the correct promissory notes in court during
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

foreclosure proceedings; gaps in the chain of title, including printouts of the title that
have differed substantially from information provided previously; retroactive assign-
ments of notes and mortgages in an effort to clean up the paperwork problems from
earlier years; questionable signatures on assignments and affidavits attesting
to the ownership of the note and mortgage; and questionable notary stamps on
assignments.
On November , , a bankruptcy court ruled that the Bank of New York
could not foreclose on a loan it had purchased from Countrywide, because MERS
had failed to endorse or deliver the note to the Bank of New York as required by the
pooling and servicing agreement. This ruling could have further implications, be-
cause it was customary for Countrywide to maintain possession of the note and re-
lated loan documents when loans were securitized.
Across the market, some mortgage securities holders have sued the issuers of
those securities, demanding that the issuers rescind their purchases. If the legal
challenges succeed, investors that own mortgage-backed securities could force the is-
suers to buy them back at the original price—possibly with interest. The issuers
would then be the owners of the securities and would bear the risk of loss.
The Congressional Oversight Panel, in a report issued in November , said it
is on the lookout for such risks: “If documentation problems prove to be pervasive
and, more importantly, throw into doubt the ownership of not only foreclosed prop-
erties but also pooled mortgages, the consequences could be severe.” This sentiment
was echoed by University of Iowa law professor Katherine Porter who has studied
foreclosures and the law: “It is lack of knowledge of how widespread the problems
may be that is turning the allegations into a crisis. Lack of knowledge feeds specula-
tion and worst-case scenarios.” Adam Levitin, a Georgetown University associate
professor of law, has estimated that the claims could be in the trillions of dollars, ren-
dering major U.S. banks insolvent.

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 cir-
cle to forests of “for sale” signs—but this time attracting few buyers. Stores have shut-
tered; employers have cut jobs; hopes have fled. Too many Americans today find
themselves in suburban ghost towns or urban wastelands, where properties are va-
cant 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  of
buildings with foreclosures in  and  were renter-occupied, according to sta-
tistics 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.
 THE FORECLOSURE CRISIS 

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, ac-
cording 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 . million people living in and around Las Vegas, was forced to cut its Fi-
nancial 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.”
And the stories continue. Karen Mann, the appraiser from Discovery Bay, Cali-
fornia, testified to the Commission about her family’s circumstances. Her daughter
and son-in-law refinanced their mortgage into an adjustable-rate mortgage. When
the time came for the rate to adjust upward, new financial troubles made the pay-
ments more than the family could afford. Because the market value of the home was
nearly equal to their mortgage debt, the family’s attempts to get the mortgage modi-
fied were fruitless. They lined up a buyer for a short sale, but the deal was nixed.
Then, when medical problems created yet another challenge, the couple and their
four children moved in with Mann. “The children were relocated to new schools,
and the adults dealt with the pain and emotional suffering while they were trying to
rebuild their lives,” Mann said. The couple filed for bankruptcy. Two months after
the bankruptcy was completed, the lender asked them if they wanted to modify
their mortgage.
In Cape Coral, Florida, Dawn Hunt and her husband, a mailman, and their two
children live in an attractive ranch-style home they bought for about , more
than a decade ago. It was a quiet, -year-old subdivision where most of the residents
were homeowners. In  and , builders rushed to the area and threw up
dozens of new homes on empty lots. Homebuilder Comfort Homes of Florida LLC
broke ground for a house across the street from the Hunts, but did not complete it.
This fall, the house sat vacant, an empty shell. No stucco was ever applied to the con-
crete block exterior, and the house had no interior walls. A wasp nest decorated the
electrical box near the front door. The untended grass had grown four feet high.
Sharp sand spurs in the brush made it difficult to approach the property. Two doors
down from the Hunts, another house was also vacant, left empty when a family split
up and moved a year earlier. They abandoned a car in the garage. The roof leaked,
and a blue plastic tarp put in place to keep the rain out now flaps in the breeze. The
Hunts called the police after vandals broke into the house one night; intruders have
been back twice more in the daylight.
 F I N A N C I A L C R I S I S I N Q U I RY C O M M I S S I O N R E P O R T

Now  of the homes in the Hunts’ neighborhood are in default, are in the fore-
closure process, or have been taken back by the bank. Most of the other houses in
the community are occupied by renters whose absentee landlords bought the houses
when the homeowners lost their homes to their banks. The Hunts’ house has lost
two-thirds of its value from the peak of the market. Nonetheless, even though the
neighborhood is not as lovely as it used to be, Dawn Hunt told the FCIC, “I’m not
leaving.”

COMMISSION CONCLUSIONS ON CHAPTER 22

The Commission concludes the unchecked increase in the complexity of mort-
gages and securitization has made it more difficult to solve problems in the
mortgage market. This complexity has created powerful competing interests, in-
cluding those of the holders of first and second mortgages and of mortgage ser-
vicers; has reduced transparency for policy makers, regulators, financial
institutions, and homeowners; and has impeded mortgage modifications. The
resulting disputes and inaction have caused pain largely borne by individual
homeowners and created further uncertainty about the health of the housing
market and financial institutions.
 Dissenting Statement of

Commissioner Commissioner

KEITH D OUGLAS
HENNESSEY HOLTZ-EAKIN

Vice Chairman

BILL
THOMAS
 CAUSES OF THE
FINANCIAL AND ECONOMIC CRISIS

CONTENTS
Introduction.......................................................................................................
How Our Approach Differs from Others’ ..........................................................
Stages of the Crisis..............................................................................................
The Ten Essential Causes of the Financial and Economic Crisis........................
The Credit Bubble: Global Capital Flows, Underpriced Risk,
and Federal Reserve Policy.................................................................................
The Housing Bubble ..........................................................................................
Turning Bad Mortgages into Toxic Financial Assets ..........................................
Big Bank Bets and Why Banks Failed................................................................
Two Types of Systemic Failure............................................................................
The Shock and the Panic....................................................................................
The System Freezing ..........................................................................................

INTRODUCTION
We have identified ten causes that are essential to explaining the crisis. In this dis-
senting view:

• We explain how our approach differs from others’;

• We briefly describe the stages of the crisis;
• We list the ten essential causes of the crisis; and
• We walk through each cause in a bit more detail.

We find areas of agreement with the majority’s conclusions, but unfortunately the
areas of disagreement are significant enough that we dissent and present our views in
this report.
We wish to compliment the Commission staff for their investigative work. In
many ways it helped shape our thinking and conclusions.
Due to a length limitation recently imposed upon us by six members of the Com-
mission, this report focuses only on the causes essential to explaining the crisis. We
regret that the limitation means that several important topics that deserve a much
fuller discussion get only a brief mention here.


 D I S S E N T I N G S TAT E M E N T

HOW OUR APPROACH DIFFERS FROM OTHERS’

During the course of the Commission’s hearings and investigations, we heard fre-
quent arguments that there was a single cause of the crisis. For some it was interna-
tional capital flows or monetary policy; for others, housing policy; and for still
others, it was insufficient regulation of an ambiguously defined shadow banking sec-
tor, or unregulated over-the-counter derivatives, or the greed of those in the financial
sector and the political influence they had in Washington.
In each case, these arguments, when used as single-cause explanations, are too
simplistic because they are incomplete. While some of these factors were essential
contributors to the crisis, each is insufficient as a standalone explanation.
The majority’s approach to explaining the crisis suffers from the opposite prob-
lem–it is too broad. Not everything that went wrong during the financial crisis
caused the crisis, and while some causes were essential, others had only a minor im-
pact. Not every regulatory change related to housing or the financial system prior to
the crisis was a cause. The majority’s almost -page report is more an account of
bad events than a focused explanation of what happened and why. When everything
is important, nothing is.
As an example, non-credit derivatives did not in any meaningful way cause or
contribute to the financial crisis. Neither the Community Reinvestment Act nor re-
moval of the Glass-Steagall firewall was a significant cause. The crisis can be ex-
plained without resorting to these factors.
We also reject as too simplistic the hypothesis that too little regulation caused the
crisis, as well as its opposite, that too much regulation caused the crisis. We question
this metric for determining the effectiveness of regulation. The amount of financial
regulation should reflect the need to address particular failures in the financial sys-
tem. For example, high-risk, nontraditional mortgage lending by nonbank lenders
flourished in the s and did tremendous damage in an ineffectively regulated en-
vironment, contributing to the financial crisis. Poorly designed government housing
policies distorted market outcomes and contributed to the creation of unsound
mortgages as well. Countrywide’s irresponsible lending and AIG’s failure were in part
attributable to ineffective regulation and supervision, while Fannie Mae and Freddie
Mac’s failures were the result of policymakers using the power of government to
blend public purpose with private gains and then socializing the losses. Both the “too
little government” and “too much government” approaches are too broad-brush to
explain the crisis.
The majority says the crisis was avoidable if only the United States had adopted
across-the-board more restrictive regulations, in conjunction with more aggressive
regulators and supervisors. This conclusion by the majority largely ignores the global
nature of the crisis. For example:

• A credit bubble appeared in both the United States and Europe. This tells us
that our primary explanation for the credit bubble should focus on factors
common to both regions.
 K E I T H H E N N E S S E Y, D O U G L A S H O LT Z - E A K I N , AND BILL THOMAS 

House Price Appreciation in Selected Countries, 2002-2008

The United States was one of many countries to experience rapid house price growth

2002 INDEX = 100

United States United Kingdom Spain

200
192

158
150

118
100
’02 ’04 ’06 ’08 ’02 ’04 ’06 ’08 ’02 ’04 ’06 ’08

Australia France Ireland

200

168
152
150
142

100
’02 ’04 ’06 ’08 ’02 ’04 ’06 ’08 ’02 ’04 ’06 ’08

SOURCES: Standard and Poors, Nationwide, Banco de España, AusStats, FNAIM, Permanent TSB

• The report largely ignores the credit bubble beyond housing. Credit spreads de-
clined not just for housing, but also for other asset classes like commercial real
estate. This tells us to look to the credit bubble as an essential cause of the U.S.
housing bubble. It also tells us that problems with U.S. housing policy or mar-
kets do not by themselves explain the U.S. housing bubble.
• There were housing bubbles in the United Kingdom, Spain, Australia, France
and Ireland, some more pronounced than in the United States. Some nations
with housing bubbles relied little on American-style mortgage securitization. A
good explanation of the U.S. housing bubble should also take into account its
parallels in other nations. This leads us to explanations broader than just U.S.
housing policy, regulation, or supervision. It also tells us that while failures in
U.S. securitization markets may be an essential cause, we must look for other
things that went wrong as well.
• Large financial firms failed in Iceland, Spain, Germany, and the United King-
dom, among others. Not all of these firms bet solely on U.S. housing assets, and
 D I S S E N T I N G S TAT E M E N T

they operated in different regulatory and supervisory regimes than U.S. com-
mercial and investment banks. In many cases these European systems have
stricter regulation than the United States, and still they faced financial firm fail-
ures similar to those in the United States.

These facts tell us that our explanation for the credit bubble should focus on fac-
tors common to both the United States and Europe, that the credit bubble is likely an
essential cause of the U.S. housing bubble, and that U.S. housing policy is by itself an
insufficient explanation of the crisis. Furthermore, any explanation that relies too
heavily on a unique element of the U.S. regulatory or supervisory system is likely to
be insufficient to explain why the same thing happened in parts of Europe. This
moves inadequate international capital and liquidity standards up our list of causes,
and it moves the differences between the regulation of U.S. commercial and invest-
ment banks down that list.
Applying these international comparisons directly to the majority’s conclusions
provokes these questions:

• If the political influence of the financial sector in Washington was an essential

cause of the crisis, how does that explain similar financial institution failures in
the United Kingdom, Germany, Iceland, Belgium, the Netherlands, France,
Spain, Switzerland, Ireland, and Denmark?
• How can the “runaway mortgage securitization train” detailed in the majority’s
report explain housing bubbles in Spain, Australia, and the United Kingdom,
countries with mortgage finance systems vastly different than that in the
United States?
• How can the corporate and regulatory structures of investment banks explain
the decisions of many U.S. commercial banks, several large American univer-
sity endowments, and some state public employee pension funds, not to men-
tion a number of large and midsize German banks, to take on too much U.S.
housing risk?
• How did former Fed Chairman Alan Greenspan’s “deregulatory ideology” also
precipitate bank regulatory failures across Europe?

Not all of these factors identified by the majority were irrelevant; they were just
not essential.
The Commission’s statutory mission is “to examine the causes, domestic and
global, of the current financial and economic crisis in the United States.” By fo-
cusing too narrowly on U.S. regulatory policy and supervision, ignoring interna-
tional parallels, emphasizing only arguments for greater regulation, failing to
prioritize the causes, and failing to distinguish sufficiently between causes and ef-
fects, the majority’s report is unbalanced and leads to incorrect conclusions about
what caused the crisis.
We begin our explanation by briefly describing the stages of the crisis.
 K E I T H H E N N E S S E Y, D O U G L A S H O LT Z -E A K I N , AND BILL THOMAS 

STAGES OF THE CRISIS

As of December , the United States is still in an economic slump caused by a fi-
nancial crisis that first manifested itself in August  and ended in early . The
primary features of that financial crisis were a financial shock in September  and
a concomitant financial panic. The financial shock and panic triggered a severe con-
traction in lending and hiring beginning in the fourth quarter of .
Some observers describe recent economic history as a recession that began in
December  and continued until June , and from which we are only now be-
ginning to recover. While this definition of the recession is technically accurate, it ob-
scures a more important chronology that connects financial market developments
with the broader economy. We describe recent U.S. macroeconomic history in five
stages:

• A series of foreshocks beginning in August , followed by an economic

slowdown and then a mild recession through August , as liquidity prob-
lems emerged and three large U.S. financial institutions failed;
• A severe financial shock in September , in which ten large financial institu-
tions failed, nearly failed, or changed their institutional structure; triggering
• A financial panic and the beginning of a large contraction in the real economy
in the last few months of ; followed by
• The end of the financial shock, panic, and rescue at the beginning of ;
followed by
• A continued and deepening contraction in the real economy and the beginning
of the financial recovery and rebuilding period.

As of December , the United States is still in the last stage. The financial sys-
tem is still recovering and being restructured, and the U.S. economy struggles to re-
turn to sustained strong growth. The remainder of our comments focuses on the
financial crisis in the first three stages by examining its ten essential causes.

THE TEN ESSENTIAL CAUSES

OF THE FINANCIAL AND ECONOMIC CRISIS
The following ten causes, global and domestic, are essential to explaining the finan-
cial and economic crisis.

I. Credit bubble. Starting in the late s, China, other large developing
countries, and the big oil-producing nations built up large capital surpluses.
They loaned these savings to the United States and Europe, causing interest
rates to fall. Credit spreads narrowed, meaning that the cost of borrowing to
finance risky investments declined. A credit bubble formed in the United
States and Europe, the most notable manifestation of which was increased
 D I S S E N T I N G S TAT E M E N T

investment in high-risk mortgages. U.S. monetary policy may have con-

tributed to the credit bubble but did not cause it.
II. Housing bubble. Beginning in the late s and accelerating in the s,
there was a large and sustained housing bubble in the United States. The
bubble was characterized both by national increases in house prices well
above the historical trend and by rapid regional boom-and-bust cycles in
California, Nevada, Arizona, and Florida. Many factors contributed to the
housing bubble, the bursting of which created enormous losses for home-
owners and investors.
III. Nontraditional mortgages. Tightening credit spreads, overly optimistic as-
sumptions about U.S. housing prices, and flaws in primary and secondary
mortgage markets led to poor origination practices and combined to in-
crease the flow of credit to U.S. housing finance. Fueled by cheap credit, firms
like Countrywide, Washington Mutual, Ameriquest, and HSBC Finance
originated vast numbers of high-risk, nontraditional mortgages that were in
some cases deceptive, in many cases confusing, and often beyond borrowers’
ability to repay. At the same time, many homebuyers and homeowners did
not live up to their responsibilities to understand the terms of their mort-
gages and to make prudent financial decisions. These factors further ampli-
fied the housing bubble.
IV. Credit ratings and securitization. Failures in credit rating and securitization
transformed bad mortgages into toxic financial assets. Securitizers lowered
the credit quality of the mortgages they securitized. Credit rating agencies er-
roneously rated mortgage-backed securities and their derivatives as safe in-
vestments. Buyers failed to look behind the credit ratings and do their own
due diligence. These factors fueled the creation of more bad mortgages.
V. Financial institutions concentrated correlated risk. Managers of many
large and midsize financial institutions in the United States amassed enor-
mous concentrations of highly correlated housing risk. Some did this know-
ingly by betting on rising housing prices, while others paid insufficient
attention to the potential risk of carrying large amounts of housing risk on
their balance sheets. This enabled large but seemingly manageable mortgage
losses to precipitate the collapse of large financial institutions.
VI. Leverage and liquidity risk. Managers of these financial firms amplified this
concentrated housing risk by holding too little capital relative to the risks
they were carrying on their balance sheets. Many placed their firms on a hair
trigger by relying heavily on short-term financing in repo and commercial
paper markets for their day-to-day liquidity. They placed solvency bets
(sometimes unknowingly) that their housing investments were solid, and liq-
uidity bets that overnight money would always be available. Both turned out
to be bad bets. In several cases, failed solvency bets triggered liquidity crises,
causing some of the largest financial firms to fail or nearly fail. Firms were in-
sufficiently transparent about their housing risk, creating uncertainty in mar-
 K E I T H H E N N E S S E Y, D O U G L A S H O LT Z - E A K I N , AND BILL THOMAS 

kets that made it difficult for some to access additional capital and liquidity
when needed.
VII. Risk of contagion. The risk of contagion was an essential cause of the crisis.
In some cases, the financial system was vulnerable because policymakers
were afraid of a large firm’s sudden and disorderly failure triggering balance-
sheet losses in its counterparties. These institutions were deemed too big and
interconnected to other firms through counterparty credit risk for policy-
makers to be willing to allow them to fail suddenly.
VIII. Common shock. In other cases, unrelated financial institutions failed be-
cause of a common shock: they made similar failed bets on housing. Uncon-
nected financial firms failed for the same reason and at roughly the same
time because they had the same problem: large housing losses. This common
shock meant that the problem was broader than a single failed bank–key
large financial institutions were undercapitalized because of this common
shock.
IX. Financial shock and panic. In quick succession in September , the fail-
ures, near-failures, and restructurings of ten firms triggered a global financial
panic. Confidence and trust in the financial system began to evaporate as the
health of almost every large and midsize financial institution in the United
States and Europe was questioned.
X. Financial crisis causes economic crisis. The financial shock and panic
caused a severe contraction in the real economy. The shock and panic ended
in early . Harm to the real economy continues through today.

We now describe these ten essential causes of the crisis in more detail.

THE CREDIT BUBBLE: GLOBAL CAPITAL FLOWS,

UNDERPRICED RISK, AND FEDERAL RESERVE POLICY
The financial and economic crisis began with a credit bubble in the United States and
Europe. Credit spreads narrowed significantly, meaning that the cost of borrowing to
finance risky investments declined relative to safe assets such as U.S. Treasury securi-
ties. The most notable of these risky investments were high-risk mortgages.
The U.S. housing bubble was the most visible effect of the credit bubble but not
the only one. Commercial real estate, high-yield debt, and leveraged loans were all
boosted by the surplus of inexpensive credit.
There are three major possible explanations for the credit bubble: global capital
flows, the repricing of risk, and monetary policy.

Global capital flows

Starting in the late s, China, other large developing countries, and the big oil-
producing nations consumed and invested domestically less than they earned. As
 D I S S E N T I N G S TAT E M E N T

China and other Asian economies grew, their savings grew as well. In addition,
boosted by high global oil prices, the largest oil-producing nations built up large cap-
ital surpluses and looked to invest in the United States and Europe. Massive amounts
of inexpensive capital flowed into the United States, making borrowing inexpensive.
Americans used the cheap credit to make riskier investments than in the past. The
same dynamic was at work in Europe. Germany saved, and its capital flowed to Ire-
land, Italy, Spain and Portugal.
Fed Chairman Ben Bernanke describes the strong relationship between financial
account surplus growth (the mirror of current account deficit growth) and house
price appreciation: “Countries in which current accounts worsened and capital in-
flows rose . . . had greater house price appreciation [from  to ] . . . The rela-
tionship is highly significant, both statistically and economically, and about 
percent of the variability in house price appreciation across countries is explained.”
Global imbalances are an essential cause of the crisis and the most important
macroeconomic explanation. Steady and large increases in capital inflows into the
U.S. and European economies encouraged significant increases in domestic lending,
especially in high-risk mortgages.

The repricing of risk

Low-cost capital can but does not necessarily have to lead to an increase in risky in-
vestments. Increased capital flows to the United States and Europe cannot alone ex-
plain the credit bubble.
We still don’t know whether the credit bubble was the result of rational or irra-
tional behavior. Investors may have been rational—their preferences may have
changed, making them willing to accept lower returns for high-risk investments.
They may have collectively been irrational—they may have adopted a bubble mental-
ity and assumed that, while they were paying a higher price for risky assets, they
could resell them later for even more. Or they may have mistakenly assumed that the
world had gotten safer and that the risk of bad outcomes (especially in U.S. housing
markets) had declined.
For some combination of these reasons, over a period of many years leading up to
the crisis, investors grew willing to pay more for risky assets. When the housing bub-
ble burst and the financial shock hit, investors everywhere reassessed what return they
would demand for a risky investment, and therefore what price they were willing to
pay for a risky asset. Credit spreads for all types of risk around the world increased
suddenly and sharply, and the prices of risky assets plummeted. This was most evident
in but not limited to the U.S. market for financial assets backed by high-risk, nontradi-
tional mortgages. The credit bubble burst and caused tremendous damage.

Monetary policy
The Federal Reserve significantly affects the availability and price of capital. This
leads some to argue that the Fed contributed to the increased demand for risky in-
 K E I T H H E N N E S S E Y, D O U G L A S H O LT Z -E A K I N , AND BILL THOMAS 

vestments by keeping interest rates too low for too long. Critics of Fed policy argue
that, beginning under Chairman Greenspan and continuing under Chairman
Bernanke, the Fed kept rates too low for too long and created a bubble in housing.
Dr. John B. Taylor is a proponent of this argument. He argues that the Fed set in-
terest rates too low in – and that these low rates fueled the housing bubble
as measured by housing starts. He suggests that this Fed-created housing bubble was
the essential cause of the financial crisis. He further argues that, had federal funds
rates instead followed the path recommended by the Taylor Rule (a monetary policy
formula for setting the funds rate), the housing boom and subsequent bust would
have been much smaller. He also applies this analysis to European economies and
concludes that similar forces were at play.
Current Fed Chairman Bernanke and former Fed Chairman Greenspan disagree
with Taylor’s analysis. Chairman Bernanke argues that the Taylor Rule is a descriptive
rule of thumb, but that “simple policy rules” are insufficient for making monetary
policy decisions. He further argues that, depending on the construction of the par-
ticular Taylor Rule, the monetary policy stance of the Fed may not have diverged sig-
nificantly from its historical path. Former Chairman Greenspan adds that the
connection between short-term interest rates and house prices is weak—that even if
the Fed’s target for overnight lending between banks was too low, this has little power
to explain why rates on thirty-year mortgages were also too low.
This debate intertwines several monetary policy questions:

• How heavily should the Fed weigh a policy rule in its decisions to set interest
rates? Should monetary policy be mostly rule-based or mostly discretionary?
• If the Fed thinks an asset bubble is developing, should it use monetary policy to
try to pop or prevent it?
• Were interest rates too low in –?
• Did too-low federal funds rates cause or contribute to the housing bubble?

This debate is complex and thus far unresolved. Loose monetary policy does not
necessarily lead to smaller credit spreads. There are open questions about the link be-
tween short-term interest rates and house price appreciation, whether housing starts
are the best measure of the housing bubble, the timing of housing price increases rel-
ative to the interest rates in –, the European comparison, and whether the
magnitude of the bubble can be explained by the gap between the Taylor Rule pre-
scription and historic rates. At the same time, many observers argue that Taylor is
right that short-term interest rates were too low during this period, and therefore
that his argument is at least plausible if not provable.
We conclude that global capital flows and risk repricing caused the credit bubble,
and we consider them essential to explaining the crisis. U.S. monetary policy may
have been an amplifying factor, but it did not by itself cause the credit bubble, nor
was it essential to causing the crisis.
The Commission should have focused more time and energy on exploring these
questions about global capital flows, risk repricing, and monetary policy. Instead, the
 D I S S E N T I N G S TAT E M E N T

Commission focused thousands of staff hours on investigation, and not nearly

enough on analyzing these critical economic questions. The investigations were in
many cases productive and informative, but there should have been more balance be-
tween investigation and analysis.

Conclusions:
• The credit bubble was an essential cause of the financial crisis.
• Global capital flows lowered the price of capital in the United States and much
of Europe.
• Over time, investors lowered the return they required for risky investments.
Their preferences may have changed, they may have adopted an irrational bub-
ble mentality, or they may have mistakenly assumed that the world had become
safer. This inflated prices for risky assets.
• U.S. monetary policy may have contributed to the credit bubble but did not
cause it.

THE HOUSING BUBBLE

The housing bubble had two components: the actual homes and the mortgages that
financed them. We look briefly at each component and its possible causes.
There was a housing bubble in the United States—the price of U.S. housing in-
creased by more than could be explained by market developments. This included
both a national housing bubble and more concentrated regional bubbles in four
“Sand States”: California, Nevada, Arizona, and Florida.
Conventional wisdom is that a bubble is hard to spot while you’re in one, and
painfully obvious after it has burst. Even after the U.S. housing bubble burst, there is
no consensus on what caused it.
While we still don’t know the relative importance of the possible causes of the
housing bubble, we can at least identify some of the most important hypotheses:

• Population growth. Arizona, Florida, Nevada, and parts of California all expe-
rienced population growth that far exceeded the national average. More people
fueled more demand for houses.
• Land use restrictions. In some areas, local zoning rules and other land use re-
strictions, as well as natural barriers to building, made it hard to build new
houses to meet increased demand resulting from population growth. When
supply is constrained and demand increases, prices go up.
• Over-optimism. Even absent market fundamentals driving up prices, shared
expectations of future price increases can generate booms. This is the classic
explanation of a bubble.
• Easy financing. Nontraditional (and higher risk) mortgages made it easier for
potential homebuyers to borrow enough to buy more expensive homes. This
doesn’t mean they could afford those homes or future mortgage payments in
 K E I T H H E N N E S S E Y, D O U G L A S H O LT Z - E A K I N , AND BILL THOMAS 

the long run, but only that someone was willing to provide the initial loan.
Mortgage originators often had insufficient incentive to encourage borrowers
to get sustainable mortgages.

Some combination of the first two factors may apply in parts of the Sand States,
but these don’t explain the nationwide increase in prices.
The closely related and nationwide mortgage bubble was the largest and most sig-
nificant manifestation of a more generalized credit bubble in the United States and Eu-
rope. Mortgage rates were low relative to the risk of losses, and risky borrowers, who
in the past would have been turned down, found it possible to obtain a mortgage.
In addition to the credit bubble, the proliferation of nontraditional mortgage
products was a key cause of this surge in mortgage lending. Use of these products in-
creased rapidly from the early part of the decade through . There was a steady
deterioration in mortgage underwriting standards (enabled by securitizers that low-
ered the credit quality of the mortgages they would accept, and credit rating agencies
that overrated the subsequent securities and derivatives). There was a contemporane-
ous increase in mortgages that required little to no documentation.
As house prices rose, declining affordability would normally have constrained
demand, but lenders and borrowers increasingly relied on nontraditional mortgage
products to paper over this affordability issue. These mortgage products included
interest-only adjustable rate mortgages (ARMs), pay-option ARMs that gave bor-
rowers flexibility on the size of early monthly payments, and negative amortization
products in which the initial payment did not even cover interest costs. These exotic
mortgage products would often result in significant reductions in the initial
monthly payment compared with even a standard ARM. Not surprisingly, they were
the mortgages of choice for many lenders and borrowers focused on minimizing
initial monthly payments.
Fed Chairman Bernanke sums up the situation this way: “At some point, both
lenders and borrowers became convinced that house prices would only go up. Bor-
rowers chose, and were extended, mortgages that they could not be expected to serv-
ice in the longer term. They were provided these loans on the expectation that
accumulating home equity would soon allow refinancing into more sustainable
mortgages. For a time, rising house prices became a self-fulfilling prophecy, but ulti-
mately, further appreciation could not be sustained and house prices collapsed.”
This explanation posits a relationship between the surge in housing prices and the
surge in mortgage lending. There is not yet a consensus on which was the cause and
which the effect. They appear to have been mutually reinforcing.
In understanding the growth of nontraditional mortgages, it is also difficult to de-
termine the relative importance of causal factors, but again we can at least list those
that are important:

• Nonbank mortgage lenders like New Century and Ameriquest flourished un-
der ineffective regulatory regimes, especially at the state level. Weak disclosure
standards and underwriting rules made it easy for irresponsible lenders to issue
 D I S S E N T I N G S TAT E M E N T

mortgages that would probably never be repaid. Federally regulated bank and
thrift lenders, such as Countrywide, Wachovia, and Washington Mutual, had
lenient regulatory oversight on mortgage origination as well.
• Mortgage brokers were paid for new originations but did not ultimately bear
the losses on poorly performing mortgages. Mortgage brokers therefore had an
incentive to ignore negative information about borrowers.
• Many borrowers neither understood the terms of their mortgage nor appreci-
ated the risk that home values could fall significantly, while others borrowed
too much and bought bigger houses than they could ever reasonably expect to
afford.
• All these factors were supplemented by government policies, many of which
had been in effect for decades, that subsidized homeownership but created hid-
den costs to taxpayers and the economy. Elected officials of both parties pushed
housing subsidies too far.

The Commission heard convincing testimony of serious mortgage fraud prob-

lems. Excruciating anecdotes showed that mortgage fraud increased substantially
during the housing bubble. There is no question that this fraud did tremendous
harm. But while that fraud is infuriating and may have been significant in certain ar-
eas (like Florida), the Commission was unable to measure the impact of fraud rela-
tive to the overall housing bubble.
The explosion of legal but questionable lending is an easier explanation for the
creation of so many bad mortgages. Lending standards were lax enough that lenders
could remain within the law but still generate huge volumes of bad mortgages. It is
likely that the housing bubble and the crisis would have occurred even if there had
been no mortgage fraud. We therefore classify mortgage fraud not as an essential
cause of the crisis but as a contributing factor and a deplorable effect of the bubble.
Even if the number of fraudulent loans was not substantial enough to have a large im-
pact on the bubble, the increase in fraudulent activity should have been a leading in-
dicator of deeper structural problems in the market.

Conclusions:
• Beginning in the late s and accelerating in the s, there was a large and
sustained housing bubble in the United States. The bubble was characterized
both by national increases in house prices well above the historical trend and by
more rapid regional boom-and-bust cycles in California, Nevada, Arizona, and
Florida.
• There was also a contemporaneous mortgage bubble, caused primarily by the
broader credit bubble.
• The causes of the housing bubble are still poorly understood. Explanations in-
clude population growth, land use restrictions, bubble psychology, and easy fi-
nancing.
• The causes of the mortgage bubble and its relationship to the housing bubble
 K E I T H H E N N E S S E Y, D O U G L A S H O LT Z -E A K I N , AND BILL THOMAS 

are also still poorly understood. Important factors include weak disclosure
standards and underwriting rules for bank and nonbank mortgage lenders
alike, the way in which mortgage brokers were compensated, borrowers who
bought too much house and didn’t understand or ignored the terms of their
mortgages, and elected officials who over years piled on layer upon layer of gov-
ernment housing subsidies.
• Mortgage fraud increased substantially, but the evidence gathered by the Com-
mission does not show that it was quantitatively significant enough to conclude
that it was an essential cause.

TURNING BAD MORTGAGES INTO TOXIC FINANCIAL ASSETS

The mortgage securitization process turned mortgages into mortgage-backed securi-
ties through the government-sponsored enterprises (GSEs) Fannie Mae and Freddie
Mac, as well as Countrywide and other “private label” competitors. The securitiza-
tion process allows capital to flow from investors to homebuyers. Without it, mort-
gage lending would be limited to banks and other portfolio lenders, supported by
traditional funding sources such as deposits. Securitization allows homeowners ac-
cess to enormous amounts of additional funding and thereby makes homeownership
more affordable. It also can diversify housing risk among different types of lenders. If
everything else is working properly, these are good things. Everything else was not
working properly.
Some focus their criticism on the form of these financial instruments. For exam-
ple, financial instruments called collateralized debt obligations (CDOs) were engi-
neered from different bundled payment streams from mortgage-backed securities.
Some argue that the conversion of a bundle of simple mortgages to a mortgage-
backed security, and then to a collateralized debt obligation, was a problem. They ar-
gue that complex financial derivatives caused the crisis. We conclude that the details
of this engineering are incidental to understanding the essential causes of the crisis. If
the system works properly, reconfiguring streams of mortgage payments has little ef-
fect. The total amount of risk in a mortgage is unchanged if the pieces are put to-
gether in a different way.
Unfortunately, the system did not work as it should have. There were several flaws
in the securitization and collateralization process that made things worse.

• Fannie Mae and Freddie Mac, as well as Countrywide and other private label
competitors, all lowered the credit quality standards of the mortgages they se-
curitized. A mortgage-backed security was therefore “worse” during the crisis
than in preceding years because the underlying mortgages were generally of
poorer quality. This turned a bad mortgage into a worse security.
• Mortgage originators took advantage of these lower credit quality securitization
standards and the easy flow of credit to relax the underwriting discipline in the
loans they issued. As long as they could resell a mortgage to the secondary mar-
ket, they didn’t care about its quality.
 D I S S E N T I N G S TAT E M E N T

• The increasing complexity of housing-related assets and the many steps be-
tween the borrower and final investor increased the importance of credit rating
agencies and made independent risk assessment by investors more difficult. In
this respect, complexity did contribute to the problem, but the other problems
listed here are more important.
• Credit rating agencies assigned overly optimistic ratings to the CDOs built
from mortgage-backed securities. By erroneously rating these bundles of
mortgage-backed security payments too highly, the credit rating agencies sub-
stantially contributed to the creation of toxic financial assets.
• Borrowers, originators, securitizers, rating agencies, and the ultimate buyers of
the securities into which the risky mortgages were packaged all failed to exer-
cise prudence and perform due diligence in their respective transactions. In
particular, CDO buyers who were, in theory, sophisticated investors relied too
heavily on credit ratings.
• Many financial institutions chose to make highly concentrated bets on housing
prices. While in some cases they did that with whole loans, they were able to
more easily and efficiently do so with CDOs and derivative securities.
• Regulatory capital standards, both domestically and internationally, gave pref-
erential treatment to highly rated debt, further empowering the rating agencies
and increasing the desirability of mortgage-backed structured products.
• There is a way that housing bets can be magnified using a form of derivative. A
synthetic CDO is a security whose payments mimic that of a CDO that contains
real mortgages. This is a “side bet” that allows you to assume the same risk as if
you held pieces of actual mortgages. To the extent that investors and financial
institutions wanted to increase their bets on housing, they were able to use syn-
thetic CDOs. The risks in these synthetic CDOs, however, are zero-sum, since
for every investor making a bet that housing performance will fall there must
be other investors with equal-sized bets in the opposite direction.

These are related but different problems. While many involve the word “deriva-
tive,” it is a mistake to bundle them together and say, “Derivatives or CDOs caused
the crisis.” In each case, we assign responsibility for the failures to the people and in-
stitutions rather than to the financial instruments they used.

Conclusions:
Rather than “derivatives and CDOs caused the financial crisis,” it is more accurate
to say:

• Securitizers lowered credit quality standards;

• Mortgage originators took advantage of this to create junk mortgages;
• Credit rating agencies assigned overly optimistic ratings;
• Securities investors and others failed to perform sufficient due diligence;
 K E I T H H E N N E S S E Y, D O U G L A S H O LT Z - E A K I N , AND BILL THOMAS 

• International and domestic regulators encouraged arbitrage toward lower capi-

tal standards;
• Some investors used these securities to concentrate rather than diversify risk;
and
• Others used synthetic CDOs to amplify their housing bets.

The dangerous imprecision of the term “shadow banking”

Part II of the majority’s report begins with an extensive discussion of the failures of
the “shadow banking system,” which it defines as a “financial institutions and activi-
ties that in some respects parallel banking activities but are subject to less regulation
than commercial banks.” The majority’s report suggests that the shadow banking sys-
tem was a cause of the financial crisis.
“Shadow banking” is a term used to represent a collection of different financial in-
stitutions, instruments, and issues within the financial system. Indeed, “shadow
banking” can refer to any financial activity that transforms short-term borrowing
into long-term lending without a government backstop. This term can therefore in-
clude financial instruments and institutions as diverse as:

• The tri-party repo market;

• Structured Investment Vehicles and other off-balance-sheet entities used to in-
crease leverage;
• Fannie Mae and Freddie Mac;
• Credit default swaps; and
• Hedge funds, monoline insurers, commercial paper, money market mutual
funds, and investment banks.

As discussed in other parts of this paper, some of these items were important
causes of the crisis. No matter what their individual roles in causing or contributing
to the crisis, however, they are undoubtedly different. It is a mistake to group these is-
sues and problems together. Each should be considered on its merits, rather than
painting a poorly defined swath of the financial sector with a common brush of “too
little regulation.”

BIG BANK BETS AND WHY BANKS FAILED

The story so far involves significant lost housing wealth and diminished values of se-
curities financing those homes. Yet even larger past wealth losses did not bring the
global financial system to its knees. The key differences in this case were leverage and
risk concentration. Highly correlated housing risk was concentrated in large and
highly leveraged financial institutions in the United States and much of Europe. This
leverage magnified the effect of a housing loss on a financial institution’s capital re-
serve, and the concentration meant these losses occurred in parallel.
 D I S S E N T I N G S TAT E M E N T

In effect, many of the largest financial institutions in the world, along with hun-
dreds of smaller ones, bet the survival of their institutions on housing prices. Some
did this knowingly; others not.
Many investors made three bad assumptions about U.S. housing prices. They
assumed:

• A low probability that housing prices would decline significantly;

• Prices were largely uncorrelated across different regions, so that a local housing
bubble bursting in Nevada would not happen at the same time as one bursting
in Florida; and
• A relatively low level of strategic defaults, in which an underwater homeowner
voluntarily defaults on a non-recourse mortgage.

When housing prices declined nationally and quite severely in certain areas, these
flawed assumptions, magnified by other problems described in previous steps, cre-
ated enormous financial losses for firms exposed to housing investments.
An essential cause of the financial and economic crisis was appallingly bad risk
management by the leaders of some of the largest financial institutions in the United
States and Europe. Each failed firm that the Commission examined failed in part be-
cause its leaders poorly managed risk.
Based on testimony from the executives of several of the largest failed firms and
the Commission staff ’s investigative work, we can group common risk management
failures into several classes:

• Concentration of highly correlated (housing) risk. Firm managers bet mas-

sively on one type of asset, counting on high rates of return while comforting
themselves that their competitors were doing the same.
• Insufficient capital. Some of the failed institutions were levered : or higher.
This meant that every  of assets was financed with  of equity capital and
 of debt. This made these firms enormously profitable when things were go-
ing well, but incredibly sensitive to even a small loss, as a  percent decline in
the market value of these assets would leave them technically insolvent. In
some cases, this increased leverage was direct and transparent. In other cases,
firms used Structured Investment Vehicles, asset-backed commercial paper
conduits, and other off-balance-sheet entities to try to have it both ways: fur-
ther increasing their leverage while appearing not to do so. Highly concen-
trated, highly correlated risk combined with high leverage makes a fragile
financial sector and creates a financial accident waiting to happen. These firms
should have had much larger capital cushions and/or mechanisms for contin-
gent capital upon which to draw in a crisis.
• Overdependence on short-term liquidity from repo and commercial paper
markets. Just as each lacked sufficient capital cushions, in each case the failing
firm’s liquidity cushion ran out within days. The failed firms appear to have
based their liquidity strategies on the flawed assumption that both the firm and
 K E I T H H E N N E S S E Y, D O U G L A S H O LT Z - E A K I N , AND BILL THOMAS 

these funding markets would always be healthy and functioning smoothly. By

failing to provide sufficiently for disruptions in their short-term financing,
management put their firm’s survival on a hair trigger.
• Poor risk management systems. A number of firms were unable to easily ag-
gregate their housing risks across various business lines. Once the market be-
gan to decline, those firms that understood their total exposure were able to
effectively sell or hedge their risk before the market turned down too far. Those
that didn’t were stuck with toxic assets in a disintegrating market.

Solvency failure versus liquidity failure

The Commission heard testimony from the former heads of Bear Stearns, Lehman,
Citigroup, and AIG, among others. A common theme pervaded the testimony of
these witnesses:

• We were solvent before the liquidity run started.

• Someone (unnamed) spread bad information and started an unjustified liquid-
ity run.
• Had that unjustified liquidity run not happened, given enough time we would
have recovered and returned to a position of strength.
• Therefore, the firm failed because we ran out of time, and it’s not my fault.

In each case, experts and regulators contested the former CEO’s “we were solvent”
claim. Technical issues make it difficult to prove otherwise, especially because the an-
swer depends on when solvency is measured. After a few days of selling assets at fire-
sale prices during a liquidity run, a highly leveraged firm’s balance sheet will look
measurably worse. In each case, whether or not the firm was technically solvent, the
evidence strongly supports the claim that those pulling back from doing business
with the firm were not irrational. In each of the cases we examined, there were huge
financial losses that at a minimum placed the firm’s solvency in serious doubt.
Interestingly, in each case, the CEO was willing to admit that he had poorly man-
aged his firm’s liquidity risk, but unwilling to admit that his firm was insolvent or
nearly so. In each case the CEO’s claims were highly unpersuasive. These firm man-
agers knew or should have known that they were risking the solvency and therefore
the survival of their firms.

Conclusions:
• Managers of many large and midsize financial institutions in the United States
and Europe amassed enormous concentrations of highly correlated housing
risk on their balance sheets. In doing so they turned a building housing crisis
into a subsequent crisis of failing financial institutions. Some did this know-
ingly; others, unknowingly.
• Managers of the largest financial firms further amplified these big bad bets by
 D I S S E N T I N G S TAT E M E N T

holding too little capital and having insufficiently robust access to liquidity.
Many placed their firms on a hair trigger by becoming dependent upon short-
term financing from commercial paper and repo markets for their day-to-day
funding. They placed failed solvency bets that their housing investments were
solid, and failed liquidity bets that overnight money would always be there no
matter what. In several cases, failed solvency bets triggered liquidity crises,
causing some of the largest financial firms to fail or nearly fail.

“Investment banks caused the crisis”

A persistent debate among members of the Commission was the relative importance
of a firm’s legal form and regulatory regime in the failures of large financial institu-
tions. For example, Commissioners agreed that investment bank holding companies
were too lightly (barely) regulated by the SEC leading up to the crisis and that the
Consolidated Supervised Entities program of voluntary regulation of these firms
failed. As a result, no regulator could force these firms to strengthen their capital or
liquidity buffers. There was agreement among Commissioners that this was a con-
tributing factor to the failure of these firms. The Commission split, however, on
whether the relatively weaker regulation of investment banks was an essential cause
of the crisis.
Institutional structure and differential regulation of various types of financial in-
stitutions were less important in causing the crisis than common factors that spanned
different firm structures and regulatory regimes. Investment banks failed in the
United States, and so did many commercial banks, large and small, despite a stronger
regulatory and supervisory regime. Wachovia, for example, was a large insured de-
pository institution supervised by the Fed, OCC, and FDIC. Yet it experienced a liq-
uidity run that led to its near failure and prompted the first-ever invocation of the
FDIC’s systemic risk exception. Insurance companies failed as well, notably AIG and
the monoline bond insurers.
Banks with different structures and operating in vastly differing regulatory
regimes failed or had to be rescued in the United Kingdom, Germany, Iceland, Bel-
gium, the Netherlands, France, Spain, Switzerland, Ireland, and Denmark. Some of
these nations had far stricter regulatory and supervisory regimes than the United
States. The bad loans in the United Kingdom, Ireland, and Spain were financed by
federally-regulated lenders–not by “shadow banks.”
Rather than attributing the crisis principally to differences in the stringency of
regulation of these large financial institutions, it makes more sense to look for com-
mon factors:

• Different types of financial firms in the United States and Europe made highly
concentrated, highly correlated bets on housing.
• Managers of different types of financial firms in the United States and Europe
poorly managed their solvency and liquidity risk.
 K E I T H H E N N E S S E Y, D O U G L A S H O LT Z - E A K I N , AND BILL THOMAS 

TWO TYPES OF SYSTEMIC FAILURE

Government policymakers were afraid of large firms’ sudden and disorderly failure
and chose to intervene as a result. At times, intervention itself contributed to fear and
uncertainty about the stability of the financial system. These interventions responded
to two types of systemic failure.

Systemic failure type one: contagion

We begin by defining contagion and too big to fail.
If financial firm X is a large counterparty to other firms, X’s sudden and disorderly
bankruptcy might weaken the finances of those other firms and cause them to fail.
We call this the risk of contagion, when, because of a direct financial link between
firms, the failure of one causes the failure of another. Financial firm X is too big to
fail if policymakers fear contagion so much that they are unwilling to allow it to go
bankrupt in a sudden and disorderly fashion. Policymakers make this judgment in
large part based on how much counterparty risk other firms have to the failing firm,
along with a judgment about the likelihood and possible damage of contagion.
Policymakers may also act if they worry about the effects of a failed firm on a par-
ticular financial market in which that firm is a large participant.
The determination of too big to fail rests in the minds of the policymakers who
must decide whether to “bail out” a failing firm. They may be more likely to act if
they are uncertain about the size of counterparty credit risk or about the health of an
important financial market, or if broader market or economic conditions make them
more risk averse.
This logic can explain the actions of policymakers in several cases in :

• In March, the Fed facilitated JPMorgan’s purchase of Bear Stearns by providing

a bridge loan and loss protection on a pool of Bear’s assets. While policymakers
were concerned about the failure of Bear Stearns itself and its direct effects on
other firms, their decision to act was heightened by their uncertainty about po-
tential broader market instability and the potential impact of Bear Stearns’ sud-
den failure on the tri-party repo market.
• In September, the Federal Housing Finance Agency (FHFA) put Fannie Mae
and Freddie Mac into conservatorship. Policymakers in effect promised that
“the line would be drawn between debt and equity,” such that equity holders
were wiped out but GSE debt would be worth  cents on the dollar. They
made this decision because banking regulators (and others) treated Fannie and
Freddie debt as equivalent to Treasuries. A bank cannot hold all of its assets in
debt issued by General Electric or AT&T, but can hold it all in Fannie or Fred-
die debt. The same is true for many other investors in the United States and
around the world–they assumed that GSE debt was perfectly safe and so they
weighted it too heavily in their portfolios. Policymakers were convinced that
 D I S S E N T I N G S TAT E M E N T

this counterparty risk faced by many financial institutions meant that any
write-down of GSE debt would trigger a chain of failures throughout the finan-
cial system. In addition, GSE debt was used as collateral in short-term lending
markets, and by extension, their failure would have led to a sudden massive
contraction of credit beyond what did occur. Finally, mortgage markets de-
pended so heavily on the GSEs for securitization that policymakers concluded
that their sudden failure would effectively halt the creation of new mortgages.
All three reasons led policymakers to conclude that Fannie Mae and Freddie
Mac were too big to fail.
• In September, the Federal Reserve, with support from Treasury, “bailed out”
AIG, preventing it from sudden disorderly failure. They took this action because
AIG was a huge seller of credit default swaps to a number of large financial
firms, and they were concerned that an AIG default would trigger mandatory
write-downs on those firms’ balance sheets, forcing counterparties to scramble
to replace hedges in a distressed market and potentially triggering a cascade of
failures. AIG also had important lines of business in insuring consumer and
business activities that would have been threatened by a failure of AIG’s financial
products division and potentially led to severe shocks to business and consumer
confidence. The decision to aid AIG was also influenced by the extremely
stressed market conditions resulting from other institutional failures in prior
days and weeks.
• In November, the Federal Reserve, FDIC, and Treasury provided assistance to
Citigroup. Regulators feared that the failure of Citigroup, one of the nation’s
largest banks, would both undermine confidence the financial system gained
after TARP and potentially lead to the failures of Citi’s major counterparties.

Conclusion:
The risk of contagion was an essential cause of the crisis. In some cases the financial
system was vulnerable because policymakers were afraid of a large firm’s sudden and
disorderly failure triggering balance-sheet losses in its counterparties. These institu-
tions were too big and interconnected to other firms, through counterparty credit
risk, for policymakers to be willing to allow them to fail suddenly.

Systemic failure type two: a common shock

If contagion is like the flu, then a common shock is like food poisoning. A common
factor affects a number of firms in the same way, and they all get sick at the same
time. In a common shock, the failure of one firm may inform us about the breadth
or depth of the problem, but the failure of one firm does not cause the failure of
another.
The common factor in this case was concentrated losses on housing-related assets
in large and midsize financial firms in the United States and some in Europe.
 K E I T H H E N N E S S E Y, D O U G L A S H O LT Z - E A K I N , AND BILL THOMAS 

These losses wiped out capital throughout the financial sector. Policymakers were
not just dealing with a single insolvent firm that might transmit its failure to others.
They were dealing with a scenario in which many large, midsize, and small financial
institutions took large losses at roughly the same time.

Conclusion:
Some financial institutions failed because of a common shock: they made similar
failed bets on housing. Unconnected financial firms were failing for the same reason
and at roughly the same time because they had the same problem of large housing
losses. This common shock meant the problem was broader than a single failed
bank–key large financial institutions were undercapitalized because of this common
shock.
We examine two frequently debated topics about the events of September .

“The government should not have bailed out _____”

Some argue that no firm is too big to fail, and that policymakers erred when they
“bailed out” Bear Stearns, Fannie and Freddie, AIG, and later Citigroup. In our view,
this misses the basic arithmetic of policymaking. Policymakers were presented, for
example, with the news that “AIG is about to fail” and counseled that its sudden and
disorderly failure might trigger a chain reaction. Given the preceding failures of Fan-
nie Mae and Freddie Mac, the Merrill Lynch merger, Lehman’s bankruptcy, and the
Reserve Primary Fund breaking the buck, market confidence was on a knife’s edge. A
chain reaction could cause a run on the global financial system. They feared not just a
run on a bank, but a generalized panic that might crash the entire system–that is, the
risk of an event comparable to the Great Depression.
For a policymaker, the calculus is simple: if you bail out AIG and you’re wrong,
you will have wasted taxpayer money and provoked public outrage. If you don’t bail
out AIG and you’re wrong, the global financial system collapses. It should be easy to
see why policymakers favored action–there was a chance of being wrong either way,
and the costs of being wrong without action were far greater than the costs of being
wrong with action.

“Bernanke, Geithner, and Paulson

should not have chosen to let Lehman fail”
This is probably the most frequently discussed element of the financial crisis. To
make this case one must argue:

• Bernanke, Geithner, and Paulson had a legal and viable option available to
them other than Lehman filing bankruptcy.
• They knew they had this option, considered it, and rejected it.
 D I S S E N T I N G S TAT E M E N T

• They were wrong to do so.

• They had a reason for choosing to allow Lehman to fail.

We have yet to find someone who can make a plausible case on all four counts. We
think that these three policymakers would have saved Lehman if they thought they
had a legal and viable option to do so. In hindsight, we also think they were right at
the time–they did not have a legal and viable option to save Lehman.
Many prominent public officials and market observers have accused these three of
making a mistake. These critics usually argue that these three should have saved Lehman.
When asked what else they could have done, the critic’s usual response is, “I don’t know,
but surely they could have done something. They chose not to and caused the crisis.”
Those who want to label Lehman’s failure a policy mistake are obliged to suggest
an alternate course of action.
The Fed’s assistance for Bear Stearns, and FDIC and Treasury’s assistance for Wa-
chovia, followed a pattern. In each case, the failing firm or the government found a
buyer, and the government subsidized the purchase. In the case of Bear Stearns, the
government subsidized the purchase, and in the case of Wachovia, the government
made clear that assistance would be available if it were needed. The specific mechan-
ics of the subsidy differed between the two cases, but in each bailout the key condi-
tion was the presence of a willing buyer.
Lehman had no willing buyer. Bank of America bought Merrill Lynch instead, and
no other American financial institution was willing or able to step up. For months,
government officials had tried and failed to facilitate transactions with possible
domestic and foreign purchasers. At the end of “Lehman weekend,” the most viable
candidate was the British bank Barclays. To make the purchase, Barclays needed either
a shareholder vote, which would take several weeks to execute, or the permission of
their regulator. They could get neither in the time available.
Lehman was therefore facing an imminent liquidity run without a path to success.
There was no buyer. There was the possibility that Barclays might be a buyer, some
weeks in the future. Bernanke, Geithner, and Paulson were then confronted with the
question of whether to provide an effectively uncapped loan to Lehman to supplant
its disappearing liquidity while Lehman searched for a buyer.
This loan would have to come from the Fed, since before the enactment of the
TARP legislation, Treasury had no authority to provide such financing. The law lim-
its the Fed in these cases. The Fed can only provide secured loans. They were able to
make this work for Bear Stearns and AIG because there were sufficient unencum-
bered assets to serve as collateral. Fed officials argue that Lehman had insufficient un-
pledged assets to secure the loan it would have needed to survive. Former Lehman
executives and Fed critics argue otherwise, even though private market participants
were unwilling to provide credit.
Was there another option? The Fed leaders would have had to direct the staff to
re-evaluate in a more optimistic way the analysis of Lehman’s balance sheet to justify
a secured loan. They then would have had to decide to provide liquidity support to
 K E I T H H E N N E S S E Y, D O U G L A S H O LT Z -E A K I N , AND BILL THOMAS 

Lehman for an indefinite time period while Lehman searched for a buyer. That asset
revaluation would later have come under intense legal scrutiny, especially given the
likely large and potentially uncapped cost to the taxpayer. In the meantime, other
creditors to Lehman could have cashed out at  cents on the dollar, leaving taxpay-
ers holding the bag for losses.
Fed Chairman Bernanke, his general counsel Scott Alvarez, and New York Fed
general counsel Thomas C. Baxter Jr. all argued in sworn testimony that this option
would not have been legal. Bernanke suggested that it also would have been unwise
because, in effect, the Fed would have been providing an open-ended commitment to
allow Lehman to shop for a buyer. Bernanke testified that such a loan would merely
waste taxpayer money for an outcome that was quite unlikely to change.
Based on their actions to deal with other failing financial institutions in , we
think these policymakers would have taken any available option they thought was
legal and viable. This was an active team that was in all cases erring on the side of in-
tervention to reduce the risk of catastrophic outcomes. Fed Chairman Bernanke
said that he “was very, very confident that Lehman’s demise was going to be a catas-
trophe.” We find it implausible to conclude that they would have broken pattern on
this one case at such an obviously risky moment if they had thought they had an-
other option.
Some find it inconceivable that policymakers could be confronted with a situation
in which there was no legal and viable course of action to avoid financial catastrophe.
In this case, that is what happened.

THE SHOCK AND THE PANIC

Conventional wisdom is that the failure of Lehman Brothers triggered the financial
panic. This is because Lehman’s failure was unexpected and because the debate about
whether government officials could have saved Lehman is so intense.
The focus on Lehman’s failure is too narrow. The events of September  were a
chain of one firm failure after another:

• Sunday, September , FHFA put Fannie Mae and Freddie Mac into
conservatorship.
• This was followed by “Lehman weekend at the New York Fed,” which was in
fact broader than just Lehman. At the end of that weekend, Bank of America
had agreed to buy Merrill Lynch, Lehman was filing for bankruptcy, and AIG
was on the verge of failure.
• Monday, September , Lehman filed for Chapter  bankruptcy protection.
• Tuesday, September , the Reserve Primary Fund, a money market mutual fund,
“broke the buck” after facing an investor run. Its net asset value declined below
, meaning that an investment in the fund had actually lost money. This is a crit-
ical psychological threshold for a money market fund. On the same day, the Fed
approved an  billion emergency loan to AIG to prevent it from sudden failure.
 D I S S E N T I N G S TAT E M E N T

• Thursday, September , the Bush Administration, supported by Fed Chair-

man Bernanke, proposed to Congressional leaders that they appropriate funds
for a new Troubled Asset Relief Program (TARP) to recapitalize banks.
• Friday, September , the  billion TARP was publically announced.
• Sunday, September , the Fed agreed to accept Goldman Sachs and Morgan
Stanley as bank holding companies, putting them under the Fed’s regulatory
purview. After this, there were no large standalone investment banks remaining
in the United States.
• Thursday, September , the FDIC was appointed receiver of Washington Mu-
tual and later sold it to JPMorgan.
• Monday, September , the TARP bill failed to pass the House of Representa-
tives, and the FDIC agreed to provide assistance to facilitate a sale of Wachovia
to Citigroup.
• Wednesday, October , the Senate passed a revised TARP bill. Two days later,
the House passed it, and the President signed it into law. Wells Fargo, rather
than Citigroup, bought Wachovia.
• As the month progressed, interbank lending rates soared, indicating the height-
ened fear and threatening a complete freeze of lending.

The financial panic was triggered and then amplified by the close succession of
these events, and not just by Lehman’s failure. Lehman was the most unexpected bad
news in that succession, but it’s a mistake to attribute the panic entirely to Lehman’s
failure. There was growing realization by investors that mortgage losses were concen-
trated in the financial system, but nobody knew precisely where they lay.

Conclusion:
In quick succession in September , the failure, near-failure, or restructuring of
ten firms triggered a global financial panic. Confidence and trust in the financial sys-
tem began to evaporate as the health of almost every large and midsize financial in-
stitution in the United States and Europe was questioned.
We briefly discuss two of these failures.

The Reserve Primary Fund

The role of the Reserve Primary Fund’s failure in triggering the panic is underappreci-
ated. This money market mutual fund faced escalating redemption requests and had
to take losses from its holdings of Lehman debt. On Tuesday, September , it broke
the buck in a disorganized manner. Investors who withdrew early recouped  cents
on the dollar, with the remaining investors bearing the losses. This spread fear among
investors that other similarly situated funds might follow. By the middle of the follow-
ing week, prime money market mutual fund investors had withdrawn  billion.
When the SEC was unable to reassure market participants that the problem was iso-
lated, money market mutual fund managers, in anticipation of future runs, refused to
 K E I T H H E N N E S S E Y, D O U G L A S H O LT Z - E A K I N , AND BILL THOMAS 

renew the commercial paper they were funding and began to convert their holdings to
Treasuries and cash. Corporations that had relied on commercial paper markets for
short-term financing suddenly had to draw down their backstop lines of credit. No one
had expected these corporate lines of credit to be triggered simultaneously, and this
“involuntary lending” meant that banks would have to pull back on other activities.

The role of Fannie Mae and Freddie Mac in causing the crisis
The government-sponsored enterprises Fannie Mae and Freddie Mac were elements
of the crisis in several ways:

• They were part of the securitization process that lowered mortgage credit quality
standards.
• As large financial institutions whose failures risked contagion, they were massive
and multidimensional cases of the too big to fail problem. Policymakers were un-
willing to let them fail because:
– Financial institutions around the world bore significant counterparty
risk to them through holdings of GSE debt;
– Certain funding markets depended on the value of their debt; and
– Ongoing mortgage market operation depended on their continued
existence.
• They were by far the most expensive institutional failures to the taxpayer and are
an ongoing cost.

There is vigorous debate about how big a role these two firms played in securitiza-
tion relative to “private label” securitizers. There is also vigorous debate about why
these two firms got involved in this problem. We think both questions are less impor-
tant than the multiple points of contact Fannie Mae and Freddie Mac had with the fi-
nancial system.
These two firms were guarantors and securitizers, financial institutions holding
enormous portfolios of housing-related assets, and the issuers of debt that was treated
like government debt by the financial system. Fannie Mae and Freddie Mac did not by
themselves cause the crisis, but they contributed significantly in a number of ways.

THE SYSTEM FREEZING

Following the shock and panic, financial intermediation operated with escalating
frictions. Some funding markets collapsed entirely. Others experienced a rapid
blowout in spreads following the shock and stabilized slowly as the panic subsided
and the government stepped in to backstop markets and firms. We highlight three
funding markets here:

• Interbank lending. Lending dynamics changed quickly in the federal funds

market where banks loan excess reserves to one another overnight. Even large
 D I S S E N T I N G S TAT E M E N T

banks were unable to get overnight loans, compounding an increasingly re-

stricted ability to raise short-term funds elsewhere.
• Repo. By September , repo rates increased substantially, and haircuts bal-
looned. Nontraditional mortgages were no longer acceptable collateral.
• Commercial paper. The failure of Lehman and the Reserve Primary Fund
breaking the buck sparked a run on prime money market mutual funds. Money
market mutual funds withdrew from investing in the commercial paper mar-
ket, leading to a rapid increase in funding costs for financial and nonfinancial
firms that relied on commercial paper.

The inability to find funding, financial firm deleveraging, and macroeconomic

weakness translated into tighter credit for consumers and businesses. Securitization
markets for other kinds of debt collapsed rapidly in  and still have not recovered
fully, cutting off a substantial source of financing for credit cards, car loans, student
loans, and small business loans.
Decreased credit availability, the collapse of the housing bubble, and additional
wealth losses from a declining stock market led to a sharp contraction in consump-
tion and output and an increase in unemployment.
Real GDP contracted at an annual rate of . percent in the third quarter of ,
. percent in the fourth quarter, and . percent in the first quarter of . The eco-
nomic contraction in the fourth quarter of  was the worst in nearly three
decades. Firms and households that had not previously been directly affected by the
financial crisis suddenly pulled back–businesses stopped hiring and halted new in-
vestments, while families put spending plans on hold. After the panic began, the rate
at which the economy shed jobs jumped, going from an average of , jobs lost
per month in the first three quarters of , to an average of over , jobs lost
per month in the fourth quarter of  and the first quarter of . The economy
continued to lose jobs through most of , with the unemployment rate peaking at
. percent in October  and remaining above . percent for the rest of 
and the first eleven months of .
While the shock and panic therefore appear to have ended in early , the harm
to the real economy continues through today. Firms and families are still deleverag-
ing and are uncertain about both future economic growth and the direction of future
policy. The final tragedy of the financial and economic crisis is that the needed recov-
ery is slow and looks to be so for a while longer.

NOTES
1. A vote of the Commission on December 6, 2010, limited dissenters to nine pages each in the
approximately 550-page commercially published book. No limits apply to the official version sub-
mitted to the President and the Congress.
2. Ben S. Bernanke, “Monetary Policy and the Housing Bubble,” Speech at the Annual Meeting of
the American Economic Association, Atlanta, Georgia, January 3, 2010 (www.federalreserve.gov/
newsevents/speech/bernanke20100103a.htm).
3. Ibid.
 K E I T H H E N N E S S E Y, D O U G L A S H O LT Z - E A K I N , AND BILL THOMAS 

4. “Risky borrowers” does not mean poor. While many risky borrowers were low-income, a
borrower with unproven income applying for a no-documentation mortgage for a vacation home
was also risky.
5. Bernanke, “Monetary Policy and the Housing Bubble.”
6. The Commission vigorously debated the relative importance and the motivations of the dif-
ferent types of securitizers in lowering credit quality. We think that both types of securitizers were
in part responsible and that these debates are less important than the existence of lower standards
and how this problem fits into the broader context.
7. While bad information created by credit rating agencies was an essential cause of the crisis, it
is less clear why they did this. Important hypotheses include: (1) bad analytic models that failed to
account for correlated housing price declines across wide geographies, (2) an industry model that
encouraged the rating agencies to skew their ratings upward to generate business, and (3) a lack of
market competition due to their government-induced oligopoly.
8. In most cases during the crisis, the three key policymakers were Treasury Secretary Henry
Paulson, Federal Reserve Chairman Ben Bernanke, and Federal Reserve Bank of New York Presi-
dent Timothy Geithner. Other officials were key in particular cases, such as FHFA Director Jim
Lockhart’s GSE actions and FDIC Chairman Sheila Bair’s extension of temporary loan guarantees
to bank borrowing in the fall of 2008. During the financial recovery and rebuilding stage that be-
gan in early 2009, the three key policymakers were Treasury Secretary Timothy Geithner, Fed
Chairman Ben Bernanke, and White House National Economic Council Director Larry Summers.
9. Ben S. Bernanke, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and
Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial
Crisis, session 1: The Federal Reserve, September 2, transcript, p. 78.
 F I NA N C IA L C R I SI S

I N QU I RY C OM M I S SI ON

DI S SE N T I N G S TAT E M E N T

PETER J. WALLISON
ARTHUR F. BURNS
FELLOW IN FINANCIAL POLICY STUDIES
AMERICAN ENTERPRISE INSTITUTE

JANAUARY 2011
Contact: pwallison@aei.org
 INTRODUCTION

Why a Dissent?
The question I have been most frequently asked about the Financial Crisis
Inquiry Commission (the “FCIC” or the “Commission”) is why Congress bothered
to authorize it at all. Without waiting for the Commission’s insights into the causes
of the financial crisis, Congress passed and the President signed the Dodd-Frank
Act (DFA), far reaching and highly consequential regulatory legislation. Congress
and the President acted without seeking to understand the true causes of the
wrenching events of 2008, perhaps following the precept of the President’s chief of
staff—“Never let a good crisis go to waste.” Although the FCIC’s work was not the
full investigation to which the American people were entitled, it has served a useful
purpose by focusing attention again on the financial crisis and whether—with some
distance from it—we can draw a more accurate assessment than the media did with
what is often called the “first draft of history.”
To avoid the next financial crisis, we must understand what caused the one
from which we are now slowly emerging, and take action to avoid the same mistakes
in the future. If there is doubt that these lessons are important, consider the ongoing
efforts to amend the Community Reinvestment Act of 1977 (CRA). Late in the last
session of the 111th Congress, a group of Democratic congressmembers introduced
HR 6334. This bill, which was lauded by House Financial Services Committee
Chairman Barney Frank as his “top priority” in the lame duck session of that
Congress, would have extended the CRA to all “U.S. nonbank financial companies,”
and thus would apply, to even more of the national economy, the same government
social policy mandates responsible for the mortgage meltdown and the financial
crisis. Fortunately, the bill was not acted upon. Because of the recent election, it is
unlikely that supporters of H.R. 6334 will have the power to adopt similar legislation
in the next Congress, but in the future other lawmakers with views similar to Barney
Frank’s may seek to mandate similar requirements. At that time, the only real
bulwark against the government’s use of private entities for social policy purposes
will be a full understanding of how these policies were connected to the financial
crisis of 2008.
Like Congress and the Administration, the Commission’s majority erred
in assuming that it knew the causes of the financial crisis. Instead of pursuing a
thorough study, the Commission’s majority used its extensive statutory investigative
authority to seek only the facts that supported its initial assumptions—that the
crisis was caused by “deregulation” or lax regulation, greed and recklessness on
Wall Street, predatory lending in the mortgage market, unregulated derivatives
and a financial system addicted to excessive risk-taking. The Commission did not
seriously investigate any other cause, and did not effectively connect the factors

443
444 Dissenting Statement

it investigated to the financial crisis. The majority’s report covers in detail many
elements of the economy before the financial crisis that the authors did not like, but
generally failed to show how practices that had gone on for many years suddenly
caused a world-wide financial crisis. In the end, the majority’s report turned out to
be a just so story about the financial crisis, rather than a report on what caused the
financial crisis.

What Caused the Financial Crisis?

George Santayana is often quoted for the aphorism that “Those who cannot
remember the past are condemned to repeat it.” Looking back on the financial crisis,
we can see why the study of history is often so contentious and why revisionist
histories are so easy to construct. There are always many factors that could have
caused an historical event; the difficult task is to discern which, among a welter of
possible causes, were the significant ones—the ones without which history would
have been different. Using this standard, I believe that the sine qua non of the
financial crisis was U.S. government housing policy, which led to the creation of 27
million subprime and other risky loans—half of all mortgages in the United States—
which were ready to default as soon as the massive 1997-2007 housing bubble began
to deflate. If the U.S. government had not chosen this policy path—fostering the
growth of a bubble of unprecedented size and an equally unprecedented number of
weak and high risk residential mortgages—the great financial crisis of 2008 would
never have occurred.
Initiated by Congress in 1992 and pressed by HUD in both the Clinton and
George W. Bush Administrations, the U.S. government’s housing policy sought to
increase home ownership in the United States through an intensive effort to reduce
mortgage underwriting standards. In pursuit of this policy, HUD used (i) the
affordable housing requirements imposed by Congress in 1992 on the government-
sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, (ii) its control over the
policies of the Federal Housing Administration (FHA), and (iii) a “Best Practices
Initiative” for subprime lenders and mortgage banks, to encourage greater subprime
and other high risk lending. HUD’s key role in the growth of subprime and other
high risk mortgage lending is covered in detail in Part III.
Ultimately, all these entities, as well as insured banks covered by the CRA,
were compelled to compete for mortgage borrowers who were at or below the median
income in the areas in which they lived. This competition caused underwriting
standards to decline, increased the numbers of weak and high risk loans far beyond
what the market would produce without government influence, and contributed
importantly to the growth of the 1997-2007 housing bubble.
When the bubble began to deflate in mid-2007, the low quality and high
risk loans engendered by government policies failed in unprecedented numbers.
The effect of these defaults was exacerbated by the fact that few if any investors—
including housing market analysts—understood at the time that Fannie Mae and
Freddie Mac had been acquiring large numbers of subprime and other high risk
loans in order to meet HUD’s affordable housing goals.
Alarmed by the unexpected delinquencies and defaults that began to appear
in mid-2007, investors fled the multi-trillion dollar market for mortgage-backed
 Peter J. Wallison 445

securities (MBS), dropping MBS values—and especially those MBS backed by

subprime and other risky loans—to fractions of their former prices. Mark-to-
market accounting then required financial institutions to write down the value of
their assets—reducing their capital positions and causing great investor and creditor
unease. The mechanism by which the defaults and delinquencies on subprime and
other high risk mortgages were transmitted to the financial system as a whole is
covered in detail in Part II.
In this environment, the government’s rescue of Bear Stearns in March of
2008 temporarily calmed investor fears but created a significant moral hazard;
investors and other market participants reasonably believed after the rescue of
Bear that all large financial institutions would also be rescued if they encountered
financial difficulties. However, when Lehman Brothers—an investment bank even
larger than Bear—was allowed to fail, market participants were shocked; suddenly,
they were forced to consider the financial health of their counterparties, many of
which appeared weakened by losses and the capital writedowns required by mark-
to-market accounting. This caused a halt to lending and a hoarding of cash—a
virtually unprecedented period of market paralysis and panic that we know as the
financial crisis of 2008.

Weren’t There Other Causes of the Financial Crisis?

Many other causes of the financial crisis have been cited, including some in
the report of the Commission’s majority, but for the reasons outlined below none of
them alone—or all in combination—provides a plausible explanation of the crisis.
Low interest rates and a flow of funds from abroad. Claims that various policies
or phenomena—such as low interest rates in the early 2000s or financial flows from
abroad—were responsible for the growth of the housing bubble, do not adequately
explain either the bubble or the destruction that occurred when the bubble deflated.
The U.S. has had housing bubbles in the past—most recently in the late 1970s and
late 1980s—but when these bubbles deflated they did not cause a financial crisis.
Similarly, other developed countries experienced housing bubbles in the 2000s,
some even larger than the U.S. bubble, but when their bubbles deflated the housing
losses were small. Only in the U.S. did the deflation of the most recent housing
bubble cause a financial meltdown and a serious financial crisis. The reason for this
is that only in the U.S. did subprime and other risky loans constitute half of all
outstanding mortgages when the bubble deflated. It wasn’t the size of the bubble
that was the key; it was its content. The 1997-2007 U.S. housing bubble was in a
class by itself. Nevertheless, demand by investors for the high yields offered by
subprime loans stimulated the growth of a market for securities backed by these
loans. This was an important element in the financial crisis, although the number
of mortgages in this market was considerably smaller than the number fostered
directly by government policy. Without the huge number of defaults that arose out
of U.S. housing policy, defaults among the mortgages in the private market would
not have caused a financial crisis.
Deregulation or lax regulation. Explanations that rely on lack of regulation or
deregulation as a cause of the financial crisis are also deficient. First, no significant
deregulation of financial institutions occurred in the last 30 years. The repeal of a
446 Dissenting Statement

portion of the Glass-Steagall Act, frequently cited as an example of deregulation,

had no role in the financial crisis.1 The repeal was accomplished through the
Gramm-Leach-Bliley Act of 1999, which allowed banks to affiliate for the first time
since the New Deal with firms engaged in underwriting or dealing in securities.
There is no evidence, however, that any bank got into trouble because of a securities
affiliate. The banks that suffered losses because they held low quality mortgages or
MBS were engaged in activities—mortgage lending—always permitted by Glass-
Steagall; the investment banks that got into trouble—Bear Stearns, Lehman and
Merrill Lynch—were not affiliated with large banks, although they had small bank
affiliates that do not appear to have played any role in mortgage lending or securities
trading. Moreover, the Federal Deposit Insurance Corporation Improvement Act of
1991 (FDICIA) substantially increased the regulation of banks and savings and loan
institutions (S&Ls) after the S&L debacle in the late 1980s and early 1990s, and it is
noteworthy that FDICIA—the most stringent bank regulation since the adoption of
deposit insurance—failed to prevent the financial crisis.
The shadow banking business. The large investment banks—Bear, Lehman,
Merrill, Goldman Sachs and Morgan Stanley—all encountered difficulty in the
financial crisis, and the Commission majority’s report lays much of the blame for this
at the door of the Securities and Exchange Commission (SEC) for failing adequately
to supervise them. It is true that the SEC’s supervisory process was weak, but many
banks and S&Ls—stringently regulated under FDICIA—also failed. This casts doubt
on the claim that if investment banks had been regulated like commercial banks—
or had been able to offer insured deposits like commercial banks—they would not
have encountered financial difficulties. The reality is that the business model of the
investment banks was quite different from banking; it was to finance a short-term
trading business with short-term liabilities such as repurchase agreements (often
called repos). This made them especially vulnerable in the panic that occurred in
2008, but it is not evidence that the existence of investment banks, or the quality of
their regulation, was a cause of the financial crisis.
Failures of risk management. Claims that there was a general failure of risk
management in financial institutions or excessive leverage or risk-taking are part of
what might be called a “hindsight narrative.” With hindsight, it is easy to condemn
managers for failing to see the dangers of the housing bubble or the underpricing of
risk that now looks so clear. However, the FCIC interviewed hundreds of financial
experts, including senior officials of major banks, bank regulators and investors.
It is not clear that any of them—including the redoubtable Warren Buffett—were
sufficiently confident about an impending crisis that they put real money behind
their judgment. Human beings have a tendency to believe that things will continue
to go in the direction they are going, and are good at explaining why this must
be so. Blaming the crisis on the failure to foresee it is facile and of little value for
policymakers, who cannot legislate prescience. The fact that virtually all participants
in the financial system failed to foresee this crisis—as they failed to foresee every
other crisis—does not tell us anything about why this crisis occurred or what we
should do to prevent the next one.

1
See, e.g., Peter J. Wallison, “Deregulation and the Financial Crisis: Another Urban Myth,” Financial
Services Outlook, American Enterprise Institute, October 2009.
 Peter J. Wallison 447

Securitization and structured products. Securitization—often pejoratively

described as the “originate to distribute process”—has also been blamed for the
financial crisis. But securitization is only a means of financing. If securitization was
a cause of the financial crisis, so was lending. Are we then to condemn lending?
For decades, without serious incident, securitization has been used to finance car
loans, credit card loans and jumbo mortgages that were not eligible for acquisition
by Fannie Mae and Freddie Mac. The problem was not securitization itself, it was
the weak and high risk loans that securitization financed. Under the category of
securitization, it is necessary to mention the role of collateralized debt obligations,
known as CDOs. These instruments were “toxic assets” because they were ultimately
backed by the subprime mortgages that began to default in huge numbers when the
bubble deflated, and it was difficult to determine where those losses would ultimately
settle. CDOs, accordingly, for all their dramatic content, were just another example
of the way in which subprime and other high risk loans were distributed throughout
the world’s financial system. The question still remains why so many weak loans
were created, not why a system that securitized good assets could also securitize
bad ones.
Credit default swaps and other derivatives. Despite a diligent search, the FCIC
never uncovered evidence that unregulated derivatives, and particularly credit
default swaps (CDS), was a significant contributor to the financial crisis through
“interconnections”. The only company known to have failed because of its CDS
obligations was AIG, and that firm appears to have been an outlier. Blaming CDS
for the financial crisis because one company did not manage its risks properly is like
blaming lending generally when a bank fails. Like everything else, derivatives can
be misused, but there is no evidence that the “interconnections” among financial
institutions alleged to have caused the crisis were significantly enhanced by CDS
or derivatives generally. For example, Lehman Brothers was a major player in the
derivatives market, but the Commission found no indication that Lehman’s failure
to meet its CDS and other derivatives obligations caused significant losses to any
other firm, including those that had written CDS on Lehman itself.
Predatory lending. The Commission’s report also blames predatory lending
for the large build-up of subprime and other high risk mortgages in the financial
system. This might be a plausible explanation if there were evidence that predatory
lending was so widespread as to have produced the volume of high risk loans that
were actually originated. In predatory lending, unscrupulous lenders take advantage
of unwitting borrowers. This undoubtedly occurred, but it also appears that many
people who received high risk loans were predatory borrowers, or engaged in
mortgage fraud, because they took advantage of low mortgage underwriting
standards to benefit from mortgages they knew they could not pay unless rising
housing prices enabled them to sell or refinance. The Commission was never able
to shed any light on the extent to which predatory lending occurred. Substantial
portions of the Commission majority’s report describe abusive activities by some
lenders and mortgage brokers, but without giving any indication of how many such
loans were originated. Further, the majority’s report fails to acknowledge that most
of the buyers for subprime loans were government agencies or private companies
complying with government affordable housing requirements.
448 Dissenting Statement

Why Couldn’t We Reach Agreement?

After the majority’s report is published, many people will lament that it was
not possible to achieve a bipartisan agreement on the facts. It may be a surprise
that I am asking the same question. If the Commission’s investigation had been
an objective and thorough investigation, many of the points I raise in this dissent
would have been known to the other commissioners before reading this dissent, and
perhaps would have been influential with them. Similarly, I might have found facts
that changed my own view. But the Commission’s investigation was not structured
or carried out in a way that could ever have garnered my support or, I believe, the
support of the other Republican members.
One glaring example will illustrate the Commission’s lack of objectivity.
In March 2010, Edward Pinto, a resident fellow at the American Enterprise
Institute (AEI) who had served as chief credit officer at Fannie Mae, provided to
the Commission staff a 70-page, fully sourced memorandum on the number of
subprime and other high risk mortgages in the financial system immediately before
the financial crisis. In that memorandum, Pinto recorded that he had found over
25 million such mortgages (his later work showed that there were approximately 27
million).2 Since there are about 55 million mortgages in the U.S., Pinto’s research
indicated that, as the financial crisis began, half of all U.S. mortgages were of inferior
quality and liable to default when housing prices were no longer rising. In August,
Pinto supplemented his initial research with a paper documenting the efforts of the
Department of Housing and Urban Development (HUD), over two decades and
through two administrations, to increase home ownership by reducing mortgage
underwriting standards.3
This research raised important questions about the role of government
housing policy in promoting the high risk mortgages that played such a key role in
both the mortgage meltdown and the financial panic that followed. Any objective
investigation of the causes of the financial crisis would have looked carefully at this
research, exposed it to the members of the Commission, taken Pinto’s testimony,
and tested the accuracy of Pinto’s research. But the Commission took none of these
steps. Pinto’s research was never made available to the other members of the FCIC,
or even to the commissioners who were members of the subcommittee charged with
considering the role of housing policy in the financial crisis.
Accordingly, the Commission majority’s report ignores hypotheses about the
causes of the financial crisis that any objective investigation would have considered,
while focusing solely on theories that have political currency but far less plausibility.
This is not the way a serious and objective inquiry should have been carried out, but
that is how the Commission used its resources and its mandate.
There were many other deficiencies. The scope of the Commission’s work was
determined by a list of public hearings that was handed to us in early December 2009.
At that point the Commission members had never discussed the possible causes of
the crisis, and we were never told why those particular subjects were important or
were chosen as the key issues for a set of hearings that would form the backbone

2
Edward Pinto, “Triggers of the Financial Crisis” (Triggers memo), http://www.aei.org/paper/100174.
3
Edward Pinto, “Government Housing Policies in the Lead-up to the Financial Crisis: A Forensic Study,”
http//ww.aei.org/docLib/Government-Housing-Policies-Financial-Crisis-Pinto-102110.pdf.
 Peter J. Wallison 449

of all the Commission’s work. The Commission members did not get together to
discuss or decide on the causes of the financial crisis until July, 2010, well after it was
too late to direct the activities of the staff. The Commission interviewed hundreds of
witnesses, and the majority’s report is full of statements such as “Smith told the FCIC
that….” However, unless the meeting was public, the commissioners were not told
that an interview would occur, did not know who was being interviewed, were not
encouraged to attend, and of course did not have an opportunity to question these
sources or understand the contexts in which the quoted statements were made. The
Commission majority’s report uses these opinions as substitutes for data, which is
notably lacking in their report; opinions in general are not worth much, especially
in hindsight and when given without opportunity for challenge.
The Commission’s authorizing statute required that the Commission report
on or before December 15, 2010. The original plan was for us to start seeing drafts
of the report in April. We didn’t see any drafts until November. We were then given
an opportunity to submit comments in writing, but never had an opportunity to go
over the wording as a group or to know whether our comments were accepted. We
received a complete copy of the majority’s report, for the first time, on December 15.
It was almost 900 double-spaced pages long. The date for approval of the report was
eight days later, on December 23. That is not the way to achieve a bipartisan report,
or the full agreement of any group that takes the issues seriously.
This dissenting statement is organized as follows: Part I summarizes the main
points of the dissent. Part II describes how the failure of subprime and other high
risk mortgages drove the growth of the bubble and weakened financial institutions
around the world when these mortgages began to default. Part III outlines in detail
the housing policies of the U.S. government that were primarily responsible for the
fact that approximately one half of all U.S. mortgages in 2007 were subprime or
otherwise of low quality. Part IV is a brief conclusion.
450 Dissenting Statement
 SUMMARY

Although there were many contributing factors, the housing bubble of 1997-
2007 would not have reached its dizzying heights or lasted as long, nor would
the financial crisis of 2008 have ensued, but for the role played by the housing
policies of the United States government over the course of two administrations.
As a result of these policies, by the middle of 2007, there were approximately 27
million subprime and Alt-A mortgages in the U.S. financial system—half of all
mortgages outstanding—with an aggregate value of over $4.5 trillion.4 These were
unprecedented numbers, far higher than at any time in the past, and the losses
associated with the delinquency and default of these mortgages fully account for
the weakness and disruption of the financial system that has become known as the
financial crisis.
Most subprime and Alt-A mortgages are high risk loans. A subprime
mortgage is a loan to a borrower who has blemished credit, usually signified by
a FICO credit score lower than 660.5 Typically, a subprime borrower has failed in
4
Unless otherwise indicated, all estimates for the number of subprime and Alt-A mortgages outstanding,
as well as the use of specific terms such as loan to value ratios and delinquency rates, come from research
done by Edward Pinto, a resident fellow at the American Enterprise Institute. Pinto is also a consultant
to the housing finance industry and a former chief credit officer of Fannie Mae. Much of this work is
posted on both my and Pinto’s scholar pages at AEI as follows: http://www.aei.org/docLib/Pinto-Sizing-
Total-Exposure.pdf, which accounts for all 27 million high risk loans; http://www.aei.org/docLib/
Pinto-Sizing-Total-Federal-Contributions.pdf, which covers the portion of these loans that were held or
guaranteed by federal agencies and the four large banks that made these loans under CRA; and http://
www.aei.org/docLib/Pinto-High-LTV-Subprime-Alt-A.pdf, which covers the acquisition of these loans
by government agencies from the early 1990s. The information in these memoranda is fully cited to
original sources. These memoranda were the data exhibits to a Pinto memorandum submitted to the
FCIC in January 2010, and revised and updated in March 2010 (collectively, the “Triggers memo”).
5
One of the confusing elements of any study of the mortgage markets is the fact that the key definitions
have never been fully agreed upon. For many years, Fannie Mae treated as subprime loans only those
that it purchased from subprime originators. Inside Mortgage Finance, a common source of data on
the mortgage market, treated and recorded as subprime only those loans reported as subprime by the
originators or by Fannie and Freddie. Other loans were recorded as prime, even if they had credit scores
that would have classified them as subprime. However, a FICO credit score of less than 660 is generally
regarded as a subprime loan, no matter how originated. That is the standard, for example, used by the
Office of the Comptroller of the Currency. In this statement and in Pinto’s work on this issue, loans that
are classified as subprime by their originators are called “self-denominated” subprime loans, and loans
to borrowers with FICO scores of less than 660 are called subprime by characteristic. Fannie and Freddie
reported only a very small percentage of their loans as subprime, so in effect the subprime loans acquired
by Fannie and Freddie should be added to the self-denominated subprime loans originated by others in
order to derive something closer to the number and principal amount of the subprime loans outstanding
in the financial system at any given time. One of the important elements of Edward Pinto’s work was to
show that Fannie and Freddie, for many years prior to the financial crisis, were buying loans that should
have been classified as subprime because of the borrowers’ credit scores and not simply because they were
originated by subprime lenders. Fannie and Freddie did not do this until after they were taken over by
the federal government. This lack of disclosure on the part of the GSEs appears to have been a factor in
the failure of many market observers to foresee the potential severity of the mortgage defaults when the
housing bubble deflated in 2007.

451
452 Dissenting Statement

the past to meet other financial obligations. Before changes in government policy
in the early 1990s, most borrowers with FICO scores below 660 did not qualify as
prime borrowers and had difficulty obtaining mortgage credit other than through
the Federal Housing Administration (FHA), the government’s original subprime
lender, or through a relatively small number of specialized subprime lenders.
An Alt-A mortgage is one that is deficient by its terms. It may have an
adjustable rate, lack documentation about the borrower, require payment of interest
only, or be made to an investor in rental housing, not a prospective homeowner.
Another key deficiency in many Alt-A mortgages is a high loan-to-value ratio—that
is, a low downpayment. A low downpayment for a home may signify the borrower’s
lack of financial resources, and this lack of “skin in the game” often means a reduced
borrower commitment to the home. Until they became subject to HUD’s affordable
housing requirements, beginning in the early 1990s, Fannie and Freddie seldom
acquired loans with these deficiencies.
Given the likelihood that large numbers of subprime and Alt-A mortgages
would default once the housing bubble began to deflate in mid- 2007—with
devastating effects for the U.S. economy and financial system—the key question
for the FCIC was to determine why, beginning in the early 1990s, mortgage
underwriting standards began to deteriorate so significantly that it was possible to
create 27 million subprime and Alt-A mortgages. The Commission never made a
serious study of this question, although understanding why and how this happened
must be viewed as one of the central questions of the financial crisis.
From the beginning, the Commission’s investigation was limited to validating
the standard narrative about the financial crisis—that it was caused by deregulation
or lack of regulation, weak risk management, predatory lending, unregulated
derivatives and greed on Wall Street. Other hypotheses were either never considered
or were treated only superficially. In criticizing the Commission, this statement is
not intended to criticize the staff, which worked diligently and effectively under
difficult circumstances, and did extraordinarily fine work in the limited areas they
were directed to cover. The Commission’s failures were failures of management.

1. Government Policies Resulted in an

Unprecedented Number of Risky Mortgages
Three specific government programs were primarily responsible for the
growth of subprime and Alt-A mortgages in the U.S. economy between 1992 and
2008, and for the decline in mortgage underwriting standards that ensued.
The GSEs’ Affordable Housing Mission. The fact that high risk mortgages
formed almost half of all U.S. mortgages by the middle of 2007 was not a chance
event, nor did it just happen that banks and other mortgage originators decided on
their own to offer easy credit terms to potential homebuyers beginning in the 1990s.
In 1992, Congress enacted Title XIII of the Housing and Community
Development Act of 19926 ( the GSE Act), legislation intended to give low and

6
Public Law 102-550, 106 Stat. 3672, H.R. 5334, enacted October 28, 1992.
 Peter J. Wallison 453

moderate income7 borrowers better access to mortgage credit through Fannie Mae
and Freddie Mac. This effort, probably stimulated by a desire to increase home
ownership, ultimately became a set of regulations that required Fannie and Freddie
to reduce the mortgage underwriting standards they used when acquiring loans
from originators. As the Senate Committee report said at the time, “The purpose of
[the affordable housing] goals is to facilitate the development in both Fannie Mae
and Freddie Mac of an ongoing business effort that will be fully integrated in their
products, cultures and day-to-day operations to service the mortgage finance needs
of low-and-moderate-income persons, racial minorities and inner-city residents.”8
The GSE Act, and its subsequent enforcement by HUD, set in motion a series of
changes in the structure of the mortgage market in the U.S. and more particularly
the gradual degrading of traditional mortgage underwriting standards. Accordingly,
in this dissenting statement, I will refer to the subprime and Alt-A mortgages that
were acquired because of the affordable housing AH goals, as well as other subprime
and Alt-A mortgages, as non-traditional mortgages, or NTMs
The GSE Act was a radical departure from the original conception of the GSEs
as managers of a secondary market in prime mortgages. Fannie Mae was established
as a government agency in the New Deal era to buy mortgages from banks and other
loan originators, providing them with new funds with which to make additional
mortgages. In 1968, it was authorized to sell shares to the public and became a
government-sponsored enterprise (GSE)9—a shareholder-owned company with a
government mission to maintain a liquid secondary market in mortgages. Freddie
Mac was chartered by Congress as another GSE in 1970. Fannie and Freddie carried
out this mission effectively until the early 1990s, and in the process established
conservative lending standards for the mortgages they were willing to purchase,
including such elements as downpayments of 10 to 20 percent, and minimum credit
standards for borrowers.
The GSE Act, however, created a new “mission” for Fannie Mae and Freddie
Mac—a responsibility to support affordable housing—and authorized HUD to
establish and administer what was in effect a mortgage quota system in which a
certain percentage of all Fannie and Freddie mortgage purchases had to be loans to
low-and- moderate income (LMI) borrowers—defined as persons with income at or
below the median income in a particular area or to borrowers living in certain low
income communities. The AH goals put Fannie and Freddie into direct competition
with the FHA, which was then and is today an agency within HUD that functions as
the federal government’s principal subprime lender.

7
Low income is usually defined as 80 percent of area median income (AMI) and moderate income as
100 percent of AMI.
8
Report of the Committee on Banking Housing and Urban Affairs, United States Senate to accompany
S. 2733. Report 102-282, May 15, 1992, pp. 34-5.
9
Fannie and Freddie were considered to be government sponsored enterprises because they had been
chartered by Congress and were given various privileges (such as exemption from the Securities Act of
1933 and the Securities Exchange Act of 1934) and a line of credit at the Treasury that signaled a special
degree of government support. As a result, the capital markets (which continued to call them “Agencies”)
assumed that in the event of financial difficulties the government would stand behind them. This implied
government backing gave them access to funding that was lower cost than any AAA borrower and often
only a few basis points over the applicable Treasury rate.
454 Dissenting Statement

Over the next 15 years, HUD consistently enhanced and enlarged the AH
goals. In the GSE Act, Congress had initially specified that 30 percent of the GSEs’
mortgage purchases meet the AH goals. This was increased to 42 percent in 1995,
and 50 percent in 2000. By 2008, the main LMI goal was 56 percent, and a special
affordable subgoal had been added requiring that 27 percent of the loans acquired
by the GSEs be made to borrowers who were at or below 80 percent of area median
income (AMI). Table 10, page 510, shows that Fannie and Freddie met the goals in
almost every year between 1996 and 2008.
There is very little data available concerning Fannie and Freddie’s acquisitions
of subprime and Alt-A loans in the early 1990s, so it is difficult to estimate the GSEs’
year-by-year acquisitions of these loans immediately after the AH goals went into
effect. However, Pinto estimates the total value of these purchases at approximately
$4.1 trillion (see Table 7, page 504). As shown in Table 1, page 456, on June 30,
2008, immediately prior to the onset of the financial crisis, the GSEs held or had
guaranteed 12 million subprime and Alt-A loans. This was 37 percent of their total
mortgage exposure of 32 million loans, which in turn was approximately 58 percent
of the 55 million mortgages outstanding in the U.S. on that date. Fannie and Freddie,
accordingly, were by far the dominant players in the U.S. mortgage market before
the financial crisis and their underwriting standards largely set the standards for the
rest of the mortgage financing industry.
The Community Reinvestment Act. In 1995, the regulations under the
Community Reinvestment Act (CRA)10 were tightened. As initially adopted in
1977, the CRA and its associated regulations required only that insured banks
and S&Ls reach out to low-income borrowers in communities they served. The
new regulations, made effective in 1995, for the first time required insured banks
and S&Ls to demonstrate that they were actually making loans in low-income
communities and to low-income borrowers.11 A qualifying CRA loan was one made
to a borrower at or below 80 percent of the AMI, and thus was similar to the loans
that Fannie and Freddie were required to buy under HUD’s AH goals.
In 2007, the National Community Reinvestment Coalition (NCRC), an
umbrella organization for community activist organizations, reported that between
1997 and 2007 banks that were seeking regulatory approval for mergers committed
in agreements with community groups to make over $4.5 trillion in CRA loans.12
A substantial portion of these commitments appear to have been converted into
mortgage loans, and thus would have contributed substantially to the number
of subprime and other high risk loans outstanding in 2008. For this reason, they
deserved Commission investigation and analysis. Unfortunately, as outlined in Part
III, this was not done.
Accordingly, the GSE Act put Fannie and Freddie, FHA, and the banks
that were seeking CRA loans into competition for the same mortgages—loans to
borrowers at or below the applicable AMI.
HUD’s Best Practices Initiative. In 1994, HUD added another group to this list
when it set up a “Best Practices Initiative,” to which 117 members of the Mortgage
10
Pub.L. 95-128, Title VIII of the Housing and Community Development Act of 1977, 91 Stat. 1147, 12
U.S.C. § 2901 et seq.
11
http://www.fdic.gov/regulations/laws/rules/2000-6500.html.
12
See http://www.community-wealth.org/_pdfs/articles-publications/cdfis/report-silver-brown.pdf.
 Peter J. Wallison 455

Bankers Association eventually adhered. As shown later, this program was explicitly
intended to encourage a reduction in underwriting standards so as to increase access
by low income borrowers to mortgage credit. Countrywide was by far the largest
member of this group and by the early 2000s was also competing, along with others,
for the same NTMs sought by Fannie and Freddie, FHA, and the banks under the
CRA .
With all these entities seeking the same loans, it was not likely that all of them
would find enough borrowers who could meet the traditional mortgage lending
standards that Fannie and Freddie had established. It also created ideal conditions
for a decline in underwriting standards, since every one of these competing entities
was seeking NTMs not for purposes of profit but in order to meet an obligation
imposed by the government. The obvious way to meet this obligation was simply to
reduce the underwriting standards that impeded compliance with the government’s
requirements.
Indeed, by the early 1990s, traditional underwriting standards had come to
be seen as an obstacle to home ownership by LMI families. In a 1991 Senate Banking
Committee hearing, Gail Cincotta, a highly respected supporter of low-income
lending, observed that “Lenders will respond to the most conservative standards
unless [Fannie Mae and Freddie Mac] are aggressive and convincing in their efforts
to expand historically narrow underwriting.”13
In this light, it appears that Congress set out deliberately in the GSE Act not
only to change the culture of the GSEs, but also to set up a mechanism that would
reduce traditional underwriting standards over time, so that home ownership
would be more accessible to LMI borrowers. For example, the legislation directed
the GSEs to study “The implications of implementing underwriting standards
that—(A) establish a downpayment requirement for mortgagors of 5 percent or
less;14 (B) allow the use of cash on hand as a source of downpayments; and (C)
approve borrowers who have a credit history of delinquencies if the borrower can
demonstrate a satisfactory credit history for at least the 12-month period ending on
the date of the application for the mortgage.”15 None of these elements was part of
traditional mortgage underwriting standards as understood at the time.
I have been unable to find any studies by Fannie or Freddie in response to
this congressional direction, but HUD treated these cues as a mandate to use the
AH goals as a mechanism for eroding the traditional standards. HUD was very
explicit about this, as shown in Part II. In the end, the goal was accomplished by
gradually expanding the requirements and enlarging the AH goals over succeeding
years, so that the only way Fannie and Freddie could meet the AH goals was by
purchasing increasing numbers of subprime and Alt-A mortgages, and particularly
mortgages with low or no downpayments. Because the GSEs were the dominant
players in the mortgage market, their purchases also put competitive pressure on
the other entities that were subject to government control—FHA and the banks

13
Allen Fishbein, “Filling the Half-Empty Glass: The Role of Community Advocacy in Redefining the
Public Responsibilities of Government-Sponsored Housing Enterprises”, Chapter 7 of Organizing Access
to Capital: Advocacy and the Democratization of Financial Institutions, 2003, Gregory Squires, editor.
14
At that time the GSEs’ minimum downpayment was 5 percent, and was accompanied by conservative
underwriting. The congressional request was to break through that limitation.
15
GSE Act, Section 1354(a).
456 Dissenting Statement

under CRA—to reach deeper into subprime lending in order to find the mortgages
they needed to comply with their own government requirements. This was also true
of the mortgage banks—the largest of which was Countrywide—that were bound to
promote affordable housing through HUD’s Best Practices Initiative.
By 2008, the result of these government programs was an unprecedented
number of subprime and other high risk mortgages in the U.S. financial system. Table
1 shows which agencies or firms were holding the credit risk of these mortgages-
-or had distributed it to investors through mortgage-backed securities (MBS)--
immediately before the financial crisis began. As Table 1 makes clear, government
agencies, or private institutions acting under government direction, either held or
had guaranteed 19.2 million of the NTM loans that were outstanding at this point.
By contrast, about 7.8 million NTMs had been distributed to investors through the
issuance of private mortgage-backed securities, or PMBS,16 primarily by private
issuers such as Countrywide and other subprime lenders.
The fact that the credit risk of two-thirds of all the NTMs in the financial
system was held by the government or by entities acting under government control
demonstrates the central role of the government’s policies in the development of
the 1997-2007 housing bubble, the mortgage meltdown that occurred when the
bubble deflated, and the financial crisis and recession that ensued. Similarly, the
fact that only 7.8 million NTMs were held by investors and financial institutions in
the form of PMBS shows that this group of NTMs were less important as a cause of
the financial crisis than the government’s role. The Commission majority’s report
focuses almost entirely on the 7.8 million PMBS, and is thus an example of its
determination to ignore the government’s role in the financial crisis.
Table 1.17

Entity No. of Subprime Unpaid Principal Amount

and Alt-A Loans
Fannie Mae and Freddie Mac 12 million $1.8 trillion
FHA and other Federal* 5 million $0.6 trillion
CRA and HUD Programs 2.2 million $0.3 trillion
Total Federal Government 19.2 million $2.7 trillion
Other (including subprime and 7.8 million $1.9 trillion
Alt-A PMBS issued by Countrywide,
Wall Street and others)
Total 27 million $4.6 trillion
*Includes Veterans Administration, Federal Home Loan Banks and others.

To be sure, the government’s efforts to increase home ownership through the

AH goals succeeded. Home ownership rates in the U.S. increased from approximately
64 percent in 1994 (where it had been for 30 years) to over 69 percent in 2004.18
Almost everyone in and out of government was pleased with this—a long term goal
16
In the process known as securitization, securities backed by a pool of mortgages (mortgage-
backed securities, or MBS) and issued by private sector firms were known as private label securities
(distinguishing them from securities issued by the GSEs or Ginnie Mae) or private MBS (PMBS).
17
See Edward Pinto’s analysis in Exhibit 2 to the Triggers Memo, April 21, 2010, p.4. http://www.aei.org/
docLib/Pinto-Sizing-Total-Federal-Contributions.pdf.
18
Census Bureau data.
 Peter J. Wallison 457

of U.S. housing policy—until the true costs became clear with the collapse of the
housing bubble in 2007. Then an elaborate process of shifting the blame began.

2. The Great Housing Bubble and Its Effects

Figure 1 below, based on the data of Robert J. Shiller, shows the dramatic
growth of the 1997-2007 housing bubble in the United States. By mid-2007, home
prices in the U.S. had increased substantially for ten years. The growth in real dollar
terms had been almost 90 percent, ten times greater than any other housing bubble
in modern times. As discussed below, there is good reason to believe that the 1997-
2007 bubble grew larger and extended longer in time than previous bubbles because
of the government’s housing policies, which artificially increased the demand for
housing by funneling more money into the housing market than would have been
available if traditional lending standards had been maintained and the government
had not promoted the growth of subprime lending.
Figure 1. The Bubble According to Shiller

That the 1997-2007 bubble lasted about twice as long as the prior housing
bubbles is significant in itself. Mortgage quality declines as a housing bubble grows
and originators try to structure mortgages that will allow buyers to meet monthly
payments for more expensive homes; the fact that the most recent bubble was so
long-lived was an important element in its ultimate destructiveness when it deflated.
Why did this bubble last so long? Housing bubbles deflate when delinquencies and
defaults begin to appear in unusual numbers. Investors and creditors realize that the
risks of a collapse are mounting. One by one, investors cash in and leave. Eventually,
the bubble tops out, those who are still in the game run for the doors, and a deflation
in prices sets in. Generally, in the past, this process took three or four years. In the
case of the most recent bubble, it took ten. The reason for this longevity is that one
458 Dissenting Statement

major participant in the market was not in it for profit and was not worried about
the risks to itself or to those it was controlling. It was the U.S. government, pursuing
a social policy—increasing homeownership by making mortgage credit available
to low and moderate income borrowers—and requiring the agencies and financial
institutions it controlled or could influence through regulation to keep pumping
money into housing long after the bubble, left to itself, would have deflated.
Economists have been vigorously debating whether the Fed’s monetary policy
in the early 2000s caused the bubble by keeping interest rates too low for too long.
Naturally enough, Ben Bernanke and Alan Greenspan have argued that the Fed was
not at fault. On the other hand, John Taylor, author of the Taylor rule, contends
that the Fed’s violation of the Taylor rule was the principal cause of the bubble.
Raghuram Rajan, a professor at the Chicago Booth School of Business, argues that
the Fed’s low interest rates caused the bubble, but that the Fed actually followed this
policy in order to combat unemployment rather than deflation.19 Other theories
blame huge inflows of funds from emerging markets or from countries that were
recycling the dollars they received from trade surpluses with the U.S. These debates,
however, may be missing the point. It doesn’t matter where the funds that built the
bubble actually originated; the important question is why they were transformed
into the NTMs that were prone to failure as soon as the great bubble deflated.
Figure 2 illustrates clearly that the 1997-2007 bubble was built on a foundation
of 27 million subprime and Alt-A mortgages and shows the relationship between the
cumulative growth in the dollar amount of NTMs and the growth of the bubble over
time. It includes both GSE and CRA contributions to the number of outstanding
NTMs above the normal baseline of 30 percent,20 and estimated CRA lending under
the merger-related commitments of the four large banks—Bank of America, Wells
Fargo, Citibank and JPMorgan Chase—that, with their predecessors, made most of
the commitments. As noted above, these commitments were made in connection
with applications to federal regulators for approvals of mergers or acquisitions. The
dollar amounts involved were taken from a 2007 report by the NCRC,21 and adjusted
for announced loans and likely rates of lending. The cumulative estimated CRA

19
See, Bernanke testimony before the FCIC, September 2, 2010, Alan Greenspan, in “The Crisis,” Second
Draft: March 9, 2010, Taylor, in testimony before the FCIC on October 20, 2009, John B. Taylor, Getting
Off Track, Hoover Institution Press, 2009; and Raghuram Rajan, Fault Lines: How Hidden Fractures Still
Threaten the World Economy, Princeton University Press, 2010, pp. 108-110.
20
It appears that the GSEs’ normal intake of mortgages included about 30 percent that were made to
borrowers who were at or below the median income in the area in which they lived and were thus eligible
for AH credit. It was only when the AH goals rose above this level, beginning in 1995, that government
policy required the GSEs to acquire more AH qualifying loans than they would have purchased as a matter
of course. In the case of the CRA contributions, the baseline is 1992, and includes the commitments
made by the four largest banks and their predecessors listed in the NCRC report, adjusted for the loans
actually announced by the banks after that date.
21
In 2007, the National Community Reinvestment Coalition published a report on principal amount
of CRA loans that banks had committed to make in connection with merger applications. The report
claimed that these commitments exceeded $4.5 trillion. The original report was removed from the
NCRC’s website, but can still be found at http://www.community-wealth.org/_pdfs/articles-publications/
cdfis/report-silver-brown.pdf. A portion of these commitments were in fact fulfilled through CRA
qualifying loans. A full discussion of these commitments and the number of loans made pursuant to
them is contained in Section III.
 Peter J. Wallison 459

production line also includes almost $1 trillion in NTM lending by Countrywide

Financial under HUD’s Best Practices Initiative.22
Figure 2. The Effect of Government Policies on the Growth of the Bubble

It is not true that every bubble--even a large bubble-- has the potential to
cause a financial crisis when it deflates. This is clear in Table 2 below, prepared by
Professor Dwight Jaffee of the Haas Business School at U.C. Berkley. The table shows
that in other developed countries—many of which also had large bubbles during the
1997-2007 period—the losses associated with mortgage delinquencies and defaults
when these bubbles deflated were far lower than the losses suffered in the U.S. when
the 1997-2007 deflated.

22
See note 144.
460 Dissenting Statement

Table 2.23 Troubled Mortgages, Western Europe and the United States

≥ 3 Month Impaired or Foreclosures Year

Arrears % Doubtful %
Belgium 0.46% 2009
Denmark 0.53% 2009
France 0.93% 2008
Ireland 3.32% 2009
Italy 3.00% 2008
Portugal 1.17% 2009
Spain 3.04% 0.24% 2009
Sweden 1.00% 2009
UK 2.44% 0.19% 2009

U.S. All Loans 9.47% 4.58% 2009

U.S. Prime 6.73% 3.31% 2009
U.S. Subprime 25.26% 15.58% 2009
Source: European Mortgage Federation (2010) and Mortgage Bankers Association for U.S. Data.

The underlying reasons for the outcomes in Professor Jaffee’s data were
provided in testimony before the Senate Banking Committee in September 2010 by
Dr. Michael Lea, Director of the Corky McMillin Center for Real Estate at San Diego
State University:
The default and foreclosure experience of the U.S. market has been far worse than in
other countries. Serious default rates remain less than 3 percent in all other countries
and less than 1 percent in Australia and Canada. Of the countries in this survey only
Ireland, Spain and the UK have seen a significant increase in mortgage default during
the crisis.
There are several factors responsible for this result. First sub-prime lending was rare
or non-existent outside of the U.S. The only country with a significant subprime
share was the UK (a peak of 8 percent of mortgages in 2006). Subprime accounted
for 5 percent of mortgages in Canada, less than 2 percent in Australia and negligible
proportions elsewhere.
…[T]here was far less “risk layering” or offering limited documentation loans
to subprime borrowers with little or no downpayment. There was little “no doc”
lending…the proportion of loans with little or no downpayment was less than the
U.S. and the decline in house prices in most countries was also less…[L]oans in other
developed countries are with recourse and lenders routinely go after borrowers for
deficiency judgments.24
The fact that the destructiveness of the 1997-2007 bubble came from its
composition—the number of NTMs it contained—rather than its size is also
illustrated by data on foreclosure starts published by the Mortgage Bankers

23
Dwight M. Jaffee, “Reforming the U.S. Mortgage Market Through Private Market Incentives,” Paper
prepared for presentation at “Past, Present and Future of the Government Sponsored Enterprises,”
Federal Reserve Bank of St. Louis, Nov 17, 2010, Table 4.
24
Dr. Michael J. Lea, testimony before the Subcommittee on Security and International Trade and
Finance of the Senate Banking Committee, September 29, 2010, p.6.
 Peter J. Wallison 461

Association (MBA).25 This data allows a comparison between the foreclosure starts
that have thus far come out of the 1997-2007 bubble and the foreclosure starts in the
two most recent housing bubbles (1977-1979 and 1985-1989) shown in Figure 1.
After the housing bubble that ended in 1979, when almost all mortgages were prime
loans of the traditional type, foreclosure starts in the ensuing downturn reached a
high point of only .87 percent in 1983. After the next bubble, which ended in 1989
and in which a high proportion of the loans were the traditional type, foreclosure
starts reached a high of 1.32 percent in 1994. However, after the collapse of the
1997-2007 bubble—in which half of all mortgages were NTMs—foreclosure starts
reached the unprecedented level (thus far) of 5.3 percent in 2009. And this was true
despite numerous government and bank efforts to prevent or delay foreclosures.
All the foregoing data is significant for a proper analysis of the role of
government policy and NTMs in the financial crisis. What it suggests is that
whatever effect low interest rates or money flows from abroad might have had in
creating the great U.S. housing bubble, the deflation of that bubble need not have
been destructive. It wasn’t just the size of the bubble; it was also the content. The
enormous delinquency rates in the U.S. (see Table 3 below) were not replicated
elsewhere, primarily because other developed countries did not have the numbers
of NTMs that were present in the U.S. financial system when the bubble deflated.
As shown in later sections of this dissent, these mortgage defaults were translated
into huge housing price declines and from there—through the PMBS they were
holding—into actual or apparent financial weakness in the banks and other firms
that held these securities.
Accordingly, if the 1997-2007 housing bubble had not been seeded with an
unprecedented number of NTMs, it is likely that the financial crisis would never
have occurred.

3. Delinquency Rates
on Nontraditional Mortgages
NTMs are non-traditional because, for many years before the government
adopted affordable housing policies, mortgages of this kind constituted only a
small portion of all housing loans in the United States.26 The traditional residential
mortgage—known as a conventional mortgage—generally had a fixed rate, often
for 15 or 30 years, a downpayment of 10 to 20 percent, and was made to a borrower
who had a job, a steady income and a good credit record. Before the GSE Act, even
subprime loans, although made to borrowers with impaired credit, often involved
substantial downpayments or existing equity in homes.27
Table 3 shows the delinquency rates of the NTMs that were outstanding on
June 30, 2008. The grayed area contains virtually all the NTMs. The contrast in
quality, based on delinquency rates, between these loans and Fannie and Freddie
prime loans in lines 9 and 10 is clear.
25
Mortgage Bankers Association National Delinquency Survey.
26
See Pinto, “Government Housing Policies in the Lead-Up to the Financial Crisis: A Forensic Study,”
November 4, 2010, p.58, http://www.aei.org/docLib/Government-Housing-Policies-Financial-Crisis-
Pinto-102110.pdf.
27
Id., p.42.
462 Dissenting Statement

Table 3.28 Delinquency rates on nontraditional mortgages

Loan Type Estimated # of Loans Total Delinquency Rate

(30+ Days and in Foreclosure)
1. High Rate Subprime (including Fannie/ 6.7 million 45.0%
Freddie private MBS holdings)
2. Option Arm 1.1 million 30.5%
3. Alt-A (inc. Fannie/Freddie/FHLBs 2.4 million† 23.0%
private MBS holdings)
4. Fannie Subprime/Atl-A/Nonprime 6.6 million 17.3%
5. Freddie Subprime/Alt-A/Nonprime 4.1 million 13.8%
6. Government 4.8 million 13.5%
Subtotal # of Loans 25.7 million
7. Non-Agency Jumbo Prime 9.4 million ‡ 6.8%
8. Non-Agency Conforming Prime * 5.6%
9. Fannie Prime ** 11.2 million 2.6%
10. Freddie Prime *** 8.7 million 2.0%
Total # of Loans 55 million
* Includes an estimated 1 million subprime (FICO<660) that were (i) not high rate and (ii) non-prime
CRA and HUD Best Practices Initiative loans. These are included in the “CRA and HUD Programs”
line in Table 1.
** Excludes Fannie subprime/Alt-A/nonprime.
*** Excludes Freddie subprime/Alt-A/nonprime.
† Excludes loans owned or securitized by Fannie and Freddie.
‡ Non-agency jumbo prime and conforming prime counted together.
Total delinquency data sources:
1, 2, 3, 6, 7 & 8: Lender Processing Services, LPS Mortgage Monitor, June 2009.
4 & 9: Based on Fannie Mae 2009 2Q Credit Supplement. Converted from a serious delinquency rate
(90+ days & in foreclosure) to an estimated Total Delinquency Rate (30+ days and in foreclosure).
5 & 10: Based on Freddie Mac 2009 2Q Financial Results Supplement. Converted from a serious
delinquency rate (90+ days & in foreclosure) to an estimated Total Delinquency Rate (30+ days and in
foreclosure).

4. The Origin and Growth of Subprime PMBS

It was only in 2002 that the market for subprime PMBS—that is private
mortgage-backed securities backed by subprime loans or other NTMs—reached
$100 billion. In that year, the top five issuers were GMAC-RFC ($11.5 billion),
Lehman ($10.6 billion), CS First Boston ($10.5 billion), Bank of America ($10.4
billion) and Ameriquest ($9 billion).29 The issuances of PMBS that year totaled
$134 billion, of which $43 billion in PMBS were issued by Wall Street financial
institutions. In subsequent years, as the market grew, Wall Street institutions fell
behind the major subprime issuers, so that by 2005—the biggest year for subprime
PMBS issuance—only Lehman was among the top five issuers and Wall Street
issuers as a group were only 27 percent of the $507 billion in total PMBS issuance
in that year.30

28
Id., Figure 53.
29
Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual—Vol. II, p143.
30
Id., p.140.
 Peter J. Wallison 463

One of the many myths about the financial crisis is that Wall Street banks led
the way into subprime lending and the GSEs followed. The Commission majority’s
report adopts this idea as a way of explaining why Fannie and Freddie acquired
so many NTMs. This notion simply does not align with the facts. Not only were
Wall Street institutions small factors in the subprime PMBS market, but well before
2002 Fannie and Freddie were much bigger players than the entire PMBS market
in the business of acquiring NTM and other subprime loans. Table 7, page 504,
shows that Fannie and Freddie had already acquired at least $701 billion in NTMs
by 2001. Obviously, the GSEs did not have to follow anyone into NTM or subprime
lending; they were already the dominant players in that market before 2002. Table
7 also shows that in 2002, when the entire PMBS market was $134 billion, Fannie
and Freddie acquired $206 billion in whole subprime mortgages and $368 billion in
other NTMs, demonstrating again that the GSEs were no strangers to risky lending
well before the PMBS market began to develop.
Further evidence about which firms were first into subprime or NTM lending
is provided by Fannie’s 2002 10-K. This disclosure document reports that 14 percent
of Fannie’s credit obligations (either in portfolio or guaranteed) had FICO credit
scores below 660 as of December 31, 2000, 16 percent at the end of 2001 and 17
percent at the end of 2002.31 So Fannie and Freddie were active and major buyers
of subprime loans in years when the PMBS market had total issuances of only $55
billion (2000) and $94 billion (2001). In other words, it would be more accurate
to say that Wall Street followed Fannie and Freddie into subprime lending rather
than vice versa. At the same time, the GSEs’ purchases of subprime whole loans
throughout the 1990s stimulated the growth of the subprime lending industry,
which ultimately became the mainstay of the subprime PMBS market in the 2000s.
2005 was the biggest year for PMBS subprime issuances, and Ameriquest
($54 billion) and Countrywide ($38 billion) were the two largest issuers in the top
25. These numbers were still small in relation to what Fannie and Freddie had been
buying since data became available in 1997. The total in Table 7 for Fannie and
Freddie between 1997 and 2007 is approximately $1.5 trillion for subprime loans
and over $4 trillion for all NTMs as a group.
Because subprime PMBS were rich in NTM loans eligible for credit under
HUD’s AH goals, Fannie and Freddie were also the largest individual purchasers
of subprime PMBS from 2002 to 2006, acquiring 33 percent of the total issuances,
or $579 billion.32 In Table 3 above, which organizes mortgages by delinquency rate,
these purchases are included in line 1, which had the highest rate of delinquency.
These were self-denominated subprime—designated as subprime by the lender
when originated—and thus had low FICO scores and usually a higher interest rate
than prime loans; many also had low downpayments and were subject to other
deficiencies.
Ultimately, HUD’s policies were responsible for both the poor quality of
the subprime and Alt-A mortgages that backed the PMBS and for the enormous
size to which this market grew. This was true not only because Fannie and Freddie
31
2003 10-K, Table 33, p.84 http://www.sec.gov/Archives/edgar/data/310522/000095013303001151/
w84239e10vk.htm#031.
32
See Table 3 of “High LTV, Subprime and Alt-A Originations Over the Period 1992-2007 and Fannie,
Freddie, FHA and VA’s Role” found at http://www.aei.org/docLib/Pinto-High-LTV-Subprime-Alt-A.pdf.
464 Dissenting Statement

stimulated the growth of that market through their purchases of PMBS, but also
because the huge inflow of government or government-directed funds into the
housing market turned what would have been a normal housing bubble into a bubble
of unprecedented size and duration. This encouraged and enabled unprecedented
growth in the PMBS market in two ways.
First, the gradual increase of the AH goals, the competition between the GSEs
and the FHA, the effect of HUD’s Best Practices Initiative, and bank lending under
the CRA, assured a continuing flow of funds into weaker and weaker mortgages.
This had the effect of extending the life of the housing bubble as well as increasing
its size. The growth of the bubble in turn disguised the weakness of the subprime
mortgages it contained; as housing prices rose, subprime borrowers who might
otherwise have defaulted were able to refinance their mortgages, using the equity
that had developed in their homes solely through rising home prices. Without the
continuous infusion of government or government-directed funds, delinquencies
and defaults would have begun showing up within a year or two, bringing the
subprime PMBS market to a halt. Instead, the bubble lasted ten years, permitting
that market to grow until it reached almost $2 trillion.
Second, as housing prices rose in the bubble, it was necessary for borrowers to
seek riskier mortgages so they could afford the monthly payments on more expensive
homes. This gave rise to new and riskier forms of mortgage debt, such as option
ARMs (resulting in negative amortization) and interest-only mortgages. Mortgages
of this kind could be suitable for some borrowers, but not for those who were only
eligible for subprime loans. Nevertheless, subprime loans were necessary for PMBS,
because they generally bore higher interest rates and thus could support the yields
that investors were expecting. As subprime loans were originated, Fannie and
Freddie were willing consumers of those that might meet the AH goals; moreover,
because of their lower cost of funds, they were able to buy the “best of the worst,”
the highest quality among the NTMs on offer. These factors—the need for higher
yielding loans and the ability of Fannie and Freddie to pay up for the loans they
wanted—drove private sector issuers further out on the risk curve as they sought
to meet the demands of investors who were seeking exposure to subprime PMBS.
From the investors’ perspective, as long as the bubble kept growing, PMBS were
offering the high yields associated with risk but were not showing commensurate
numbers of delinquencies and defaults.

5. What was Known About NTMs

Prior to the Crisis?
Virtually everyone who testified before the Commission agreed that the
financial crisis was initiated by the mortgage meltdown that began when the housing
bubble began to deflate in 2007. None of these witnesses, however, including
the academics consulted by the Commission, the representatives of the rating
agencies, the officers of financial institutions that were ultimately endangered by the
mortgage downdraft, regulators and supervisors of financial institutions and even
the renowned investor Warren Buffett,33 seems to have understood the dimensions

33
See Buffett, testimony before the FCIC, June 2, 2010.
 Peter J. Wallison 465

of the NTM problem or recognized its significance before the bubble deflated.
The Commission majority’s report notes that “there were warning signs.” There
always are if one searches for them; they are most visible in hindsight, in which the
Commission majority, and many of the opinions it cites for this proposition, happily
engaged. However, as Michael Lewis’s acclaimed book, The Big Short, showed so
vividly, very few people in the financial world were actually willing to bet money—
even at enormously favorable odds—that the bubble would burst with huge losses.
Most seem to have assumed that NTMs were present in the financial system, but not
in unusually large numbers.
Even today, there are few references in the media to the number of NTMs that
had accumulated in the U.S. financial system before the meltdown began. Yet this is
by far the most important fact about the financial crisis. None of the other factors
offered by the Commission majority to explain the crisis—lack of regulation, poor
regulatory and risk management foresight, Wall Street greed and compensation
policies, systemic risk caused by credit default swaps, excessive liquidity and easy
credit—do so as plausibly as the failure of a large percentage of the 27 million NTMs
that existed in the financial system in 2007.
It appears that market participants were unprepared for the destructiveness of
this bubble’s collapse because of a chronic lack of information about the composition
of the mortgage market. In September 2007, for example, after the deflation of the
bubble had begun, and various financial firms were beginning to encounter capital
and liquidity difficulties, two Lehman Brothers analysts issued a highly detailed
report entitled “Who Owns Residential Credit Risk?”34 In the tables associated with
the report, they estimated the total unpaid principal balance of subprime and Alt-A
mortgages outstanding at $2.4 trillion, about half the actual number at the time.
Based on this assessment, when they applied a stress scenario in which housing
prices declined about 30 percent, they still found that “[t]he aggregate losses in the
residential mortgage market under the ‘stressed’ housing conditions could be about
$240 billion, which is manageable, assuming it materializes over a five-to six-year
horizon.” In the end, of course, the losses were much larger, and were recognized
under mark-to-market accounting almost immediately, rather than over a five to six
year period. But the failure of these two analysts to recognize the sheer size of the
subprime and Alt-A market, even as late as 2007, is the important point.
Along with most other observers, the Lehman analysts were not aware of
the true composition of the mortgage market in 2007. Under the “stressed” housing
conditions they applied, they projected that the GSEs would suffer aggregate losses
of $9.5 billion (net of mortgage insurance coverage) and that their guarantee fee
income would be more than sufficient to cover these losses. Based on known losses
and projections recently made by the Federal Housing Finance Agency (FHFA), the
GSEs’ credit losses alone could total $350 billion—more than 35 times the Lehman
analysts’ September 2007 estimate. The analysts could only make such a colossal
error if they did not realize that 37 percent—or $1.65 trillion—of the GSEs’ credit
risk portfolio consisted of subprime and Alt-A loans (see Table 1, supra) or that
these weak loans would account for about 75% of the GSEs’ default losses over 2007-

34
Vikas Shilpiekandula and Olga Gorodetski, “Who Owns Residential Credit Risk?” Lehman Brothers
Fixed Income U.S. Securitized Products Research, September 7, 2007.
466 Dissenting Statement

2010.35 It is also instructive to compare the Lehman analysts’ estimate that the 2006
vintage of subprime loans would suffer lifetime losses of 19 percent under “stressed”
conditions to other, later, more informed estimates. In early 2010, for example,
Moody’s made a similar estimate for the 2006 vintage and projected a 38 percent
loss rate after the 30 percent decline in housing prices had actually occurred.36
The Lehman loss rate projection suggests that the analysts did not have an
accurate estimate of the number of NTMs actually outstanding in 2006. Indeed, I
have not found any studies in the period before the financial crisis in which anyone—
scholar or financial analyst—actually seemed to understand how many NTMs were
in the financial system at the time. It was only after the financial crisis, when my AEI
colleague, Edward Pinto, began gathering this information from various unrelated
and disparate sources that the total number of NTMs in the financial markets
became clear. As a result, all loss projections before Pinto’s work were bound to be
faulty.
Much of the Commission majority’s report, which criticizes firms, regulators,
corporate executives, risk managers and ratings agency analysts for failure to perceive
the losses that lay ahead, is sheer hindsight. It appears that information about the
composition of the mortgage market was simply not known when the bubble began
to deflate. The Commission never attempted a serious study of what was known
about the composition of the mortgage market in 2007, apparently satisfied simply
to blame market participants for failing to understand the risks that lay before them,
without trying to understand what information was actually available.
The mortgage market is studied constantly by thousands of analysts,
academics, regulators, traders and investors. How could all these people have
missed something as important as the actual number of NTMs outstanding? Most
market participants appear to have assumed in the bubble years that Fannie and
Freddie continued to adhere to the same conservative underwriting policies they
had previously pursued. Until Fannie and Freddie were required to meet HUD’s AH
goals, they rarely acquired subprime or other low quality mortgages. Indeed, the
very definition of a traditional prime mortgage was a loan that Fannie and Freddie
would buy. Lesser loans were rejected, and were ultimately insured by FHA or made
by a relatively small group of subprime originators and investors.
Although anyone who followed HUD’s AH regulations, and thought through
their implications, would have realized that Fannie and Freddie must have been
shifting their buying activities to low quality loans, few people had incentives to
uncover the new buying pattern. Investors believed that there was no significant
risk in MBS backed by Fannie and Freddie, since they were thought (correctly, as
it turns out) to be implicitly backed by the federal government. In addition, the
GSEs were exempted by law from having to file information with the Securities and
Exchange Commission (SEC)--they agreed to file voluntarily in 2002--leaving them
free from disclosure obligations and questions from analysts about the quality of
their mortgages.
When Fannie voluntarily began filing reports with the SEC in 2003, it disclosed
35
Fannie Mae, 2010 Second Quarter Credit Supplement, http://www.fanniemae.com/ir/pdf/sec/2010/
q2credit_summary.pdf.
36
“Moody’s Projects Losses of Almost Half of Original Balance from 2007 Subprime Mortgage
Securities,” http://seekingalpha.com/article/182556-moodys-projects-losses-of-almost-half-of-original-
balance-from-2007-subprime-mortgage-securities.
 Peter J. Wallison 467

that 16 percent of its credit obligations on mortgages had FICO scores of less than
660—the common definition of a subprime loan. There are occasionally questions
about whether a FICO score of 660 is the appropriate dividing line between prime
and subprime loans. The federal bank regulators use 660 as the dividing line,37 and
in the credit supplement it published for the first time with its 2008 10-K, Fannie
included loans with FICO scores below 660 to disclose its exposure to loans that
were other than prime. As of December 31, 2008, borrowers with a FICO of less
than 660 had a serious delinquency rate about four times that for borrowers with
a FICO equal to or greater than 660 (6.74% compared to 1.72%).38 Fannie did not
point out in its filing that a FICO score of less than 660 was considered a subprime
loan. Although at the end of 2005 Fannie was exposed to $311 billion in subprime
loans it reported in its 2005 10-K (not filed with the SEC until May 2, 2007) that:
“The percentage of our single-family mortgage credit book of business consisting
of subprime mortgage loans or structured Fannie Mae MBS backed by subprime
mortgage loans was not material as of December 31, 2005.”[emphasis supplied]39
Fannie was able to make this statement because it defined subprime loans
as loans it purchased from subprime lenders. Thus, in its 2007 10-K report, Fannie
stated: “Subprime mortgage loans are typically originated by lenders specializing
in these loans or by subprime divisions of large lenders, using processes unique to
subprime loans. In reporting our subprime exposure, we have classified mortgage
loans as subprime if the mortgage loans are originated by one of these specialty lenders
or a subprime division of a large lender.”40[emphasis supplied] The credit scores on
these loans, and the riskiness associated with these credit scores, were not deemed
relevant. Accordingly, as late as its 2007 10-K report, Fannie was able to make the
following statements, even though it is likely that at that point it held or guaranteed
enough subprime loans to drive the company into insolvency if a substantial number
of these loans were to default:
Subprime mortgage loans, whether held in our portfolio or backing Fannie Mae MBS,
represented less than 1% of our single-family business volume in each of 2007, 2006
and 2005.41 [emphasis supplied]
We estimate that subprime mortgage loans held in our portfolio or subprime mortgage
loans backing Fannie Mae MBS, excluding re-securitized private label mortgage related
securities backed by subprime mortgage loans, represented approximately 0.3% of our
single-family mortgage credit book of business as of December 31, 2007, compared with
0.2% and 0.1% as of December 31, 2006 and 2005, respectively.42[emphasis supplied]
These statements could have lulled market participants and others—including
37
Office of Comptroller of the Currency, Federal Reserve, Federal Deposit Insurance Corporation,
and Office of Thrift Supervision advised in its “Expanded Guidance for Subprime Lending Programs”,
published in 2001, http://www.federalreserve.gov/Boarddocs/SRletters/2001/sr0104a1.pdf that “the term
‘subprime’ refers to the credit characteristics of individual borrowers. Subprime borrowers typically have
weakened credit histories that include payment delinquencies and possibly more severe problems such
as charge-offs, judgments, and bankruptcies.” A FICO score of 660 or below was evidence of “relatively
high default probability.”
38
Derived from Table 12.
39
Fannie Mae, 2005 10-K report, filed May 2, 2007.
40
Fannie Mae, 2007 Form 10K, pp. 129 and 155.
41
Fannie Mae, 2007 Form 10K, p.129.
42
Fannie Mae, 2007 Form 10K, p.130.
468 Dissenting Statement

the Lehman analysts—into believing that Fannie and Freddie did not hold or had
not guaranteed substantial numbers of high risk loans, and thus that there were
many fewer such loans in the financial system than in fact existed.
Of course, in the early 2000s there was no generally understood definition
of the term “subprime,” so Fannie and Freddie could define it as they liked, and the
assumption that the GSEs only made prime loans continued to be supported by their
public disclosures. So when Fannie and Freddie reported their loan acquisitions to
various mortgage information aggregators they did not report those mortgages as
subprime or Alt-A, and the aggregators continued to follow industry practice by
placing virtually all the GSEs’ loans in the “prime” category. Without understanding
Fannie and Freddie’s peculiar and self-serving loan classification methods, the
recipients of information about the GSEs’ mortgage positions simply seemed to
assume that all these mortgages were prime loans, as they had always been in the
past, and added them to the number of prime loans outstanding. Accordingly, by
2008 there were approximately 12 million more NTMs in the financial system—and
12 million fewer prime loans—than most market participants realized.
Appendix 1 shows that the levels of delinquency and default would be 86
percent higher than expected if there were 12 million NTMs in the financial system
instead of 12 million prime loans. Appendix 2 shows that the levels of delinquency
would be 150 percent higher than expected if the feedback effect of mortgage
delinquencies—causing lower housing prices, in a downward spiral—were taken
into account. These differences in projected losses could have misled the rating
agencies into believing that, even if the bubble were to deflate, the losses on mortgage
failures would not be so substantial as to have a more than local effect and would not
adversely affect the AAA tranches in MBS securitizations.
The Commission never looked into this issue, or attempted to determine
what market participants believed to be the number of subprime and other NTMs
outstanding in the system immediately before the financial crisis. Whenever
possible in the Commission’s public hearings, I asked analysts and other market
participants how many NTMs they believed were outstanding before the financial
crisis occurred. It was clear from the responses that none of the witnesses had ever
considered that question, and it appeared that none suspected that the number was
large enough to substantially affect losses after the collapse of the bubble.
It was only on November 10, 2008, after Fannie had been taken over by the
federal government, that the company admitted in its 10-Q report for the third
quarter of 2008 that it had classified as subprime or Alt-A loans only those loans
that it purchased from self-denominated subprime or Alt-A originators, and not
loans that were subprime or Alt-A because of their risk characteristics. Even then
Fannie wasn’t fully candid. After describing its classification criteria, Fannie stated,
“[H]owever, we have other loans with some features that are similar to Alt-A and
subprime loans that we have not classified as Alt-A or subprime because they do not
meet our classification criteria.”43 This hardly described the true nature of Fannie’s
obligations.
On the issue of the number of NTMs outstanding before the crisis the
Commission studiously averted its eyes, and the Commission majority’s report
43
Fannie Mae, 2008 3rd quarter 10-Q. p.115, http://www.fanniemae.com/ir/pdf/earnings/2008/q32008.
pdf.
 Peter J. Wallison 469

never addresses the question. HUD’s role in pressing for a reduction in mortgage
underwriting standards escaped the FCIC’s attention entirely, the GSEs’ AH goals
are mentioned only in passing, CRA is defended, and neither HUD’s Best Practices
Initiative nor FHA’s activities are mentioned at all. No reason is advanced for the
accumulation of subprime loans in the bubble other than the idea—implicit in the
majority’s report—that it was profitable. In sum, the majority’s report is Hamlet
without the prince of Denmark.
Indeed, the Commission’s entire investigation seemed to be directed at
minimizing the role of NTMs and the role of government housing policy. In this
telling, the NTMs were a “trigger” for the financial crisis, but once the collapse of the
bubble had occurred the “weaknesses and vulnerabilities” of the financial system—
which had been there all along—caused the crisis. These alleged deficiencies
included a lack of adequate regulation of the so-called “shadow banking system”
and over-the-counter derivatives, the overly generous compensation arrangements
on Wall Street, and securitization (characterized as “the originate to distribute
model”). Coincidentally, all these purported weaknesses and vulnerabilities then
required more government regulation, although their baleful presence hadn’t been
noted until the unprecedented number of subprime and Alt-A loans, created largely
to comply with government housing policies, defaulted.

6. Conclusion
What is surprising about the many views of the causes of the financial crisis
that have been published since the Lehman bankruptcy, including the Commission’s
own inquiry, is the juxtaposition of two facts: (i) a general agreement that the bubble
and the mortgage meltdown that followed its deflation were the precipitating
causes—sometimes characterized as the “trigger”—of the financial crisis, and (ii)
a seemingly studious effort to avoid examining how it came to be that mortgage
underwriting standards declined to the point that the bubble contained so many
NTMs that were ready to fail as soon as the bubble began to deflate. Instead of
thinking through what would almost certainly happen when these assets virtually
disappeared from balance sheets, many observers—including the Commission
majority in their report—pivoted immediately to blame the “weaknesses and
vulnerabilities” of the free market or the financial or regulatory system, without
considering whether any system could have survived such a blow.
One of the most striking examples of this approach was presented by Larry
Summers, the head of the White House economic council and one of the President’s
key advisers. In a private interview with a few of the members of the Commission
(I was not informed of the interview), Summers was asked whether the mortgage
meltdown was the cause of the financial crisis. His response was that the financial
crisis was like a forest fire and the mortgage meltdown like a “cigarette butt” thrown
into a very dry forest. Was the cigarette butt, he asked, the cause of the forest
fire, or was it the tinder dry condition of the forest?44 The Commission majority
adopted the idea that it was the tinder-dry forest. Their central argument is that the
mortgage meltdown as the bubble deflated triggered the financial crisis because of
the “vulnerabilities” inherent in the U.S. financial system at the time—the absence
44
FCIC, Summers interview, p.77.
470 Dissenting Statement

of regulation, lax regulation, predatory lending, greed on Wall Street and among
participants in the securitization system, ineffective risk management, and excessive
leverage, among other factors. One of the majority’s singular notions is that “30
years of deregulation” had “stripped away key safeguards” against a crisis; this
ignores completely that in 1991, in the wake of the S&L crisis, Congress adopted the
FDIC Improvement Act, which was by far the toughest bank regulatory law since
the advent of deposit insurance and was celebrated at the time of its enactment as
finally giving the regulators the power to put an end to bank crises.
The forest metaphor turns out to be an excellent way to communicate the
difference between the Commission’s report and this dissenting statement. What
Summers characterized as a “cigarette butt” was 27 million high risk NTMs with
a total value over $4.5 trillion. Let’s use a little common sense here: $4.5 trillion in
high risk loans was not a “cigarette butt;” they were more like an exploding gasoline
truck in that forest. The Commission’s report blames the conditions in the financial
system; I blame 27 million subprime and Alt-A mortgages—half of all mortgages
outstanding in the U.S. in 2008—and a number that appears to have been unknown
to most if not all market participants at the time. No financial system, in my view,
could have survived the failure of large numbers of high risk mortgages once the
bubble began to deflate, and no market could have avoided a panic when it became
clear that the number of defaults and delinquencies among these mortgages far
exceeded anything that even the most sophisticated market participants expected.
This conclusion has significant policy implications. If in fact the financial
crisis was caused by government housing policies, then the Dodd-Frank Act was
legislative overreach and unnecessary. The appropriate policy choice was to reduce
or eliminate the government’s involvement in the residential mortgage markets, not
to impose significant new regulation on the financial system.
****
The balance of this statement will outline (i) how the high levels of delinquency
and default among the NTMs were transmitted as losses to the financial system, and
(ii) how the government policies summarized above caused the accumulation of an
unprecedented number of NTMs in the U.S. and around the globe.
 II. HOW 27 MILLION NTMS
PRECIPITATED A FINANCIAL CRISIS

Although the Commission never defined the financial crisis it was supposed
to investigate, it is necessary to do so in order to know where to start and stop. If, for
example, the financial crisis is still continuing, then the effect of government policies
such as the Troubled Asset Repurchase Program (TARP) should be evaluated.
However, it seems clear that Congress wanted the Commission to concentrate
on what caused the unprecedented events that occurred largely in the fall of 2008,
and for this purpose Ben Bernanke’s definition of the financial crisis seems most
appropriate:
The credit boom began to unravel in early 2007 when problems surfaced with subprime
mortgages—mortgages offered to less-creditworthy borrowers—and house prices in
parts of the country began to fall. Mortgage delinquencies and defaults rose, and the
downturn in house prices intensified, trends that continue today. Investors, stunned
by losses on assets they had believed to be safe, began to pull back from a wide range
of credit markets, and financial institutions—reeling from severe losses on mortgages
and other loans—cut back their lending. The crisis deepened [in September 2008],
when the failure or near-failure of several major financial firms caused many financial
and credit markets to freeze up.”45
In other words, the financial crisis was the result of the losses suffered by
financial institutions around the world when U.S. mortgages began to fail in large
numbers; the crisis became more severe in September 2008, when the failure of
several major financial firms—which held or were thought to hold large amounts
of mortgage-related assets—caused many financial markets to freeze up. This
summary encapsulates a large number of interconnected events, but it makes clear
that the underlying cause of the financial crisis was a rapid decline in the value of
one specific and widely held asset: U.S. residential mortgages. The next question is
how, exactly, these delinquencies and losses caused the financial crisis.
The following discussion will show that it was not all mortgages and
mortgage-backed securities that were the source of the crisis, but primarily NTMs—
including PMBS backed by NTMs. Traditional mortgages, which were generally
prime mortgages, did not suffer substantial losses at the outset of the mortgage
meltdown, although as the financial crisis turned into a recession and housing
prices continued to fall, losses among prime mortgages began to approach the level
of prime mortgage losses that had occurred in past housing crises. However, those
levels were far lower than the losses on NTMs, which reached levels of delinquency
and default between 15 and 45 percent (depending on the characteristics of the
loans in question) because the loans involved were weaker as a class than in any
previous housing crisis. The fact that they were also far larger in number than any

45
Speech at Morehouse College, April 14, 2009.

471
472 Dissenting Statement

previous bubble was what caused the catastrophic housing price declines that fueled
the financial crisis.

1. How Failures Among NTMs

were Transmitted to the Financial System
When the housing bubble began to deflate in mid-2007, delinquency rates
among NTMs began to increase substantially. Previously, although these mortgages
were weak and high risk, their delinquency rates were relatively low. This was a
consequence of the bubble itself, which inflated housing prices so that homes
could be sold with no loss in cases where borrowers could not meet their mortgage
obligations. Alternatively, rising housing prices—coupled with liberal appraisal
rules—created a form of free equity in a home, allowing the home to be refinanced
easily, perhaps even at a lower interest rate. However, rising housing prices eventually
reached the point where even easy credit terms could no longer keep the good times
rolling, and at that point the bubble flattened and weak mortgages became exposed
for what they were. As Warren Buffett has said, when the tide goes out, you can see
who’s swimming naked.
The role of the government’s housing policy is crucial at this point. As
discussed earlier, if the government had not been directing money into the
mortgage markets in order to foster growth in home ownership, NTMs in the
bubble would have begun to default relatively soon after they were originated. The
continuous inflow of government or government-backed funds, however, kept the
bubble growing—not only in size but over time—and this tended to suppress the
significant delinquencies and defaults that had brought previous bubbles to an end
in only three or four years. That explains why PMBS based on NTMs could become
so numerous and so risky without triggering the delinquencies and defaults that
caused earlier bubbles to deflate within a shorter period. With losses few and time
to continue originations, Countrywide and others were able to securitize subprime
PMBS in increasingly large amounts from 2002 ($134 billion) to 2006 ($483 billion)
without engendering the substantial increase in delinquencies that would ordinarily
have alarmed investors and brought the bubble to a halt.46
Indeed, the absence of delinquencies had the opposite effect. As investors
around the world saw housing prices rise in the U.S. without any significant losses
even among subprime and other high-yielding loans, they were encouraged to buy
PMBS that—although rated AAA—still offered attractive yields. In other words, as
shown in Figure 2, government housing policies—AH goals imposed on the GSEs,
the decline in FHA lending standards, HUD’s pressure for reduced underwriting
standards among mortgage bankers, and CRA requirements for insured banks—
by encouraging the growth of the bubble, increased the worldwide demand for
subprime PMBS. Then, in mid-2007, the bubble began to deflate, with catastrophic
consequences.

46
Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual—Volume II, MBS database.
 Peter J. Wallison 473

2. The Defaults Begin

The best summary of how the deflation of the housing bubble led to the
financial crisis was contained in the prepared testimony that FDIC chair Sheila Bair
delivered to the FCIC in a September 2 hearing:
Starting in mid 2007, global financial markets began to experience serious liquidity
challenges related mainly to rising concerns about U.S. mortgage credit quality. As
home prices fell, recently originated subprime and non-traditional mortgage loans
began to default at record rates. These developments led to growing concerns about
the value of financial positions in mortgage-backed securities and related derivative
instruments held by major financial institutions in the U.S. and around the world.
The difficulty in determining the value of mortgage-related assets and, therefore, the
balance-sheet strength of large banks and non-bank financial institutions ultimately
led these institutions to become wary of lending to one another, even on a short-term
basis.47 [emphasis supplied]
All the important elements of what happened are in Chairman Bair’s succinct
statement: (i) in mid 2007, the markets began to experience liquidity challenges
because of concerns about the credit quality of NTMs; (ii) housing prices fell; NTMs
began to default at record rates; (iii) it was difficult to determine the value of MBS,
and thus the financial condition of the institutions that held them; and, (iv) finally, as
a consequence of this uncertainty—especially after the failure of Lehman—financial
institutions would not lend to one another. That phenomenon was the financial
crisis. The following discussion will show how each of these steps operated to bring
down the financial system.

Markets Began to Experience Liquidity Challenges

To understand the transmission mechanism, it is necessary to distinguish
between PMBS, on the one hand, and the MBS that were distributed by government
agencies such as FHA/Ginnie Mae and the GSEs (referred to jointly as “Agencies”
in this section). As shown in Table 1, by 2008, the 27 million NTMs in the U.S.
financial system were held as (i) whole mortgages, (ii) MBS guaranteed by the GSEs,
or insured or held by a government agency or a bank under the CRA, or (iii) as
PMBS securitized by private firms such as Countrywide. The 27 million NTMs had
an aggregate unpaid principal balance of more than $4.5 trillion, and the portion
represented by PMBS consisted of 7.8 million mortgages with an aggregate unpaid
principal balance of approximately $1.9 trillion. As mortgage delinquencies and
defaults multiplied in the U.S. financial system, the losses were transmitted to
financial institutions through their holdings of PMBS. How did this happen, and
what role was played by government housing policy?
Both Agency MBS and PMBS pass through to investors the principal and
interest received on the mortgages in a pool that backs an issue of securities; the
difference between them is the way they protect investors against credit risk—i.e.,
the possibility of losses in the event that the mortgages in the pool begin to default.
The Agencies insure or place a guarantee on all the securities issued by a pool they
or some other entity creates. Because of the Agencies’ real or perceived government
47
Sheila C. Bair, “Systemically Important Institutions and the Issue of ‘Too-Big-to-Fail,’” Testimony to
the FCIC, September 2, 2010, p.3.
474 Dissenting Statement

backing, all these securities are rated or considered to be AAA.

PMBS rely on a classification and subordination system known as “tranching”
to provide some investors in the pool with a degree of assurance that they will not
suffer losses because of mortgage defaults. In the tranching system, different classes
of securities are issued by the pool. The rights of some classes to receive payments of
principal and interest from the mortgages in the pool are subordinated to the rights
of other classes, so that the superior classes are more likely to receive payment even
if there are some defaults among the mortgages in the pool.
Through this mechanism, approximately 90 percent of an issue of PMBS
could be rated AAA or AA, even if the underlying mortgages are NTMs that have a
higher rate of delinquency than prime loans. In theory, for example, if the historic
rates of loss on a pool of NTMs is, say, five percent, then those losses will be absorbed
by the ten percent of the securities holders who are in the classes rated lower than
AAA or AA. Of course, if the losses are greater than anticipated—exactly what
happened as the recent bubble began to deflate—they will reach into the higher
classes and substantially reduce their value.48 It is not clear whether, in 2007 or 2008,
mortgage delinquencies and defaults had actually caused cash losses in the AAA
tranches of PMBS, but the rate at which delinquencies and defaults among NTMs
were occurring throughout the financial system was so high that such losses were a
distinct possibility—obviously a matter of great concern to investors.
This means that investors in PMBS and government-backed Agency MBS
had different experiences when the bubble began to deflate. Those who invested
in Agency MBS did not suffer losses (the U.S. government has thus far protected
all investors in Agency MBS), while those who invested in PMBS were exposed to
losses if the losses on the underlying mortgages were so great that they threatened
to invade the AAA and AA classes. Even if no cash losses had actually been suffered,
the holders of PMBS would see a sharp decline in the market value of their holdings
as investors—shocked by the large number of defaults on mortgages—fled the asset-
backed market. So when we look for the direct effect of mortgage failures on the
financial condition of various financial institutions in the financial crisis we should
look only to the PMBS, not the MBS issued by the Agencies.
In addition, the default and delinquency ratios on the loans underlying the
PMBS were higher than similar ratios among the loans held or guaranteed by the
Agencies. Many of the loans which backed the PMBS were the self-denominated
subprime loans (that is, made by subprime lenders explicitly to subprime borrowers)
and were classified in the worst-performing categories in Table 3. In part, the better-
performing characteristics of the NTMs held or guaranteed by the Agencies was
due to the fact that the Agencies were not buying for economic purposes—to make
profits—but only to meet government requirements such as the AH goals. They did
not want or need the higher-yielding and thus more risky mortgages that backed
the PMBS, because they did not need higher yields in order to sell their MBS. In
addition, because of their lower cost funding, the Agencies could pay more for the
NTMs they bought and thus could acquire the “best of the worst.”

48
A thorough description of the tranching system, and many more details about various methods of
protecting senior tranches, is contained in Gary B. Gorton, Slapped By the Invisible Hand: The Panic of
2007, Oxford University Press, 2010, pp. 82-113.
 Peter J. Wallison 475

PMBS are Connected to All Other NTMs Through Housing Prices

But this does not mean that only the failure of the PMBS was responsible
for the financial crisis. In a sense, all mortgages are linked to one another through
housing prices, and housing prices in turn are highly sensitive to delinquencies and
defaults on mortgages. This is a characteristic of mortgages that is not present in
other securitized assets. If a credit card holder defaults on his obligations it has little
effect on other credit card holders, but if a homeowner defaults on a mortgage the
resulting foreclosure has an effect on the value of all homes in the vicinity and thus
on the quality of all mortgages on those homes.
Accordingly, the PMBS were intimately connected—through housing
prices—to the NTMs securitized by the Agencies. Because there were so many
more NTMs held or securitized by the Agencies (see Table 1), their unprecedented
numbers—even in cases where they had a lower average rate of delinquency and
default than the NTMs that backed the PMBS—was the major source of downward
pressure on housing prices throughout the United States. Weakening housing
prices, in turn, caused more mortgage defaults, among both NTMs in general and
the particular NTMs that were the collateral for PMBS. In other words, the NTMs
underlying the PMBS were weakened by the delinquencies and defaults among the
much larger number of mortgages held or guaranteed as MBS by the Agencies.
In reality, then, the losses on the PMBS were much higher than they would
have been if the government’s housing policies had not brought into being 19 million
other NTMs that were failing in unprecedented numbers. These failures drove down
housing prices by 30 percent--an unprecedented decline—which multiplied the
losses on the PMBS.
Finally, the funds that the government directed into the housing market in
pursuit of its social policies enlarged the housing bubble and extended it in time.
The longer housing bubbles grow, the riskier the mortgages they contain; lenders
are constantly trying to find ways to keep monthly mortgage payments down while
borrowers are buying more expensive houses. While the bubble was growing, the
risks that were building within it were obscured. Borrowers who would otherwise
have defaulted on their loans, bringing an end to the bubble, were able to use the
rising home prices to refinance, sometimes at lower interest rates. With delinquency
rates relatively low, investors did not have a reason to exit the mortgage markets,
and the continuing flow of funds into mortgages allowed the bubble to extend
for an unprecedented 10 years. This in turn enabled the PMBS market to grow to
enormous size and thus to have a more calamitous effect when it finally collapsed. If
the government policies that provided a continuing source of funding for the bubble
had not been pursued, it is doubtful that there would have been a PMBS market
remotely as large as the one that developed, or that—when the housing bubble
collapsed—the losses to financial institutions would have been as great.

PMBS, as Securities, are Vulnerable to Investor Sentiment

In addition to their link to the Agencies’ NTMs through housing prices, PMBS
were particularly vulnerable to changes in investor sentiment about mortgages.
The fact that the mortgages underlying the PMBS were held in securitized form
was an important element of the crisis. There are many reasons for the popularity
476 Dissenting Statement

of mortgage securitization. Beginning in 2002, for example, the Basel regulations

provided that mortgages held in the form of MBS—presumably because of their
superior liquidity compared to whole mortgages—required a bank to hold only
1.6 percent risk-based capital, while whole mortgages required risk-based capital
backing of four percent. This made all forms of MBS, including PMBS, much less
expensive to hold than whole mortgages. In addition, mortgages in securitized form
could be traded more easily, and used more readily as a source of liquidity through
repurchase agreements.
However, some of the benefits of securitized mortgages are also detriments
when certain mortgage market conditions prevail. If housing values are declining,
losses on whole mortgages are recognized only slowly in bank financial statements
and will be recognized even more slowly in the larger market. PMBS, however, are
far more vulnerable to swings in sentiment than whole mortgages held on bank
balance sheets. First, because they are more easily traded, PMBS values can be
more quickly and adversely affected by negative information about the underlying
mortgages than whole mortgages in the same principal amount. PMBS markets
tend to be thin, because PMBS pools differ from one another. If investors believe
that mortgages in general are declining in value, or they learn of a substantial and
unexpected number of defaults and delinquencies, they may abandon the market
for all PMBS, causing the general PMBS price level to fall precipitously.
For example, in his book Slapped by the Invisible Hand, Professor Gary Gorton
of Yale notes that the ABX index, initially published in late 2006, for the first time
gave investors a picture of how others saw the value of a selected group of PMBS
pools. The index showed steeply declining values, which caused many investors to
withdraw from the market. Gorton observed: “I view the ABX indices as revealing
hitherto unknown information, namely, the aggregated view that subprime was
worth significantly less…It is not clear whether the housing bubble was burst by
the ability to short the subprime housing market or whether house prices were
going down and the implications of this were aggregated and revealed by the ABX
indices”49
Whatever the underlying reason, as shown in Figure 3, this seems to be
exactly what happened in the financial crisis. The result was a crash in the MBS
market as investors fled what looked like major oncoming losses.

49
Gorton, Slapped by the Invisible Hand, note 41, pp.121-123.
 Peter J. Wallison 477

Figure 3. The MBS market reacts to the bubble’s deflation

Source: Thompson Reuters Debt Capital Markets Review, Fourth Quarter 2008, available at http://
thomsonreuters.com/products_services/financial/league_tables/debt_equity/ (accessed July 30, 2009).

The decline in housing values had a profound adverse effect on the liquidity
of all financial institutions that were exposed to PMBS. As noted above, one of the
benefits of holding PMBS, especially those with AAA ratings, was that they were
readily marketable. As such, they were considered sound and secure investments,
carried on balance sheets at par and suitable to serve as collateral for short term
financing through repurchase agreements, or “repos.” In a repo transaction,
a borrower sells a security to a lender with an option to repurchase it at a price
that provides the lender with a return appropriate for a secured loan. The lender
assumes that if its counterparty defaults the collateral can be sold. Accordingly, if
the collateral asset loses its reputation for high quality and liquidity, it loses much
of its value for both capital and liquidity purposes, even if the collateral itself has
not actually suffered losses. This is what happened to AAA-rated PMBS as housing
prices first leveled off and then began to fall in 2007, and as mortgage delinquencies
rolled in at rates no one had expected. As discussed more fully below, when AAA-
rated PMBS became unmarketable they lost their value for liquidity purposes,
making it difficult or impossible for many financial institutions to fund themselves
using these assets as collateral for repos. This was the liquidity challenge to which
Chairman Bair referred in her testimony.
The near-failure of Bear Stearns in March 2008 was an excellent example of
how the unexpected collapse of the PMBS market could cause a substantial loss of
liquidity by a financial institution, and ultimately its inability to survive the resulting
loss in market confidence. The FCIC staff ’s review of the liquidity problems of
Bear Stearns showed that the loss of the PMBS market was the single event that
was crippling for Bear, because it eliminated a major portion of the firm’s liquidity
478 Dissenting Statement

pool—AAA-rated PMBS—as a useful source of repo financing. According to the

Commission staff ’s Preliminary Investigative Report on Bear, prepared for hearings
on May 5 and 6, 2010, 97.4 percent of Bear’s short term funding was secured and
only 2.6 percent unsecured. “As of January 11, 2008,” the FCIC staff reported,
“$45.9 billion of Bear Stearns’ repo collateral was composed of agency (Fannie and
Freddie) mortgage-related securities, $23.7 billion was in non-agency securitized
asset backed securities [i.e., PMBS], and $19 billion was in whole loans.”50 The
Agency MBS was unaffected by the collapse of the PMBS market, and could still be
used for funding.
Thus, about 27 percent of Bear’s readily available sources of funding
consisted of PMBS that became unusable for repo financing when the PMBS market
disappeared. The loss of this source of liquidity put the firm in serious jeopardy;
rumors swept the market about Bear’s condition, and clients began withdrawing
funds. Bear’s officers told the Commission that the firm was profitable in its first 2008
quarter—the quarter in which it failed; ironically they also told the Commission’s
staff that they had moved Bear’s short term funding from commercial paper to MBS
because they believed that collateral-backed funding would be more stable. In the
week beginning March 10, 2008, according to the FCIC staff report, Bear had over
$18 billion in cash reserves, but by March 13 the liquidity pool had fallen to $2
billion.51 It was clear that Bear—solvent and profitable or not—could not survive a
run that was fueled by fear and uncertainty about its liquidity and the possibility of
its insolvency.
Parenthetically, it should be noted that the Commission’s staff focused on Bear
because the Commission’s majority apparently believed that the business model of
investment banks, which relied on relatively high leverage and repo or other short
term financing, was inherently unstable. The need to rescue Bear was thought to be
evidence of this fact. Clearly, the five independent investment banks—Bear, Lehman
Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs—were badly damaged
in the financial crisis. Only two of them remain independent firms, and those two
are now regulated as bank holding companies by the Federal Reserve. Nevertheless,
it is not clear that the investment banks fared any worse than the much more heavily
regulated commercial banks—or Fannie and Freddie which were also regulated
more stringently than the investment banks but not as stringently as banks. The
investment banks did not pass the test created by the mortgage meltdown and
the subsequent financial crisis, but neither did a large number of insured banks—
IndyMac, Washington Mutual (WaMu) and Wachovia, to name the largest—that
were much more heavily regulated and, in addition, offered insured deposits and
had access to the Fed’s discount window if they needed emergency funds to deal
with runs. The view of the Commission majority, that investment banks—as part of
the so-called “shadow banking system”—were special contributors to the financial
crisis, seems misplaced for this reason. They are better classified not as contributors
to the financial crisis but as victims of the panic that ensued after the housing bubble
and the PMBS market collapsed.
Bear went down because the delinquencies and failures of an unprecedentedly
large number of NTMs caused the collapse of the PMBS market; this destroyed the
50
FCIC, “Investigative Findings on Bear Stearns (Preliminary Draft),” April 29, 2010, p.16.
51
Id., p.45.
 Peter J. Wallison 479

usefulness of AAA-rated PMBS as assets that Bear and others relied on for both
capital and liquidity, and thus raised questions about the firm’s ability to meet its
obligations. Investment banks like Bear Stearns were not commercial banks; instead
of using short term deposits to hold long term assets—the hallmark of a bank—
their business model relied on short-term funding to carry the short term assets
of a trading business. Contrary to the views of the Commission majority, there is
nothing inherently wrong with that business model, but it could not survive an
unprecedented financial panic as severe as that which followed the collapse in value
of an asset class as large and as liquid as AAA-rated subprime PMBS.

Mortgage Defaults at Record Rates Created Balance Sheet Losses

Chairman Bair also pointed to the relationship between the decline in the
value of PMBS and “the balance sheet strength” of financial institutions that held
these assets. Adding to liquidity-based losses, balance sheet writedowns were
another major element of the loss transmission mechanism. Securitized assets held
by financial institutions are subject to the rules of fair value accounting, and must
be marked to market under certain circumstances. Thus, banks and other financial
institutions that are holding securitized mortgages in the form of PMBS could
be subject to large accounting losses—but not necessarily cash losses—if investor
sentiment were to turn against securitized mortgages and market values decline.
Accordingly, once large numbers of delinquencies and losses started showing up in
the mortgage markets generally and in the mortgage pools that backed the PMBS,
it was not necessary for all the losses to be realized before the PMBS lost substantial
value. All that was necessary was that the market for these assets become seriously
impaired. This is exactly what happened in the middle of 2007, leading immediately
not only to severe adverse liquidity consequences for financial institutions that held
PMBS but also to capital writedowns that made them appear unstable and possibly
insolvent.
These mark-to-market capital losses could be greater than the actual
credit losses to be anticipated. As one Federal Reserve study put it, “The financial
turmoil…put downward pressure on prices of structured finance products across
the whole spectrum of [asset-backed] securities, even those with only minimal ties
to the riskiest underlying assets…[I]n addition to discounts from higher expected
credit risk, large mark-to-market discounts are generated by uncertainty about the
quality of the underlying assets, by illiquidity, and by price volatility…This illiquidity
discount is the main reason why the mark-to-market discount here, and in most
similar analyses, is larger than the expected credit default rates on underlying
assets.”52 In other words, the illiquidity discount associated with the uncertainties in
value of collateral are and can be substantially larger than the credit default spread,
since the spread reflects only anticipated credit losses.
As shown so dramatically in Figure 3, the collapse of the market for PMBS
was a seminal event in the history of the financial crisis. Even though delinquencies
had only just begun to show up in mortgage pools, the absence of a functioning

52
Daniel Beltran, Laurie Pounder and Charles Thomas, “Foreign Exposure to Asset-Backed Securities of
U.S. Origin,” Board of Governors of the Federal Reserve System, International Finance Discussion Papers
939, August 2008, pp. 11-14.
480 Dissenting Statement

market meant that PMBS simply could not be sold at anything but distress prices.
The inability of financial institutions to liquidate their PMBS assets at anything like
earlier values had dire consequences, especially under mark-to-market accounting
rules, and was the crux of the crisis. In effect, a whole class of assets—involving
almost $2 trillion—came to be called “toxic assets” in the media, and had to be
written down substantially on the balance sheets of financial institutions around
the world. Although this made financial institutions look weaker than they actually
were, the PMBS they held, despite being unmarketable at that point, were in many
cases still flowing cash at close to expected rates. Instead of a slow decline in value—
which would have occurred if whole mortgages were held on bank balance sheets
and gradually deteriorated in quality—the loss of marketability of these securities
caused a crash in value.
The Commission majority did not discuss the significance of mark-to-
market accounting in its report. This was a serious lapse, given the views of many
that accounting policies played an important role in the financial crisis. Many
commentators have argued that the resulting impairment charges to balance sheets
reduced the GAAP equity of financial institutions and, therefore, their capital
positions, making them appear financially weaker than they actually were if viewed
on the basis of the cash flows they were receiving.53
The investor panic that began when unanticipated and unprecedented losses
started to appear among NTMs generally and in the PMBS mortgage pools now
spread to financial institutions themselves; investors were no longer sure which of
these institutions could survive severe mortgage-related losses. This process was
succinctly described in an analysis of fair value or mark-to-market accounting in
the financial crisis issued by the Institute of International Finance, an organization
of the world’s largest banks and financial firms:
[O]ften-dramatic write-downs of sound assets required under the current
implementation of fair-value accounting adversely affect market sentiment, in turn
leading to further write-downs, margin calls and capital impacts in a downward spiral
that may lead to large-scale fire-sales of assets, and destabilizing, pro-cyclical feedback
effects These damaging feedback effects worsen liquidity problems and contribute
to the conversion of liquidity problems into solvency problems.54 [emphasis in the
original]
At least one study attempted to assess the effect of this on financial institutions
overall. In January 2009, Nouriel Roubini and Elisa Parisi-Capone estimated the
mark-to-market losses on MBS backed by both prime loans and NTMs. Their
estimate was slightly over $1 trillion, of which U.S. banks and investment banks
were estimated to have lost $318 billion on a mark-to-market basis.55
This would be a dramatic loss if all of it were realized. In 2008, the U.S.
banking system had total assets of $10 trillion; the five largest investment banks had

53
FCIC Draft Staff Report, “The Role of Accounting During the Financial Crisis,” p.16.
54
Institute of International Finance, “IIF Board of Directors - Discussion Memorandum
on Valuation in Illiquid Markets,” April 7, 2008, p.1.
55
Nouriel Roubini and Elisa Parisi-Carbone, “Total $3.6 Trillion Projected Loan and Securities Losses in
U.S. $1.8 Trillion of Which Borneby U.S. Banks/Brokers,” RGE Monitor, January 2009, p.8.
 Peter J. Wallison 481

total assets of $4 trillion.56 If we assume that the banks had a leverage ratio of about
15-to-1 in 2008 and the investment banks about 30-to-1, that would mean that the
equity capital position of the banking industry as a whole would be about $650
billion and the same number for the investment banks would be about $130 billion,
for a total of $780 billion. Under these circumstances, the collapse of the PMBS
market alone reduced the capital positions of U.S. banks and investment banks by
approximately 41 percent on a mark-to-market basis. This does not mean that any
actual losses were suffered, only that the assets concerned might have to be written
down or could not be sold for the price at which they were previously carried on the
firm’s balance sheet.
In addition, Roubini and Parisi-Capone estimated that U.S. commercial
and investment banks suffered a further mark-to-market loss of $225 billion on
unsecuritized subprime and Alt-A mortgages.57 They also estimated that mark-to-
market losses for financial institutions outside the U.S. would be about 40 percent
of U.S. losses, so there was likely to be a major effect on banks and other financial
institutions around the world—depending, of course, on their capital position at the
time the PMBS market stopped functioning. I am not aware of any data showing the
mark-to-market effect of the collapse of the PMBS market on other U.S. financial
institutions, but it can be assumed that they also suffered similar losses in proportion
to their holdings of PMBS.
Losses of this magnitude would certainly be enough—when combined
with other losses on securities and loans not related to mortgages—to call into
question the stability of a large number of banks, investment banks and other
financial institutions in the U.S. and around the world. However, there was one
other factor that exacerbated the adverse effect of the loss of a market for PMBS.
Although accounting rules did not require all PMBS to be written down, investors
and counterparties did not know which financial institutions were holding the
weakest assets and how much of their assets would have to be written down over
time. Whatever that amount, it would reduce their capital positions at a time when
investors and counterparties were anxious about their stability. This was the balance
sheet effect that was the third element of Chairman Bair’s summary.
To summarize, then, the following are the steps through which the
government’s housing policies transmitted losses—through PMBS—to the largest
financial institutions: (i) the 19 million NTMs acquired or guaranteed by the
Agencies were major contributors to the growth of the bubble and its extension
in time; (ii) the growth of the bubble suppressed the losses that would ordinarily
have brought the development of NTM-backed PMBS to a halt; (ii) competition
for NTMs drove subprime lenders further out the risk curve to find high-yielding
mortgages to securitize, especially when these loans did not appear to be producing
losses commensurate with their risk; (iv) when the bubble finally burst, the
unprecedented number of delinquencies and defaults among all NTMs—the great
majority of which were held or guaranteed by the Agencies—caused investors to

56
Timothy F. Geithner, “Reducing Systemic Risk in a Dynamic Financial System,” Remarks at the
Economic Club of New York, June 9, 2008, available at http://www.ny.frb.org/newsevents/speeches/2008/
tfg080609.html.
57
Nouriel Roubini and Elisa Parisi-Carbone, “Total $3.6 Trillion Projected Loan and Securities
Losses,” p.7.
482 Dissenting Statement

flee the PMBS market, reducing the liquidity of the financial institutions that held
the PMBS; and (v) mark-to-market accounting required these institutions to write
down the value of the PMBS they held, as well as their other mortgage-related assets,
reducing their capital positions and raising further questions about their stability
and solvency.

Government Actions Create a Panic

More than any other phenomenon, the financial crisis of 2008 resembles
an old-fashioned investor and creditor panic. In the classic study, Manias, Panics
and Crashes: A History of Financial Crises, Charles Kindleberger and Robert Aliber
make a distinction between a remote cause and a proximate cause of a panic: “Causa
remota of any crisis is the expansion of credit and speculation, while causa proxima
is some incident that saps the confidence of the system and induces investors to sell
commodities, stocks, real estate, bills of exchange, or promissory notes and increase
their money holdings.”58 In the great financial panic of 2008, it is reasonably clear
that the remote cause was the build-up of NTMs in the financial system, primarily—
as I have shown in this analysis—as a result of government housing policy. This
unprecedented increase in weak and risky assets set the financial system up for
a crisis of some kind. The event that turned a potential crisis into a full-fledged
panic—the proximate cause of the panic—was also the government’s action: the
rescue of Bear Stearns in March 2008 and the subsequent failure to rescue Lehman
Brothers six months later. In terms of its ultimate cost to the public, this was one of
the great policy errors of all time, and the reasons for the misjudgments that led to
it have not yet been fully explored.
The lesson taught by the rescue of Bear was that all large financial
institutions—and especially those larger than Bear—would be rescued. The moral
hazard introduced by this one act irreparably changed the position of Lehman
Brothers and every other large firm in the world’s financial system. From that time
forward, (i) the critical need for more capital became less critical; the likelihood of
a government bailout would reassure creditors, so there was no need to dilute the
shareholders any further by raising additional capital; (ii) firms such as Lehman,
that might have been saved through an acquisition by a larger firm or an infusion of
fresh capital by a strategic investor, drove harder bargains with potential acquirers;
(iii) the potential acquirers themselves waited for the U.S. government to pick up
some of the cost, as it had with Bear—an offer that never came in Lehman’s case;
and (iv) the Reserve Fund, a money market mutual fund, apparently assuming
that Lehman would be rescued, decided not to sell the heavily discounted Lehman
commercial paper it held; instead, with devastating results for the money market
fund industry, it waited to be bailed out on the assumption that Lehman would be
saved.
But Lehman was not saved, and its creditors were not bailed out. At a time
when large mark-to-market losses among U.S. financial firms raised questions about
which large financial institutions were insolvent or unstable, the demise of Lehman
was a major shock. It overturned all the rational expectations about government

58
Charles P. Kindleberger and Robert Aliber, Manias, Panics, and Crashes: A History of Financial Crises,
5th edition, John Wiley & Sons, Inc., 2005, p.104.
 Peter J. Wallison 483

policies that market participants had developed after the Bear rescue. With no
certainty about who was strong or who was weak, there was a headlong rush to
U.S. government securities. Banks—afraid that their counterparties would want a
return of their investments or their corporate customers would draw on lines of
credit—began to hoard cash. Banks wouldn’t lend to other banks, even overnight.
As Chairman Bair suggested, that was the financial crisis. Everything after that was
simply cleaning up the mess.
This analysis lays the principal cause of the financial crisis squarely at the feet
of the unprecedented number of NTMs that were brought into the U.S. financial
markets by government housing policy. These weak and high risk loans helped to
build the bubble, and when the bubble deflated they defaulted in unprecedented
numbers. This threatened losses in the PMBS that were held by financial institutions
in the U.S. and around the world, impairing both their liquidity and their apparent
stability.
The accumulation of 27 million subprime and Alt-A mortgages was not a
random event, or even the result of major forces such as global financial imbalances
or excessively low interest rates. Instead, these loans and the bubble to which they
contributed were the direct consequence of something far more mundane: U.S.
government housing policy, which—led by HUD over two administrations—
deliberately reduced mortgage underwriting standards so that more people could
buy homes. While this process was going on, everyone was pleased. Homeownership
in the U.S. actually grew to the highest level ever recorded. But the result was a
financial catastrophe from which the U.S. has still not recovered.
484 Dissenting Statement
 III. THE U.S. GOVERNMENT’S ROLE
IN FOSTERING THE GROWTH OF
THE NTM MARKET

The preceding section of this dissenting statement described the damage

that was done to the financial system by the unprecedented number of defaults and
delinquencies that occurred among the 27 million NTMs that were present there
in 2008. Given the damage they caused, the most important question about the
financial crisis is why so many low quality mortgages were created. Another way
to state this question is to ask why mortgage standards declined so substantially
before and during the 1997-2007 bubble, allowing so many NTMs to be created.
This massive and unprecedented change in underwriting standards had to have a
cause—some factor that was present during the 1990s and thereafter that was not
present in any earlier period. Part III addresses this fundamental question.
The conventional explanation for the financial crisis is the one given by Fed
Chairman Bernanke in the same speech at Morehouse College quoted at the outset
of Part II:
Saving inflows from abroad can be beneficial if the country that receives those inflows
invests them well. Unfortunately, that was not always the case in the United States
and some other countries. Financial institutions reacted to the surplus of available
funds by competing aggressively for borrowers, and, in the years leading up to the crisis,
credit to both households and businesses became relatively cheap and easy to obtain. One
important consequence was a housing boom in the United States, a boom that was
fueled in large part by a rapid expansion of mortgage lending. Unfortunately, much of
this lending was poorly done, involving, for example, little or no down payment by the
borrower or insufficient consideration by the lender of the borrower’s ability to make the
monthly payments. Lenders may have become careless because they, like many people
at the time, expected that house prices would continue to rise--thereby allowing
borrowers to build up equity in their homes--and that credit would remain easily
available, so that borrowers would be able to refinance if necessary. Regulators did not
do enough to prevent poor lending, in part because many of the worst loans were made
by firms subject to little or no federal regulation. [Emphasis supplied]59
In other words, the liquidity in the world financial market caused U.S. banks
to compete for borrowers by lowering their underwriting standards for mortgages
and other loans. Lenders became careless. Regulators failed. Unregulated originators
made bad loans. One has to ask: is it plausible that banks would compete for
borrowers by lowering their mortgage standards? Mortgage originators—whether
S&Ls, commercial banks, mortgage banks or unregulated brokers—have been
competing for 100 years. That competition involved offering the lowest rates and
the most benefits to potential borrowers. It did not, however, generally result in
59
Speech at Morehead College April 14, 2009.

485
486 Dissenting Statement

or involve the weakening of underwriting standards. Those standards—what made

up the traditional U.S. mortgage—were generally 15 or 30 year amortizing loans to
homebuyers who could provide a downpayment of at least 10-to-20 percent and had
good credit records, jobs and steady incomes. Because of its inherent quality, this
loan was known as a prime mortgage.
There were subprime loans and subprime lenders, but in the early 1990s
subprime lenders were generally niche players that made loans to people who
could not get traditional mortgage loans; the number of loans they generated was
relatively small and bore higher than normal interest rates to compensate for the
risks of default. In addition, mortgage bankers and others relied on FHA insurance
for loans with low downpayments, impaired credit and high debt ratios. Until the
1990s, these NTMs were never more than a fraction of the total number of mortgages
outstanding. The reason that low underwriting standards were not generally used is
simple. Low standards would result in large losses when these mortgages defaulted,
and very few lenders wanted to hold such mortgages. In addition, Fannie and
Freddie were the buyers for most middle class mortgages in the United States, and
they were conservative in their approach. Unless an originator made a traditional
mortgage it was unlikely that Fannie or Freddie or another secondary market buyer
could be found for it.
This is common sense. If you produce an inferior product—whether it’s a
household cleaner, an automobile, or a loan—people soon recognize the lack of
quality and you are out of business. This was not the experience with mortgages,
which became weaker and riskier as the 1990s and 2000s progressed. Why did this
happen?
In its report, the Commission majority seemed to assume that originators of
mortgages controlled the quality of mortgages. Much is made in the majority’s report
of the so-called “originate to distribute” idea, where an originator is not supposed to
care about the quality of the mortgages because they would eventually be sold off.
The originator, it is said, has no “skin in the game.” The motivation for making poor
quality mortgages in this telling is to earn fees, not only on the origination but in
each of the subsequent steps in the securitization process.
This theory turns the mortgage market upside down. Mortgage originators
could make all the low quality mortgages they wanted, but they wouldn’t earn a
dime unless there was a buyer. The real question, then, is why there were buyers
for inferior mortgages and this, as it turns out, is the same as asking why mortgage
underwriting standards, beginning in the early 1990s, deteriorated so badly. As
Professor Raghuram Rajan notes in Fault Lines, “[A]s brokers came to know that
someone out there was willing to buy subprime mortgage-backed securities without
asking too many questions, they rushed to originate loans without checking the
borrowers’ creditworthiness, and credit quality deteriorated. But for a while, the
problems were hidden by growing house prices and low defaults—easy credit
masked the problems caused by easy credit—until house prices stopped rising and
the flood of defaults burst forth.”60
Who were these buyers? Table 1, reporting the number of NTMs outstanding
on June 30, 2008, identified government agencies and private organizations required
by the government to acquire, hold or securitize NTMs as responsible for two-thirds
60
Raghuram G. Rajan, Fault Lines, p.44.
 Peter J. Wallison 487

of these mortgages, about 19 million. The table also identifies the private sector as
the securitizer of the remaining one-third, about 7.8 million loans. In other words,
if we are looking for the buyer of the NTMs that were being created by originators
at the local level, the government’s policies would seem to be the most likely culprit.
The private sector certainly played a role, but it was a subordinate one. Moreover,
what the private sector did was respond to demand—that’s what the private sector
does—but the government’s role involved deliberate policy, an entirely different
matter. Of its own volition, it created a demand that would not otherwise have been
there.
The deterioration in mortgage standards did not occur—contrary to the
Commission majority’s apparent view—because banks and other originators
suddenly started to make deficient loans; nor was it because of insufficient regulation
at the originator level. The record shows unambiguously that government regulations
made FHA, Fannie and Freddie, mortgage banks and insured banks of all kinds into
competing buyers. All of them needed NTMs in order to meet various government
requirements. Fannie and Freddie were subject to increasingly stringent affordable
housing requirements; FHA was tasked with insuring loans to low-income borrowers
that would not be made unless insured; banks and S&Ls were required by CRA to
show that they were also making loans to the same group of borrowers; mortgage
bankers who signed up for the HUD Best Practices Initiative and the Clinton
administration’s National Homeownership Strategy were required to make the same
kind of loans. Profit had nothing to do with the motivations of these firms; they
were responding to government direction. Under these circumstances, it should
be no surprise that underwriting standards declined, as all of these organizations
scrambled to acquire the same low quality mortgages.

1. HUD’s Central Role

In testimony before the House Financial Services Committee on April 14,
2010, Shaun Donovan, Secretary of Housing and Urban Development, said in
reference to the GSEs: “Seeing their market share decline [between 2004 and 2006]
as a result of [a] change of demand, the GSEs made the decision to widen their focus
from safer prime loans and begin chasing the non-prime market, loosening long-
standing underwriting and risk management standards along the way. This would
be a fateful decision that not only proved disastrous for the companies themselves
–but ultimately also for the American taxpayer.”
Earlier, in a “Report to Congress on the Root Causes of the Foreclosure
Crisis,” in January 2010, HUD declared “The serious financial troubles of the GSEs
that led to their being placed into conservatorship by the Federal government
provides strong testament to the fact that the GSEs were, indeed, overexposed to
unduly risky mortgage investments. However, the evidence suggests that the GSEs’
decisions to purchase or guarantee non-prime loans was motivated much more by
efforts to chase market share and profits than by the need to satisfy federal regulators.”
61
[emphasis supplied]
Finger-pointing in Washington is endemic when problems occur, and
61
Report to Congress on the Root Causes of the Foreclosure Crisis , January 2010, p.xii, http://www.
huduser.org/portal/publications/hsgfin/foreclosure_09.html.
488 Dissenting Statement

agencies and individuals are constantly trying to find scapegoats for their own
bad decisions, but HUD’s effort to blame Fannie and Freddie for the decline in
underwriting standards sets a new standard for running from responsibility.
Contrast the 2010 statement quoted above with this statement by HUD in 2000,
when it was significantly increasing Fannie and Freddie’s affordable housing goals:
Lower-income and minority families have made major gains in access to the
mortgage market in the 1990s. A variety of reasons have accounted for these gains,
including improved housing affordability, enhanced enforcement of the Community
Reinvestment Act, more flexible mortgage underwriting, and stepped-up enforcement
of the Fair Housing Act. But most industry observers believe that one factor behind these
gains has been the improved performance of Fannie Mae and Freddie Mac under HUD’s
affordable lending goals. HUD’s recent increases in the goals for 2001-03 will encourage
the GSEs to further step up their support for affordable lending.62 [emphasis supplied]
Or this statement in 2004, when HUD was again increasing the affordable
housing goals for Fannie and Freddie:
Millions of Americans with less than perfect credit or who cannot meet some of
the tougher underwriting requirements of the prime market for reasons such as
inadequate income documentation, limited downpayment or cash reserves, or the
desire to take more cash out in a refinancing than conventional loans allow, rely on
subprime lenders for access to mortgage financing. If the GSEs reach deeper into the
subprime market, more borrowers will benefit from the advantages that greater stability
and standardization create.63[emphasis supplied]
Or, finally, this statement in a 2005 report commissioned by HUD:
More liberal mortgage financing has contributed to the increase in demand for
housing. During the 1990s, lenders have been encouraged by HUD and banking
regulators to increase lending to low-income and minority households. The
Community Reinvestment Act (CRA), Home Mortgage Disclosure Act (HMDA),
government-sponsored enterprises (GSE) housing goals and fair lending laws
have strongly encouraged mortgage brokers and lenders to market to low-income
and minority borrowers. Sometimes these borrowers are higher risk, with blemished
credit histories and high debt or simply little savings for a down payment. Lenders have
responded with low down payment loan products and automated underwriting, which
has allowed them to more carefully determine the risk of the loan.64 [emphasis supplied]
Despite the recent effort by HUD to deny its own role in fostering the
growth of subprime and other high risk mortgage lending, there is strong—indeed
irrefutable—evidence that, beginning in the early 1990s, HUD led an ultimately
successful effort to lower underwriting standards in every area of the mortgage
market where HUD had or could obtain influence. With support in congressional
legislation, the policy was launched in the Clinton administration and extended
almost to the end of the Bush administration. It involved FHA, which was under
the direct control of HUD; Fannie Mae and Freddie Mac, which were subject to
HUD’s affordable housing regulations; and the mortgage banking industry, which—
while not subject to HUD’s legal jurisdiction—apparently agreed to pursue HUD’s

62
Issue Brief: HUD’s Affordable Housing Goals for Fannie Mae and Freddie Mac, p.5.
63
Final Rule, http://fdsys.gpo.gov/fdsys/pkg/FR-2004-11-02/pdf/04-24101.pdf.
64
HUD PDR, May 2005, HUD Contract C-OPC-21895, Task Order CHI-T0007, “Recent House Price
Trends and Homeownership Affordability”, p.85.
 Peter J. Wallison 489

policies out of fear that they would be brought under the Community Reinvestment
Act through legislation.65 In addition, although not subject to HUD’s jurisdiction,
the new tighter CRA regulations that became effective in 1995 led to a process in
which community groups could obtain commitments for substantial amounts of
CRA-qualifying mortgages and other loans to subprime borrowers when banks
were applying for merger approvals.66
By 2004, HUD believed it had achieved the “revolution” it was looking for:
Over the past ten years, there has been a ‘revolution in affordable lending’ that has
extended homeownership opportunities to historically underserved households.
Fannie Mae and Freddie Mac have been a substantial part of this ‘revolution in
affordable lending’. During the mid-to-late 1990s, they added flexibility to their
underwriting guidelines, introduced new low-downpayment products, and worked to
expand the use of automated underwriting in evaluating the creditworthiness of loan
applicants. HMDA data suggest that the industry and GSE initiatives are increasing
the flow of credit to underserved borrowers. Between 1993 and 2003, conventional
loans to low income and minority families increased at much faster rates than loans to
upper-income and nonminority families.67[emphasis supplied]
This turned out to be an immense error of policy. By 2010, even the strongest
supporters of affordable housing as enforced by HUD had recognized their error.
In an interview on Larry Kudlow’s CNBC television program in late August,
Representative Barney Frank (D-Mass.)—the chair of the House Financial Services
Committee and previously the strongest congressional advocate for affordable
housing—conceded that he had erred: “I hope by next year we’ll have abolished
Fannie and Freddie . . . it was a great mistake to push lower-income people into
housing they couldn’t afford and couldn’t really handle once they had it.” He then
added, “I had been too sanguine about Fannie and Freddie.”68

2. The Decline of Mortgage

Underwriting Standards
Before the enactment of the GSE Act in 1992, and HUD’s adoption of a
policy thereafter to reduce underwriting standards, the GSEs followed conservative
underwriting practices. For example, in a random review by Fannie Mae of 25,804
loans from October 1988 to January 1992, over 78 percent had LTV ratios of 80
percent or less, while only 5.75 percent had LTV ratios of 91 to 95 percent.69 High
risk lending was confined primarily to FHA (which was controlled by HUD) and
specialized subprime lenders who often sold the mortgages they originated to FHA.
What caused these conservative standards to decline? The Commission majority,

65
Steve Cocheo, “Fair-lending pressure builds,” ABA Banking Journal, vol. 86, 1994, http://www.questia.
com/googleScholar.qst?docId=5001707340.
66
See NCRC, CRA Commitments, 2007.
67
Federal Register,vol. 69, No. 211, November 2, 2004, Rules and Regulations, p.63585, http://fdsys.gpo.
gov/fdsys/pkg/FR-2004-11-02/pdf/04-24101.pdf .
68
Larry Kudlow, “Barney Frank Comes Home to the Facts,” GOPUSA, August 23, 2010, available at
www.gopusa.com/commentary/2010/08/kudlow-barney-frank-comes-home-to-the-facts.php#ixz
z0zdCrWpCY (accessed September 20, 2010).
69
Document in author’s files.
490 Dissenting Statement

echoing Chairman Bernanke, seems to believe that the impetus was competition
among the banks, irresponsibility among originators, and the desire for profit. The
majority’s report offers no other explanation.
However, there is no difficulty finding the source of the reductions in mortgage
underwriting standards for Fannie and Freddie, or for the originators for whom
they were the buyers. HUD made clear in numerous statements that its policy—in
order to make credit available to low-income borrowers—was specifically intended
to reduce underwriting standards. The GSE Act enabled HUD to put Fannie and
Freddie into competition with FHA, and vice versa, creating what became a contest
to lower mortgage standards. As the Fannie Mae Foundation noted in a 2000 report,
“FHA loans constituted the largest share of Countrywide’s [subprime lending]
activity, until Fannie Mae and Freddie Mac began accepting loans with higher LTVs
[loan-to-value ratios] and greater underwriting flexibilities.”70
Under the GSE Act, the HUD Secretary was authorized to establish affordable
housing goals for Fannie and Freddie. Congress required that these goals include a
low and moderate income goal and a special affordable goal (discussed below), both
of which could be adjusted in the future. Among the factors the secretary was to
consider in establishing the goals were national housing needs and “the ability of
the enterprises [Fannie and Freddie] to lead the industry in making mortgage credit
available for low-and moderate-income families.” The Act also established an interim
affordable housing goal of 30 percent for the two-year period beginning January 1,
1993. Under this requirement, 30 percent of the GSEs’ mortgage purchases had to
be affordable housing loans, defined as loans to borrowers at or below the AMI.71
Further, the Act established a “special affordable” goal to meet the
“unaddressed needs of, and affordable to, low-income families in low-income
areas and very low-income families.” This category was defined as follows: “(i) 45
percent shall be mortgages of low-income families who live in census tracts in which
the median income does not exceed 80 percent of the area median income; and
(ii) 55 percent shall be mortgages of very low income families,” which were later
defined as 60 percent of AMI.72 Although the GSE Act initially required that the
GSEs spend on special affordable mortgages “not less than 1 percent of the dollar
amount of the mortgage purchases by the [GSEs] for the previous year,” HUD raised
this requirement substantially in later years. Ultimately, it became the most difficult
affordable housing AH burden for Fannie and Freddie to meet.
Finally, the GSEs were directed to: “(A) assist primary lenders to make
housing credit available in areas with low-income and minority families; and (B)
assist insured depository institutions to meet their obligations under the Community
Reinvestment Act of 1977.”73 There will be more on the CRA and its effect on the
quality of mortgages later in this section.
Congress also made clear in the act that its intention was to call into question
the high quality underwriting guidelines of the time. It did so by directing Fannie
and Freddie to “examine—
70
Fannie Mae Foundation, “Making New Markets: Case Study of Countrywide Home Loans,” 2000,
http://content.knowledgeplex.org/kp2/programs/pdf/rep_newmortmkts_countrywide.pdf.
71
GSE Act, Section 1332.
72
Id., Section 1333.
73
Id., Section 1335.
 Peter J. Wallison 491

(1) The extent to which the underwriting guidelines prevent or inhibit the purchase
or securitization of mortgages for houses in mixed-use, urban center, and
predominantly minority neighborhoods and for housing for low-and moderate-
income families;
(2) The standards employed by private mortgage insurers and the extent to which
such standards inhibit the purchase and securitization by the enterprises of
mortgages described in paragraph (1); and
(3) The implications of implementing underwriting standards that—
(A) establish a downpayment requirement for mortgagors of 5 percent or less;
(B) allow the use of cash on hand as a source of downpayments; and
(C) approve borrowers who have a credit history of delinquencies if the borrower
can demonstrate a satisfactory credit history for at least the 12-month period
ending on the date of the application for the mortgage.”74
I could not find a record of reports by Fannie and Freddie required under
this section of the act, but it would have been fairly clear to both companies, and to
HUD, what Congress wanted in asking for these studies. Prevailing underwriting
standards were inhibiting mortgage financing for low and moderate income (LMI)
families, and would have to be substantially relaxed in order to meet the goals
of the Act. Whatever the motivation, HUD set out to assure that downpayment
requirements were substantially reduced (eventually they reached zero) and past
credit history became a much less important issue when mortgages were made
(permitting subprime mortgages to become far more common).
Until 1995, HUD enforced the temporary AH goals originally put in place
by the GSE Act. With the exception of the special affordable requirements, which
were small at this point, these goals were not burdensome. In the ordinary course of
their business, the GSEs seem to have bought enough mortgages made to borrowers
below the AMI to qualify for the 30 percent AH goal. In 1995, however, HUD raised
the LMI goal to 40 percent, applicable to 1996, and to 42 percent for subsequent
years. In terms of its effect on Fannie and Freddie, HUD’s most important move at
this time was to set a Special Affordable goal (low and very low income borrowers)
of 12 percent, which increased to 14 percent in 1997. Efforts to find loans to low or
very low income borrowers (80 percent and 60 percent of AMI, respectively) that did
not involve high risks would prove difficult. As early as November 1995, even before
the effect of these new and higher goals, Fannie’s staff had already recognized that
Fannie’s Community Homebuyer Program (CHBP), which featured a 97 percent
loan-to-value (LTV) ratio—i.e., 3 percent downpayment75—was showing significant
rates of serious delinquency that exceeded Fannie’s expected rates by 26percent in
origination year 1992, 93 percent in 1993 and 57 percent in 1994.76
In 1995, continuing its efforts to erode underwriting standards in order to
increase homeownership, HUD issued a policy statement entitled “The National
Homeownership Strategy: Partners in the American Dream.” The Strategy was
prepared by HUD, “under the direction of Secretary Henry G. Cisneros, in response

74
Id., Section 1354(a).
75
Fannie Mae, “Opening Doors with Fannie Mae’s Community Lending Products,” 1995, p.3.
76
Fannie Mae, Memo from Credit Policy Staff to Credit Policy Committee, “CHBP Performance,”
November 14, 1995, p.1.
492 Dissenting Statement

to a request from President Clinton.”77 The first paragraph of Chapter 1 stated: “The
purpose of the National Homeownership Strategy is to achieve an all-time high level
of homeownership in America within the next 6 years through an unprecedented
collaboration of public and private housing industry organizations.”
The Strategy paper then noted that “industry representatives agreed to
the formation of working groups to help develop the National Homeownership
Strategy” and made clear that one of its purposes was to increase homeownership by
reducing downpayments: “Lending institutions, secondary market investors, mortgage
insurers, and other members of the partnership should work collaboratively to reduce
homebuyer downpayment requirements. Mortgage financing with high loan-to-value
ratios should generally be associated with enhanced homebuyer counseling and,
where available, supplemental sources of downpayment assistance.”78 According to a
HUD summary, the purpose of the Strategy was to make financing “more available,
affordable, and flexible.”79 [emphasis supplied] It continued:
The inability (either real or perceived) of many younger families to qualify for a
mortgage is widely recognized as a very serious barrier to homeownership. The
National Homeownership Strategy commits both government and the mortgage
industry to a number of initiatives designed to:
Cut transaction costs through streamlined regulations and technological and
procedural efficiencies.
Reduce downpayment requirements and interest costs by making terms more
flexible, providing subsidies to low- and moderate-income families, and creating
incentives to save for homeownership.
Increase the availability of alternative financing products in housing markets
throughout the country.80 [emphasis supplied]
Reductions in downpayments, the area on which HUD particularly
concentrated in pursuing its AH goals and the National Homeownership Strategy,
are especially important in weakening underwriting standards. Table 4, below,
based on a large sample of loans from the 1990s, shows the risk relationships
between downpayments and mortgage risks. It is particularly instructive to note
that when low downpayments (i.e., high LTVs) are combined with low FICO scores
(subprime loans) the expected delinquencies and defaults are multiplied several
fold. For example, when a loan with a FICO score below 620 is combined with a
downpayment of five percent, the risk of default is 4.2 times greater than it would be
if the downpayment were 25 percent.

77
HUD, “The National Homeownership Strategy: Partners in the American Dream,” available at http://
web.archive.org/web/20010106203500/www.huduser.org/publications/affhsg/homeown/chap1.html.
78
Id., Chapter 4, Action 35.
79
The term “flexible” has a special meaning when HUD uses it. See note 8 supra.
80
HUD, Urban Policy Brief No.2, August 1995, available at http://www.huduser.org/publications/txt/
hdbrf2.txt.
 Peter J. Wallison 493

Table 4.81 High LTVs enhance the risk of low FICO scores

Column 1 Column 2 Column 3 Column 4 Column 5 Column 6

Row 1 FICO Score ≤ 70% LTV 71-80% LTV 81-90% LTV 91-95% LTV Relation of
Column 5 to
Column 3
Row 2 < 620 1.0 4.8 11 20 4.2 times
Row 3 620-679 0.5 2.3 5.3 9.4 4.1 times
Row 4 680-720 0.2 1.0 2.3 4.1 4.1 times
Row 5 > 720 0.1 0.4 0.9 1.6 4 times

Despite these obvious dangers, HUD saw the erosion of downpayment

requirements imposed by the private sector as one of the keys to the success of its
strategy to increase home ownership through the “partnership” it had established
with the mortgage financing community: “The amount of borrower equity is an
important factor in assessing mortgage loan quality. However, many low-income
families do not have access to sufficient funds for a downpayment. While members
of the partnership have already made significant strides in reducing this barrier to
home purchase, more must be done. In 1989 only 7 percent of home mortgages were
made with less than 10 percent downpayment. By August 1994, low downpayment
mortgage loans had increased to 29 percent.”82 [emphasis supplied]
HUD’s policy was highly successful in achieving the goals it sought. In 1989,
only one in 230 homebuyers bought a home with a downpayment of 3 percent or
less, but by 2003 one in seven buyers was providing a downpayment at that level,
and by 2007 the number was less than one in three. The gradual increase in LTVs
and CLTVs (first and second loans combined to produce a lower downpayment)
under HUD’s policies is shown in Figure 4. Note the date (1992) when HUD began
to have some influence over the downpayments that the GSEs would accept.
That HUD’s AH goals were the reason Fannie increased its high LTV (low
downpayment) lending is clearly described in a Fannie presentation to HUD
assistant secretary Albert Trevino on January 10, 2003: “Analyses of the market
demonstrate the greatest barrier to home ownership for most renters are related to
wealth—the lack of money for a downpayment…our low-downpayment lending—
negligible until 1994—has grown considerably. It is a key part of our strategy to serve
low-income and minority borrowers.” The figure that accompanied that statement
showed that Fannie’s home purchase loans over 95 percent LTV had increased from
one percent in 1994 to 7.9 percent in 2001.83

81
“Deconstructing the Subprime Debacle Using New Indices of Underwriting Quality and Economic
Conditions: A First Look,” by Anderson, Capozza, and Van Order, found at http://www.ufanet.com/
DeconstructingSubprimeJuly2008.pdf.
82
HUD’s “National Homeownership Strategy – Partners in the American Dream,” http://web.archive.
org/web/20010106203500/www.huduser.org/publications/affhsg/homeown/chap1.html.
83
”Fannie Mae’s Role in Affordable Housing Finance: Connecting World Capital Markets and America’s
Homebuyers,” Presentation to HUD Assistant Secretary Albert Trevino, January 10, 2003.
494 Dissenting Statement

Figure 4. Estimated Percentage of Home Purchase Volume with an LTV or CLTV >=97%
(Includes FHA and Conventional Loans*)
and Combined Foreclosure Start Rate for Conventional and Government Loans

*Fannie‘s percentage of home purchase loans with an LTV or CLTV >=97% used as the proxy for
conventional loans.
Sources: FHA 2009 Actuarial Study, and HUD”s Office of Policy Development and Research - Profiles
of GSE Mortgage Purchases in 1999 and 2000, in 2001-2004, and in 2005-2007, and Fannie’s 2007 10-K.
Compiled by Edward Pinto.

The close relationship between low downpayments and delinquencies and

defaults on mortgages is shown in Figure 5, which compares the increase in FHA 97
percent (or greater) CLTV or LTV mortgages to the increase in the foreclosure start
rate on all loans published by the Mortgage Bankers Association.
Figure 5. Relationship between low downpayments and delinquencies or defaults on mortgages

Sources: MBA National Delinquency Survey, FHA 2009 Actuarial Study, and HUD’s Office of Policy
Development and Research - Profiles of GSE Mortgage Purchases in 1999 and 2000, in 2001-2004, and
in 2005-2007, SMR’s “Piggyback Mortgage Lending,” and Fannie’s 2007 10-K. Fannie is used as the
proxy on the conventional market. Compiled by Edward Pinto.
 Peter J. Wallison 495

In 1995, HUD also ruled that Fannie and Freddie could get AH credit for
buying PMBS that were backed by loans to low-income borrowers.84 This provided
an opportunity for subprime lenders to create pools of subprime mortgages that were
likely to be AH goals-rich. These were then sold through Wall Street underwriters
to Fannie and Freddie, which became the largest buyers of these high risk PMBS
between 2002 and 2005.85 These PMBS pools were not bought for profit. As Adolfo
Marzol, Fannie’s Chief Credit Officer, noted to Fannie CEO Dan Mudd in a 2005
memorandum, “large 2004 private label [PMBS] volumes were necessary to achieve
challenging minority lending goals and housing goals.”86 There is a strong possibility
that by creating a market for PMBS backed by NTMs Fannie and Freddie enabled
Wall Street—which had previously focused on securitizing prime jumbo loans—to
get its start in developing an underwriting business in PMBS based on NTMs.
HUD pursued these policies throughout the balance of the Clinton
administration and into the administration of George W. Bush. Ultimately, they
would lead to the mortgage meltdown in 2007, as vast numbers of mortgages with
low or no downpayments and other non-traditional features suffused the financial
system. But in June, 1995, the dangers in HUD’s policies were not recognized. As
President Clinton said in a 1995 speech, “Our homeownership strategy will not cost
the taxpayers one extra red cent. It will not require legislation. It will not add more
federal programs or grow the Federal bureaucracy.”87 The lesson here is that the
government can accomplish a lot of its goals without growing, as long as it has the
power to enlist the private sector. That does not mean, however, as we have all now
learned, that the taxpayers will not ultimately be faced with the costs.
The next significant move in the AH goals was made under HUD Secretary
Andrew Cuomo, and it was a major step. On July 29, 1999, HUD issued a press
release with the heading “Cuomo Announces Action to Provide $2.4 trillion in
Mortgages for Affordable Housing for 28.1 Million Families.”88 The release began:
“Housing and Urban Development Secretary Andrew Cuomo today announced a
policy to require the nation’s two largest housing finance companies to buy $2.4
trillion in mortgages over the next 10 years to provide affordable housing for about
28.1 million low-and moderate-income families.” This was followed by a quote from
President Clinton to emphasize the importance of the initiative: “During the last six
and a half years, my Administration has put tremendous emphasis on promoting
homeownership and making housing more affordable for all Americans…Today,
the homeownership rate is at an all-time high, with more than 66 percent of all
American families owning their homes. Today, we take another significant step.”
The release then pointed out that the AH goals would be substantially
raised and that “[u]nder the higher goals, Fannie Mae and Freddie Mac will buy an
additional $488.3 billion in mortgages that will be used to provide affordable housing
for 7 million more low-and moderate-income families over the next 10 years. Those
new mortgages and families are over and above the $1.9 trillion in mortgages for
84
http://www.washingtonpost.com/wp-dyn/content/article/2008/06/09/AR2008060902626.html.
85
See Footnote 32.
86
Fannie Mae, internal memo, Adolfo Marzol to Dan Mudd, “RE: Private Label Securities,” March 2,
2005.
87
William J. Clinton, Remarks on the National Homeownership Strategy, June 5, 1995.
88
HUD Press Release, HUD No. 99-131, July 29, 1999.
496 Dissenting Statement

21.1 million families that would have been generated if the current goals had been
retained.” The release also noted that “Fannie Mae Chairman Franklin D. Raines
joined Cuomo at the news conference in which Cuomo announced the HUD action.
Raines committed Fannie Mae to reaching HUD’s increased Affordable Housing
goals.”
The policy behind this substantial increase in the AH goals was expressed in
HUD’s discussion of the rule-making: “To fulfill the intent of [the GSE Act], the GSEs
should lead the industry in ensuring that access to mortgage credit is made available
for very low-, low- and moderate-income families and residents of underserved
areas. HUD recognizes that, to lead the mortgage industry over time, the GSEs will
have to stretch to reach certain goals and close the gap between the secondary mortgage
market and the primary mortgage market. This approach is consistent with Congress’
recognition that ‘the enterprises will need to stretch their efforts to achieve’ the goals.”89
[emphasis supplied]
The new AH goals announced in 1999 were not finally issued until October
2000. Their specifics were stunning and drove Fannie and Freddie into a new and
far more challenging era. The basic goal, an LMI requirement of 42 percent, was
raised to 50 percent, and the special affordable goal was raised from 14 percent to 20
percent. As a result, 75 percent of the increase in goals was concentrated in the low-
and very-low income category—where the risks were the greatest. A HUD memo
summarized the new rules:90
For each year from 2001 through 2003, the goals are:
• Low- and moderate-income goal. At least 50 percent of the dwelling units financed by
each GSE’s mortgage purchases should be for families with incomes no greater than
area median income (AMI), defined as median income for the metropolitan area or
nonmetropolitan county. The corresponding goal was 42 percent for 1997-2000.
• Special affordable goal. At least 20 percent of the dwelling units financed by each
GSE’s mortgage purchases should be for very low-income families (those with
incomes no greater than 60 percent of AMI) or for low-income families (those with
incomes no greater than 80 percent of LMI) in low-income areas. The corresponding
goal was 14 percent for 1997-2000.
• Underserved areas goal. At least 31 percent of the dwelling units financed by each
GSE’s mortgage purchases should be for units located in underserved areas. Research
by HUD and others has demonstrated that low-income and high-minority census
tracts have high mortgage denial rates and low mortgage origination rates, and this
forms the basis for HUD’s definition of underserved areas. The corresponding goal
was 24 percent for 1997-2000.
HUD’s new and more stringent AH goal requirements immediately
stimulated strong interest at the GSEs for CRA loans, substantial portions of which
were likely to be goals-qualifying. This is evident in a speech by Fannie’s Vice Chair,
Jamie Gorelick, to an American Bankers Association conference on October 30,

89
http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=2000_register&docid=page+65043-
65092.
90
HUD, Office of Policy Development and Research, Issue Brief No. 5, January 2001, p.3.
 Peter J. Wallison 497

2000, just after HUD announced the latest increase in the AH goals for the GSEs:
Your CRA business is very important to us. Since 1997, we have done nearly $7 billion
in specially targeted CRA business—all with depositories like yours. But that is just
the beginning. Before the decade is over, Fannie Mae is committed to finance over
$20 billion in specially targeted CRA business and over $500 billion in CRA business
altogether…
We want your CRA loans because they help us meet our housing goals… We will buy
them from your portfolios, or package them into securities… We will also purchase
CRA mortgages you make right at the point of origination... You can originate CRA
loans for our purchase with one of our CRA-friendly products, like our 3 percent
down Fannie 97. Or we have special community lending products with flexible
underwriting and special financing… Our approach is “CRA your way”.91
The 50 percent level in the new HUD regulations was a turning point. Fannie
and Freddie had to stretch a bit to reach the previous goal of 42 percent, but 50
percent was a significant challenge. As Dan Mudd told the Commission,
Fannie Mae’s mission regulator, HUD, imposed ever-higher housing goals that
were very difficult to meet during my tenure as CEO [2005-2008]. The HUD goals
greatly impacted Fannie Mae’s business, as a great deal of time, resources, energy,
and personnel were dedicated to finding ways to meet these goals. HUD increased
the goals aggressively over time to the point where they exceeded the 50% mark,
requiring Fannie Mae to place greater emphasis on purchasing loans to underserved
areas. Fannie Mae had to devote a great deal of resources to running its business to
satisfy HUD’s goals and subgoals.92
Mudd’s point can be illustrated with simple arithmetic. At the 50 percent level,
for every mortgage acquired that was not goal-qualifying, Fannie and Freddie had
to acquire a goal-qualifying loan. Although about 30 percent of prime loans were
likely to be goal-qualifying in any event (because they were made to borrowers at or
below the applicable AMI), most prime loans were not. Subprime and other NTM
loans were goals-rich, but not every such loan was goal-qualifying. Accordingly, in
order to meet a 50 percent goal, the GSEs had to purchase ever larger amounts of
goals-rich NTMs in order to acquire sufficient quantities of goals-qualifying loans.
Thus, in a presentation to HUD in 2004, Fannie argued that to meet a 57
percent LMI goal (which was under consideration by HUD at the time) it would
have to acquire 151.5 percent more subprime loans than the goal in order to capture
enough goal-qualifying loans.93 Moreover, with the special affordable category at
20 percent in 2004, the GSEs had to acquire large numbers of NTM loans from
borrowers who were at or below 60 percent of the AMI. This requirement drove
Fannie and Freddie even further into risk territory in search of loans that would
meet this subgoal.

91
Jamie S. Gorelick, Remarks at American Bankers Association conference, October 30, 2000. http://
web.archive.org/web/20011120061407/www.fanniemae.com/news/speeches/speech_152.html.
92
Daniel H. Mudd’s Responses to the Questions Presented in the FCIC’s June 3, 2010, letter, Answer
to Question 6: How influential were HUD’s affordable housing guidelines in Fannie Mae’s purchase of
subprime and Alt-A loans? Were Alt-A loans “goals-rich”? Were Alt-A loans net positive for housing
goals?
93
Fannie Mae, “Discussion of HUD’s Proposed Housing Goals,” Presentation to the Department of
Housing and Urban development, June 9, 2004.
498 Dissenting Statement

Most of what was going on here was under the radar, even for specialists in
the housing finance field, but not everyone missed it. In a paper published in 2001,94
financial analyst Josh Rosner recognized the deterioration in mortgage standards
although he did not recognize how many loans were subject to this problem:
Over the past decade Fannie Mae and Freddie Mac have reduced required down
payments on loans that they purchase in the secondary market. Those requirements
have declined from 10% to 5% to 3% and in the past few months Fannie Mae
announced that it would follow Freddie Mac’s recent move into the 0% down payment
mortgage market. Although they are buying low down payment loans, those loans
must be insured with ‘private mortgage insurance’ (PMI). On homes with PMI, even
the closing costs can now be borrowed through unsecured loans, gifts or subsidies.
This means that not only can the buyer put zero dollars down to purchase a new house
but also that the mortgage can finance the closing costs….
[I]t appears a large portion of the housing sector’s growth in the 1990’s came from
the easing of the credit underwriting process….The virtuous cycle of increasing
homeownership due to greater leverage has the potential to become a vicious cycle
of lower home prices due to an accelerating rate of foreclosures.95[emphasis supplied]
The last increase in the AH goals occurred in 2004, when HUD raised the
LMI goal to 52 percent for 2005, 53 percent for 2006, 55 percent for 2007 and 56
percent for 2008. Again, the percentage increases in the special affordable category
outstripped the general LMI goal, putting added pressure on Fannie and Freddie
to acquire additional risky NTMs. This category increased from 20 percent to
27 percent over the period. In the release that accompanied the increases, HUD
declared:
Millions of Americans with less than perfect credit or who cannot meet some of
the tougher underwriting requirements of the prime market for reasons such as
inadequate income documentation, limited downpayment or cash reserves, or the
desire to take more cash out in a refinancing than conventional loans allow, rely
on subprime lenders for access to mortgage financing. If the GSEs reach deeper into
the subprime market, more borrowers will benefit from the advantages that greater
stability and standardization create.96 [emphasis supplied]
Fannie did indeed reach deeper into the subprime market, confirming
in a March 2003 presentation to HUD, “Higher goals force us deeper into FHA
and subprime.”97According to HUD data, as a result of the AH goals Fannie Mae’s
acquisitions of goal-qualifying loans (which were primarily subprime and Alt-A)
increased (i) for very low income borrowers from 5.2 percent of their acquisitions in
1993 to 12.2 percent in 2007; (ii) for special affordable borrowers from 6.4 percent
in 1993 to 15.2 percent in 2007; and (iii) for less than median income borrowers
(which includes the other two categories) from 29.2 percent in 1993 to 41.5 percent
in 2007.98
94
Josh Rosner, “Housing in the New Millennium: A Home Without Equity is Just a Rental With Debt,”
June, 2001, p.7, available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162456.
95
Id., p.29.
96
http://fdsys.gpo.gov/fdsys/pkg/FR-2004-11-02/pdf/04-24101.pdf, p.63601.
97
Fannie Mae, “The HUD Housing Goals”, March 2003.
98
HUD, Office of Policy Development and Research, Profiles of GSE Mortgage Purchases, 1992-2000,
2001-2004, and 2005-2007.
 Peter J. Wallison 499

By 2004, Fannie and Freddie were sufficiently in need of subprime loans

to meet the AH goals that their CEOs, as the following account shows, went to a
meeting of mortgage bankers to ask for more subprime loan production:
The top executives of Freddie Mac and Fannie Mae [Richard Syron and Franklin
Raines] made no bones about their interest in buying loans made to borrowers
formerly considered the province of nonprime and other niche lenders. …Fannie Mae
Chairman and [CEO] Franklin Raines told mortgage bankers in San Francisco that
his company’s lender-customers ‘need to learn the best from the subprime market
and bring the best from the prime market into [the subprime market].’ He offered
praise for nonprime lenders that, he said, ‘are some of the best marketers in financial
services.’… We have to push products and opportunities to people who have lesser credit
quality,” he said.99 [emphasis supplied]
Accordingly, by 2004, when HUD put new and tougher AH goals into effect,
Fannie and Freddie were using every available resource to meet the goals, including
subprime loans, Alt-A loans and the purchase of PMBS. Some observers, including
the Commission’s majority, have claimed that the GSEs bought NTM loans and
PMBS for profit—that these instruments did not assist Fannie and Freddie in
meeting the AH goals and therefore must have been acquired because they were
profitable. However, the statement by Adolfo Marzol reported above, and the data in
Table 5 furnished to the Commission by Fannie Mae shows that all three categories
of NTMs—subprime loans (i.e., loans to borrowers with FICO scores less than 660),
Alt-A loans and PMBS (called PLS for “Private Label Securities” in the table)—
fulfilled the AH goals or subgoals for the years and in the percentages shown below.
(Bolded numbers exceeded the applicable goal.) Table 5 also shows, significantly,
that the gradual increase in Fannie’s purchases of these NTMs closely followed the
gradual increase in the goals between 1996 and 2008.

99
Neil Morse, “Looking for New Customers,” Mortgage Banking, December 1, 2004. It may be significant
that the chairman of Freddie Mac at the time, Leland Brendsel, did not attend the 2000 press conference
or pledge support for HUD’s new goals. Raines must have forgotten his 1999 pledge to Secretary Cuomo
and his speech to the mortgage bankers when he wrote in a letter to The Wall Street Journal on August
3, 2010: “The facts about the financial collapse of Fannie and Freddie are pretty clear and a matter of
public record. The company managers, their regulator and the Treasury have all said that the losses which
crippled the companies were caused by the purchase of loans with lower credit standards between 2005
and 2007. The companies explicitly changed their credit standards in order to regain market share after
Wall Street began to define market credit standards in 2004.”
500 Dissenting Statement

Table 5.100 Nontraditional Mortgages and the Affordable Housing Goals

Year Low & Moderate Special Affordable Underserved

Income Base Goal Base Goal Base Goal
Actual* Goal Actual* Goal Actual* Goal
Credit Score <660 Originations
1996 38.08% 40 % 12.31% 12% 32.10% 21%
1997 38.04% 42% 12.35% 14% 33.03% 24%
1998 37.72% 42% 11.76% 14% 29.37% 24%
1999 40.36% 42% 14.04% 14% 30.87% 24%
2000 43.69% 42% 17.83% 14% 35.79% 24%
2001 45.98% 50% 17.90% 20% 34.91% 31%
2002 49.66% 50% 20.09% 20% 37.29% 31%
2003 49.18% 50% 19.38% 20% 34.12% 31%
2004 52.71% 50% 22.14% 20% 37.54% 31%
2005 54.39% 52% 24.21% 22% 44.38% 37%
2006 56.34% 53% 25.85% 23% 46.34% 38%
2007 55.47% 55% 24.76% 25% 46.45% 38%
2008 55.24% 56% 25.50% 27% 45.39% 39%

Alt-A Originations
1999 48.83% 42% 24.17% 14% 37.41% 24%
2000 40.61% 42% 18.74% 14% 41.03% 24%
2001 39.05% 50% 16.41% 20% 40.66% 31%
2002 42.77% 50% 18.13% 20% 40.08% 31%
2003 42.42% 50% 16.81% 20% 37.34% 31%
2004 44.13% 50% 18.56% 20% 40.08% 31%
2005 43.12% 52% 18.57% 22% 45.36% 37%
2006 40.43% 53% 18.09% 23% 46.40% 38%
2007 39.02% 55% 17.29% 25% 50.29% 38%
2008 42.37% 56% 18.52% 27% 42.10% 39%

PLS Backed by Subprime

2003 51.43% 50% 19.57% 20% 47.09% 31%
2004 ^
2005 50.95% 52% 19.86% 22% 61.13% 37%
2006 60.63% 53% 23.51% 23% 60.12% 38%
2007 52.96% 55% 19.21% 25% 54.55% 38%
2008 51.42% 56% 17.68% 27% 64.45% 39%
*% of unit financed that qualified for base goals.
^ Not included in housing goals scoring in 2004

Table 5 also shows that ordinary subprime loans, Alt-A loans and PMBS
backed by subprime loans were not always sufficient to meet the AH goals. For

100
Fannie Mae, disk produced for FCIC, April 7, 2010. Throughout this analysis, I have not discussed the
GSEs’ compliance with the “Underserved Base Goal,” which is included in this table. The Underserved
Base Goal applied mostly to minorities and involved a different set of lending decisions than the LMI
goal and the Special Affordable Goal.
 Peter J. Wallison 501

this reason, Fannie developed special categories of loans in which the firm waived
some of its regular underwriting requirements in order to supplement what they
were getting from higher quality NTMs. The two principal categories were My
Community Mortgage (MCM) and Expanded Approval (EA). In many cases, these
two categories enabled Fannie to meet the AH goals, but at the cost of much higher
delinquency rates than occurred among higher quality NTMs they acquired. As
the years progressed and the AH goals increased, Fannie had to acquire increasing
numbers of loans in these categories, and as shown in Table 6 these increasing
numbers also exhibited increasing delinquency rates:
Table 6.101 Higher Risk Loans Produced Higher Delinquency Rates at Fannie Mae

Goals by Vintage Loan Count Serious Delinquency Rate

2004 & Prior EA/MCM & Housing Goals 115,686 17.59%
2005 EA/MCM & Housing Goals 56,822 22.35%
2006 EA/MCM & Housing Goals 110,539 25.19%
2007 EA/MCM & Housing Goals 224, 513 29.70%

Just how desperate Fannie and Freddie were to meet their AH goals is revealed
by Fannie’s behavior in 2004. As reported in the American Banker on May 13, 2005,
“A House Financial Services Committee report shared with lawmakers Thursday
accused Fannie Mae and Freddie Mac of engaging over several years in a series
of dubious transactions to meet their affordable-housing goals…The report cited
several large transactions entered into by Fannie under which sellers were allowed
to repurchase loans without recourse. For example, it said that in September 2003,
Fannie bought the option to buy up to $12 billion of multifamily mortgage loans
from Washington Mutual, Inc., for a fee of $2 million, the report said. Under the
agreement, the GSE permitted WaMu to repurchase the loans…’ This was the largest
multifamily transaction ever undertaken by Fannie Mae and was critical for Fannie
Mae to reach the affordable-housing goals, the report said.”102
A clearer statement of what happened here is contained in WaMu’s 10-K for
2003. Freddie had engaged in a similar but larger transaction with WaMu in 2003,
reported as follows in WaMu’s 10-K dated December 31, 2003:
Other noninterest income increased in 2003 compared with 2002 partially due to
fees paid to the Company [WaMu] by the Federal Home Loan Mortgage Corporation
(“FHLMC” or Freddie Mac”). The Company received $100 million in nonrefundable
fees to induce the Company to swap approximately $6 billion of multi-family loans
for 100% of the beneficial interest in those loans in the form of mortgage-backed
securities issued by Freddie Mac. Since the Company has the unilateral right to
collapse the securities after one year, the Company has effectively retained control
over the loans. Accordingly, the assets continue to be accounted for and reported as
loans. This transaction was undertaken by Freddie Mac in order to facilitate fulfilling
its 2003 affordable housing goals as set by the Department of Housing and Urban
Development.
Fannie and Freddie were both paying holders of mortgages to temporarily
transfer to them possession of goal-qualifying loans that the GSEs could use to
satisfy the AH goals for the year 2003. After the end of the year, the seller had an
101
Fannie Mae, “GSE Credit Losses,” presentation to House Financial Services Committee, April 16, 2010.
102
Rob Blackwell, “Two GSEs Cut Corners to Hit Goals, Report Says,” American Banker, May 13, 2005, p.1.
502 Dissenting Statement

absolute right to reacquire these loans. There can be little doubt, then, that as early
as 2003, Fannie and Freddie were under so much pressure to find the subprime or
other loans that they needed to meet their affordable housing obligations that they
were willing to pay substantial sums to window-dress their reports to HUD.

3. The Affordable Housing Goals were the Sole

Reason That the GSEs’ Acquired So Many NTMs
Up to this point, we have seen that HUD’s policy was to reduce underwriting
standards in order to make mortgage credit more readily available to low-income
borrowers, and that Fannie and Freddie not only took the AH goals seriously
but were willing to go to extraordinary lengths to make sure that they met them.
Nevertheless, it seems to have become an accepted idea in some quarters—
including in the Commission majority’s report—that Fannie and Freddie bought
large numbers of subprime and Alt-A loans between 2004 and 2007 in order to
recover the market share they had lost to subprime lenders such as Countrywide
or Wall Street, or to make profits. Although there is no evidence whatever for this
belief—and a great deal of evidence to the contrary—it has become another urban
myth, repeated so often in books, blogs and other media that it has attained a kind
of reality.103
The formulations of the idea vary a bit. As noted earlier, HUD has claimed—
absurdly, in light of its earlier efforts to reduce mortgage underwriting standards—
that the GSEs were “chasing the nonprime market” or “chasing market share and
profits,” principally between 2004 and 2007. The inference, all too easily accepted,
is that this is another example of private greed doing harm, but it is clear that HUD
was simply trying to evade its own culpability for using the AH goals to degrade
the GSEs’ mortgage underwriting standards over the 15 year period between 1992
and 2007. The Commission majority also adopted a version of this idea in its
report, blaming the GSEs’ loosening of their underwriting standards on a desire
to please stock market analysts and investors, as well as to increase management
compensation. None of HUD’s statements about its efforts to reduce underwriting
standards managed to make it into the Commission majority’s report, which relied
entirely on the idea that the GSEs’ underwriting standards were reduced by their
desire to “follow Wall Street and other lenders in [the] rush for fool’s gold.”
These claims place the blame for Fannie and Freddie’s insolvency—and the
huge number of low quality mortgages in the U.S. financial system immediately prior
to the financial crisis—on the firms’ managements. They absolve the government,
particularly HUD, from responsibility. The GSEs’ managements made plenty of
mistakes—and won’t be defended here—but taking risks to compete for market
share was not something they actually did. Because of the AH goals, Fannie and

103
See, e.g., Barry Ritholtz, “Get Me ReWrite!” in Bailout Nation, Bailouts, Credit, Real Estate, Really,
Really Bad Calls, May 13, 2010, http://www.ritholtz.com/blog/2010/05/rewriting-the-causes-of-the-
credit-crisis/print/; Dean Baker, “NPR Tells Us that Republicans Believe that Fannie and Freddie Caused
the Crash” Beat the Press Blog, Center for Economic and Policy Research http://www.cepr.net/index.php/
blogs/beat-the-press/npr-tells-us-that-republicans-believe-that-fannie-and-freddie-caused-the-crash;
Charles Duhigg, “Roots of the Crisis,” Frontline, Feb 17, 2009, http://www.pbs.org/wgbh/pages/frontline/
meltdown/themes/howwegothere.html.
 Peter J. Wallison 503

Freddie were major buyers of NTMs well before Wall Street firms and the subprime
lenders who came to dominate the business entered the subprime PMBS market
in any significant way. Moreover, the GSEs did not (indeed, could not) appreciably
increase their purchases of NTMs during the years 2005 and 2006, when they
had lost market share to the real PMBS issuers, Countrywide and other subprime
lenders.
The following discussion addresses each of the claims about the GSEs’
motives in turn, and in the end will show that the only plausible motive for their
actions was their effort to comply with HUD’s AH goals.

Did the GSEs acquire NTMs to “compete for market share” with
Wall Street or others?
The idea that Fannie and Freddie were newcomers to the purchase of NTMs
between 2004 and 2007, and reduced their underwriting standards so they could
compete for market share with Wall Street or others, is wrong. As shown in Table 7,
the GSEs’ acquisition of subprime loans and other NTMs began in the 1990s, when
they first became subject to the AH goals. Research shows that, in contravention
of their earlier standards, the GSEs began to acquire high loan-to-value (LTV)
mortgages in 1994, shortly after the enactment of the GSE Act and the imposition
of the AH goals, and by 2001—before the PMBS market reached $100 billion in
annual issuances—the GSEs had already acquired at least $700 billion in NTMs,
including over $400 billion in subprime loans.104 Far from following Wall Street or
anyone else into subprime loans between 2004 and 2007, the GSEs had become the
largest buyers of subprime and other NTMs many years before the PMBS market
began to develop. Given these facts, it would be more accurate to say that Wall Street
and the subprime lenders who later came to dominate the PMBS market followed
the GSEs into subprime lending. Table 7 does not show any significant increase in
the GSEs’ acquisition of NTMs from 2004 to 2007, and the amount of subprime
PMBS they acquired during this period actually decreased. This is consistent with
the fact—outlined below—that the GSEs did not make any special effort to compete
for market share during these years.

104
Pinto, “Government Housing Policies in the Lead-up to the Financial Crisis: A Forensic Study,” Chart
52, p.148, http://www.aei.org/docLib/Government-Housing-Policies-Financial-Crisis-Pinto-102110.pdf.
504 Dissenting Statement

Table 7.105 GSE Purchases of Subprime and Alt-A loans

$ in billions 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1997-2007
Subprime $3* $18* $18* $11* $16* $38 $82 $180 $169 $110 $62 $707
PMBS
Subprime $37 $83 $74 $65 $159 $206 $262 $144 $139 $138 $195 $1,502
loans**
Alt-A PMBS Unk. Unk, Unk. Unk. Unk. $18 $12 $30 $36 $43 $15 $154
Alt-A loans*** Unk. Unk, Unk. Unk. Unk. $66 $77 $64 $77 $157 $178 $619
High LTV $32 $44 $62 $61 $84 $87 $159 $123 $126 $120 $226 $1,124
loans****
Total***** $72 $145 $154 $137 $259 $415 $592 $541 $547 $568 $676 $4,106
*Total purchases of PMBS for 1997-2001 are known. Subprime purchases for these years were estimated
based upon the percentage that subprime PMBS constituted of total PMBS purchases in 2002 (57%).
**Loans where borrower’s FICO <660.
*** Fannie and Freddie used their various affordable housing programs and individual lender variance
programs (many times in conjunction with their automated underwriting systems once these came into
general use in the late-1990s) to approve loans with Alt-A characteristics. However, they generally did
not classify these loans as Alt-A. Classification as Alt-A started in the early-1990s. There is an unknown
number of additional loans that had higher debt ratios, reduced reserves, loosened credit requirements,
expanded seller contributions, etc. The volume of these loans is not included.
****Loans with an original LTV or original combined LTV >90% (given industry practices, this
effectively means >=95%). Data to estimate loans with CLTV.>90% is unavailable prior to 2003.
Amounts for 2003-2007 are grossed up by 60% to account for the impact of loans with a CLTV >90%.
These estimates are based on disclosures by Fannie and Freddie that at the end of 2007 their total
exposures to loans with an LTV or CLTV >90% was 50% and 75% percent respectively higher than
their exposure to loans with an LTV >90%. Fannie reports on p. 128 of its 2007 10-K that 15% of its
entire book had an original combined LTV >90%. Its Original LTV percentage >90% (without counting
the impact of any 2nd mortgage simultaneously negotiated) is 9.9%. Freddie reports on p60 of its
Q2:2008 10 Q that 14% of its portfolio had an original combined LTV >90%. Its OLTV percentage
>90% (without counting any simultaneous 2nd) is 8%. While Fannie and Freddie purchased only the
first mortgage, these loans had the same or higher incidence of default as a loan with an LTV of >90%.
*****Since loans may have more than one characteristic, they may appear in more than one category.
Totals are not adjusted to take this into account.

The claim that the GSEs loosened their underwriting standards in order
to compete specifically with “Wall Street” can be easily dismissed—unless the
Commission majority and others who have made this statement are including
Countrywide (which was based in California) or other subprime lenders in the
term “Wall Street.” Assuming, however, that the Commission majority and other
commentators have been using the term Wall Street to apply to the commercial and
investment banks that operate in the financial markets of New York, the data shows
that Wall Street was not a significant participant in the subprime PMBS market
between 2004 and 2007 or at any time before or after those dates. The top five players
in 2004 were subprime lenders Ameriquest ($55 billion) and Countrywide ($40
billion), followed by Lehman Brothers ($27 billion), GMAC RFC ($26 billion), and
New Century ($22 billion). Other than Lehman, some other Wall Street firms were
scattered through the list of the top 25, but were not significant players as a group.
In 2005, the biggest year for subprime issuances, the five leaders were the
same, and the total for all Wall Street institutions was $137 billion, or about 27

105
Id.
 Peter J. Wallison 505

percent of the $508 billion issued that year.106 In 2006, Lehman had dropped out
of the top five and Countrywide had taken over the leadership among the issuers,
but Wall Street’s share had not significantly changed. By the middle of 2007, the
PMBS market had declined to such a degree that the market share numbers were
meaningless. However, in that year the GSEs’ market share in NTMs increased
because they had to continue buying NTMs—even though others had defaulted or
left the business—in order to comply with the AH goals. Accordingly, if Fannie had
ever loosened its lending standards to compete with some group, that group was
not Wall Street.
The next question is whether the GSEs loosened their underwriting standards
to compete with Countrywide, Ameriquest and the other subprime lenders who
were the dominant players in the PMBS market between 2004 and 2007. Again, the
answer seems clearly to be no. The subprime PMBS market was very small until
2002, when for the first time it exceeded $100 billion and reached $134 billion in
subprime PMBS issuances.107 Yet, Table 7 shows that in 2002 alone the GSEs bought
$206 billion in subprime loans, more than the total amount securitized by all the
subprime lenders and others combined in that year.
The discussion of internal documents that follows will focus almost exclusively
on Fannie Mae. The Commission concentrated its investigation on Fannie and it
was from Fannie that the Commission received the most complete set of internal
documents.
By the early 2000s, Countrywide had succeeded in creating an integrated
system of mortgage distribution that included originating, packaging, issuing and
underwriting NTMs through PMBS. Other subprime lenders, as noted above, were
also major issuers, but they sold their PMBS through Wall Street firms that were
functioning as underwriters.
The success of Countrywide and other subprime lenders as distributors of
NTMs through PMBS was troubling to Fannie for two reasons. First, Countrywide
had been Fannie’s largest supplier of subprime mortgages; the fact that it could now
securitize mortgages it formerly sold to Fannie meant that Fannie would have more
difficulty finding subprime mortgages that were AH goals-eligible. In addition, the
GSEs knew that their support in Congress depended heavily on meeting the AH
goals and “leading the market” in lending to low income borrowers. In 2005 and
2006, the Bush administration and a growing number of Republicans in Congress
were calling for tighter regulation of Fannie and Freddie, and the GSEs needed
allies in Congress to hold this off. The fact that subprime lenders were taking an
increasing market share in these years—suggesting that the GSEs were no longer the
most important sources of low income mortgage credit—was thus a matter of great
concern to Fannie’s management. Without strong support among the Democrats in
Congress, there was a significant chance that the Republican Congress would enact
tougher regulatory legislation. This was expressed at Fannie as concern about a loss
of “relevance,” and provoked wide-ranging consideration within the firm about how
they could regain their leadership role in low-income lending.
Nevertheless, although Fannie had strong reasons for wanting to compete for
market share with Countrywide and others, it did not have either the operational
106
Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual—Volume II, pp. 139 and 140.
107
Inside Mortgage Finance, The 2009 Market Statistical Annual—Volume II, p.143.
506 Dissenting Statement

or financial capacity to do so. In the end, Fannie was unable to take any significant
action during the key years 2005 and 2006 that would regain market share from
the subprime lenders or anyone else. They reduced their underwriting standards
to the degree necessary to keep pace with the increasing AH goals, but not to go
significantly beyond those requirements.
In a key memo dated June 27, 2005 (the “Crossroads” memo), Tom Lund,
Executive Vice President for Single Family Business, addressed the question of
Fannie’s loss of market share and how this share position could be regained. The date
of this memo is important. It shows that even in the middle of 2005 there was still
a debate going on within Fannie about whether to compete for market share with
Countrywide and the other subprime issuers. No such competition had actually
begun. Lund starts the discussion in the memo by saying “We are at a strategic
crossroad…[his ellipses] We face two stark choices: 1. Stay the Course [or] 2. Meet
the Market Where the Market Is”. “Staying the course” meant trying to maintain
the mortgage quality standards that Fannie had generally followed up to that
point (except as necessary to meet HUD’s AH goals). “Meeting the market” meant
competing with Countrywide and others not only by acquiring substantially more
NTMs than the AH goals required, but also by acquiring much riskier mortgages
than Fannie—which specialized in fixed rate mortgages—had been buying up to
that time.
These riskier potential acquisitions would have included much larger
numbers of Option ARMs (involving negative amortization) and other loans
involving multiple (or “layered”) risks with which Fannie had no prior experience.
Thus, Lund noted that to compete in this business Fannie lacked “capabilities
and infrastructure…knowledge… willingness to compete on price..[and] a value
proposition for subprime.” His conclusion was as stark as the choice: “Realistically,
we are not in a position to ‘Meet the Market’ today.” “Therefore,” Lund continued,
“we recommend that we: Pursue a ‘Stay the Course’ strategy and test whether market
changes are cyclical vs secular.”108 [emphasis supplied]
In the balance of the Crossroads memo, Lund notes that subprime and Alt-A
loans are driving the “leakage” of “goals rich” products to PMBS issuers. He points
out the severity of the loss of market share, but never suggests that this changes
his view that Fannie was unequipped to compete with Countrywide and others at
that time. According to an internal FCIC staff investigation, dated March 31, 2010,
other senior officials—Robert Levin (Executive Vice President and Chief Business
Officer), Kenneth Bacon (Executive Vice President for Housing and Community
Development), and Pamela Johnson (Senior Vice President for Single Family
Business)—all concurred that Fannie should follow Lund’s recommendation to
“stay the course.”
There is no indication in any of Fannie’s documents after June 2005 that
Lund’s “Stay the Course” recommendation was ever changed or challenged during
2005 or 2006—the period when Fannie and Freddie were supposed to have begun to
acquire large numbers of NTMs (beyond what was required to meet the AH goals)
in order to compete with Countrywide or (in some telling) Wall Street.
Thus, in June 2006, one year after the Lund Crossroads memo, Stephen B.
Ashley, then the chairman of the board, told Fannie’s senior executives: “2006 is a
108
Tom Lund, “Single Family Guarantee Business: Facing Strategic Crossroads” June 27, 2005.
 Peter J. Wallison 507

transition year. To be sure, there are still issues to resolve. The consent order with
OFHEO [among other things, the order raised capital requirements temporarily] is
demanding. And from a strategy standpoint, it is clear that until we have eliminated
operations and control weaknesses, taking on more risk or opening new lines of
business will be viewed dimly by our regulators.”109 [emphasis supplied] So, again,
we have confirmation that Fannie’s top officials did not believe that the firm was in
any position—in the middle of 2006—to take on the additional risk that would be
necessary s to compete with Countrywide and other subprime lenders that were
selling PMBS backed by subprime and other NTMs.
Moreover, there is very strong financially-based evidence that Fannie
either never tried or was never financially able to compete for market share with
Countrywide and other subprime lenders from 2004 to 2007. For example, set out
below are Fannie’s key financial data, published by OFHEO, its former regulator, in
early 2008.110
Table 8. Fannie Mae Financial Highlights

Earnings Performance: 2003 2004 2005 2006 2007

Net Income ($ billions) 8.1 5.0 6.3 4.2 -2.1
Net Interest Income ($ billions) 19.5 18.1 11.5 6.8 4.6
Guarantee Fees ($ billions) 3.4 3.8 4.0 4.3 5.1
Net Interest margin (%) 2.12 1.86 1.31 0.85 0.57
Average Guarantee Fee (bps) 21.9 21.8 22.3 22.2 23.7
Return on Common Equity (%) 27.6 16.6 19.5 11.3 -8.3
Dividend Payout Ratio (%) 20.8 42.1 17.2 32.4 N/M

Table 8 shows that Fannie’s average guarantee fee increased during the
period from 2003 to 2007. To understand the significance of this, it is necessary
to understand the way the mortgage business works. Most of Fannie’s guarantee
business—the business that competed with securitizations of PMBS by Countrywide
and others—was done with wholesale sellers of mortgage pools. In these deals, the
wholesaler or issuer, a Countrywide or a Wells Fargo, would assemble a pool of
mortgages and look for a guaranty mechanism that would offer the best pricing. In
the case of a Fannie MBS, the key issue was the GSEs’ guarantee fee, because that
determined how much of the profit the issuer would be able to retain. In the case of a
PMBS issue, it was the amount and cost of the credit enhancement needed to attain
a AAA rating for a large percentage of the securities backed by the mortgage pool.
The issuer had a choice of securitizing through Fannie, Freddie or one of
the Wall Street underwriters. Thus, if Fannie wanted to compete with the private
issuers for subprime and other loans there was only one way to do it—by reducing
its guarantee fees (called “G-fees” at Fannie and Freddie) and in this way making
itself a more attractive outlet than using a Wall Street underwriter. The fact that
Fannie does not appear to have done so is strong evidence that it never tried to
compete for share with Countrywide and the other subprime issuers after the date
of the Crossroads memo in June 2005.
The OFHEO financial summary also shows that Fannie in reality had very

109
Stephen B. Ashley Fannie Mae Chairman, remarks at senior management meeting, June 27, 2006.
110
OFHEO, “Mortgage Markets and the Enterprises in 2007,” pp. 33-34.
508 Dissenting Statement

little flexibility to compete by lowering its G-fees. Its net income and its return on
equity were all declining quickly during this period, and a cut in its G-fees would
have hastened this decline.
Finally, there are Fannie’s own reports about its acquisitions of subprime
loans. According to Fannie’s 10-K reports for 2004 (which, as restated, covered
periods through 2006) and 2007, Fannie’s acquisition of subprime loans barely
increased from 2004 through 2007. These are the numbers:
Table 9.111 Fannie Mae’s Acquisition of Subprime Loans, 2004-2007

2004 2005 2006 2007

FICO <620 5% 5% 6% 6%
FICO 620-<660 11% 11% 11% 12%

These percentages are consistent with Fannie’s effort to comply with the
gradual increase in the AH goals during the years 2004 through 2007; they are
not consistent with an effort to substantially increase its purchases of subprime
mortgages in order to compete with firms like Countrywide that were growing their
market share through securitizing subprime and other loans.
Finally, Fannie’s 2005 10-K (which, as restated and filed in May 2007,
also covered 2005 and 2006), contains a statement similar to that made in 2006,
confirming that the GSE made no effort to compete for subprime loans (except as
necessary to meet the AH goals), and that in fact it lost market share by declining to
do so in 2004, 2005 and 2006:
[I]n recent years, an increasing proportion of single-family mortgage loan originations
has consisted of non-traditional mortgages such as interest-only mortgages, negative-
amortizing mortgages and sub-prime mortgages, and demand for traditional 30-year
fixed-rate mortgages has decreased. We did not participate in large amounts of these
non-traditional mortgages in 2004, 2005 and 2006 because we determined that the
pricing offered for these mortgages often offered insufficient compensation for the
additional credit risk associated with these mortgages. These trends and our decision
not to participate in large amounts of these non-traditional mortgages contributed to a
significant loss in our share of new single-family mortgages-related securities issuances to
private-label issuers during this period, with our market share decreasing from 45.0% in
2003 to 29.2% in 2004, 23.5% in 2005 and 23.7 in 2006.112 [emphasis supplied]
Accordingly, despite losing market share to Countrywide and others in 2004,
2005 and 2006, Fannie did not attempt to acquire unusual numbers of subprime
loans in order to regain this share. Instead, it continued to acquire only the subprime
and other NTM loans that were necessary to meet the AH goals. That the AH goals
were Fannie’s sole motive for acquiring NTMs is shown by the firm’s actions after
the PMBS market collapsed in 2007. At that point, Fannie’s market share began to
rise as Countrywide and others could not continue to issue PMBS. Nevertheless,
despite the losses on subprime loans that were beginning to show up in the markets,
Fannie continued to buy NTMs until they were taken over by the government in

111
Fannie Mae, 2004 10-K. These totals do not include Fannie’s purchases of subprime PMBS.
http://www.fanniemae.com/ir/pdf/sec/2004/2004_form10K.pdf;jsessionid=N3RRJCZPD5SOVJ2FQSH
SFGI, p.141 and Fannie’s 2007 10-K, http://www.fanniemae.com/ir/pdf/sec/2008/form10k_022708.pdf
;jsessionid=N3RRJCZPD5SOVJ2FQSHSFGI, p.127.
112
Fannie Mae, 2005 10-K, p.37.
 Peter J. Wallison 509

September 2008. The reason for this nearly reckless behavior is obvious—they were
still subject to the AH goals, which were increasing through this period. If they had
only acquired these NTMs to compete with Countrywide and others for market
share the competition was already over; their competitors had abandoned the field.
But the fact is that Fannie did not—or could not—increase its market share between
2004 and 2006 shows without question that market share was not the reason they
had acquired so many NTMs by the time they failed in September 2008.
Beleaguered by accounting problems, suffering diminished profitability, and
lacking the capability to evaluate the risks of the new kinds of mortgages they would
have to buy, Fannie had no option but to stay the course they had been following for
15 years. The NTMs they bought during the period from 2004 to 2007 were acquired
to comply with the AH goals and not to increase their market share—as much as
Fannie might have preferred to do so. Fannie’s market share finally did increase in
2007, when the asset-backed market collapsed, Countrywide weakened, and neither
Countrywide nor anyone else could continue to securitize mortgages. In a report
to the board of directors on October 16, 2007, Mudd reported that Fannie’s market
share, which was 20 percent of the whole market at the beginning of 2007, had risen
to 42 percent.113
That leaves one other possibility—that Fannie and Freddie were buying
NTMs because they were profitable. That issue is addressed in the next section.

Did Fannie acquire NTMs because these loans were profitable?

From time to time, commentators on the GSEs have suggested that the GSEs’
real motive for acquiring NTMs was not that they had to comply with the AH
goals, but that they were seeking the profits these risky loans produced. This could
have been true in the 1990s, but after the major increase in the AH goals in 2000
Fannie began to recognize that complying with the goals was reducing the firm’s
profitability. By 2007, Fannie was asking for relief from the goals.
The following table, drawn from a FHFA publication, shows the applicable
AH goals over the period from 1996 through 2008 and the GSEs’ success in meeting
them.

113
Fannie Mae, Minutes of a Meeting of the Board of Directors, October 16, 2007, p.18.
510 Dissenting Statement

Table 10.114 GSEs’ Success in Meeting Affordable Housing Goals, 1996-2007

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Low & Mod 40% 42% 42% 42% 42% 50% 50% 50% 50% 52% 53% 55% 56%
Housing Goals
Fannie Actual 45% 45% 44% 46% 50% 51% 52% 52% 53% 55% 57% 56% 54%
Freddie Actual 41% 43% 43% 46% 50% 53% 50% 51% 52% 54% 56% 56% 51%
Special 12% 14% 14% 14% 14% 20% 20% 20% 20% 22% 23% 25% 27%
Affordable Goal
Fannie Actual 15% 17% 15% 18% 19% 22% 21% 21% 24% 24% 28% 27% 26%
Freddie Actual 14% 15% 16% 18% 21% 23% 20% 21% 23% 26% 26% 26% 23%
Underserved 21% 24% 24% 24% 24% 31% 31% 31% 31% 37% 38% 38% 39%
Goal
Fannie Actual 25% 29% 27% 27% 31% 33% 33% 32% 32% 41% 43% 43% 39%
Freddie Actual 28% 26% 26% 27% 29% 32% 31% 33% 34% 43% 44% 43% 38%

As the table shows, Fannie and Freddie exceeded the AH goals virtually each
year, but not by significant margins. They simply kept pace with the increases in the
goals as these requirements came into force over the years. This alone suggests that
they did not increase their purchases in order to earn profits. If that was their purpose
they would have substantially exceeded the goals, since their financial advantages
(low financing costs and low capital requirements) allowed them to pay more for
the mortgages they wanted than any of their competitors. As HUD noted in 2000:
“Because the GSEs have a funding advantage over other market participants, they
have the ability to underprice their competitors and increase their market share.”115
As early as 1999, there were clear concerns at Fannie about how the 50
percent LMI goal—which HUD had signaled as its next move—would be met.
In a June 15, 1999, memorandum,116 four Fannie staff members proposed three
categories of rules changes that would enable Fannie to meet the goals more easily:
(i) persuade HUD to change the goals accounting (what goes into the numerator
and denominator); (ii) enter other businesses where the pickings might be goals-
rich, such as manufactured housing and, significantly, Alt-A and subprime (“Efforts
to expand into Alt-A and A-markets (the highest grade of subprime lending) should
also yield incremental business that will have a salutary effect on our low-and
moderate-income score”); and (iii) persuade HUD to adopt different methods of
goals scoring.
By 2000, Fannie was effectively in competition with banks that were required
to make mortgage loans under CRA to roughly the same population of low-income
borrowers targeted in HUD’s AH goals. Rather than selling their CRA loans to
Fannie and Freddie, banks and S&Ls had begun to retain the loans in portfolio. In
a presentation in November 2000, Barry Zigas, a Senior Vice President of Fannie,
noted that “Our own anecdotal evidence suggests that this increase [in banks’ and

114
FHFA Mortgage Market Note 10-2, http://www.fhfa.gov/webfiles/15408/Housing%20Goals%201996-
2009%2002-01.pdf.pdf.
115
http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=2000_register&docid=page+65093
-65142.
116
Bell, Kinney, Kunde and Weech, through Zigas and Marks internal memo Frank Raines, “RE: HUD
Housing Goals Options,” June 15, 1999.
 Peter J. Wallison 511

S&Ls’ holding loans in portfolio] is due in part to below-market CRA products.”117

In other words, banks and S&Ls subject to CRA were making mortgage loans at
below market interest rates, and thus could not sell them without taking losses.
This was troubling for Fannie because it meant that in order to capture these loans
they would have to increase what they were willing to pay for these loans. Doing so
would underprice the risks they would be assuming.
It is important to recognize what was happening. Fannie, and the banks and
S&Ls under CRA, were now competing for the same kinds of NTMs, and were
doing so by lowering their mortgage underwriting standards and adding flexibilities
and subsidies. Simply as a result of supply and demand, all of the participants in
this competition were required to pay higher prices for these increasingly risky
mortgages. The banks and S&Ls that acquired these loans could not sell them,
without taking a loss, when market interest rates were higher than the rates on the
mortgages. This is the first indication in the documents that the FCIC received
from Fannie that competition for subprime loans among the GSEs, banks, S&Ls,
and FHA was causing the underpricing of risk—one of the principal causes of the
mortgage meltdown and thus the financial crisis.
In January 2003, Fannie began planning for how to confront HUD before the
next round of increases in the AH goals, expected to occur in 2004. In an “Action
Plan for the Housing Goals Rewrite,” dated January 22, 2003, Fannie staff reviewed
a number of options, and concluded that “Fannie should strongly oppose: goals
increases and new subgoals.” (Slide 35)118
In March 2003, as Fannie prepared for new increases in the AH goals, its
staff prepared a presentation, perhaps for HUD or for policy defense in public
forums. The apparent purpose was to show that the goals should not be increased
significantly in 2004. Slide 5 stated:
In 2002, Fannie Mae exceeded all our goals for the 9th straight year. But it was probably
the most challenging environment we’ve ever faced. Meeting the goals required heroic
4th quarter efforts on the part of many across the company. Vacations were cancelled.
The midnight oil burned. Moreover, the challenge freaked out the business side of
the house. Especially because the tenseness around meeting the goals meant that we
considered not doing deals—not fulfilling our liquidity function—and did deals at
risks and prices we would not have otherwise done.119 [emphasis supplied]
By September 2004, it was becoming clear that continuing increases in
the AH goals were having a major adverse effect on Fannie’s profitability. In a
memorandum to Brian Graham (another Fannie official), Paul Weech, Director of
Market Research and Policy Development, wrote: “Meeting the goals in difficult
markets imposes significant costs on the Company and potentially causes market-
distorting behaviors. In 1998, 2002, and 2003 especially, the Company has had
to pursue certain transactions as much for housing goals attainment as for the
economics of the transaction.”120
In a June 2005 presentation entitled “Costs and Benefits of Mission
117
Barry Zigas, “Fannie Mae and Minority Lending: Assessment and Action Plan” Presentation,
November 16, 2000.
118
Fannie Mae, “Action Plan for the Housing Goals Rewrite,” January 22, 2003.
119
Fannie Mae, “The HUD Housing Goals,” March 2003.
120
Fannie Mae internal memo, Paul Weech to Brian Graham, “RE: Mission Legislation,” September 3, 2004.
512 Dissenting Statement

Activities,”121 the authors noted in slide 10 that AH goal costs had risen from
$2,632,500 in 2000 to $13,447,500 in 2003. Slide 17 is entitled: “Meeting Future
HUD Goals Appear Quite Daunting and Potentially Costly” and reports, “Based on
2003 experience where goal acquisition costs (relative to Fannie Mae model fees)
cost between $65 per goals unit in the first quarter to $370 per unit in the fourth
quarter, meeting the shortfall could cost the company $6.5-$36.5 million to purchase
sufficient units.” The presentation concludes (slide 20): “Cost of mission activities—
explicit and implicit—over the 2000-2004 period likely averaged approximately
$200 million per year.”
Earlier, I noted the efforts of Fannie and Freddie to window-dress their
records for HUD by temporarily acquiring loans that would comply with the AH
goals, while giving the seller the option to reacquire the loans at a later time. In 2005,
we begin to see efforts by Fannie’s staff to accomplish the same window-dressing in
another way--delaying acquisitions of non-goal-eligible loans so Fannie can meet
the AH goals in that year; we also see the first efforts to calculate systematically
the effect of goal-compliance on Fannie’s profitability. In a presentation dated
September 30, 2005, Barry Zigas, the key Fannie official on affordable housing,
outlined a “business deferral option.” Under that initiative, Fannie would ask seven
major lenders to defer until 2006 sending non-goal loans to Fannie for acquisition.
This would reduce the denominator of the AH goal computation and thus bring
Fannie nearer to goal compliance in the 4th quarter of 2005. The cost of the deferral
alone was estimated at $30-$38 million.122
In a presentation to HUD on October 31, 2005, entitled “Update on Fannie
Mae’s Housing Goals Performance,”123 Fannie noted several “Undesirable Tradeoffs
Necessary to Meet Goals.” These included significant additional credit risk, and
negative returns (“Deal economics are well below target returns; some deals are
producing negative returns” and “G-fees may not cover expected losses”). One of
the most noteworthy points was the following: “Liquidity to Questionable Products:
Buying exotic product encourages continuation of risky lending; many products
present with significant risk-layering; consumers are at risk of payment shock and
loss of equity; potential need to waive our responsible lending policies to get goals
business.”
Much of the narrative about the financial crisis posits that unscrupulous and
unregulated mortgage originators tricked borrowers into taking on bad mortgages.
The idea that predatory lending was a major source of the NTMs in the financial
system in 2008 is a significant element of the Commission majority’s report, although
the Commission was never able to provide any data to support this point. This
Fannie slide suggests that loans later dubbed “predatory” might actually have been
made to comply with the AH goals. This possibility is suggested, too, in a message
sent in 2004 to Freddie’s CEO, Richard Syron, by Freddie’s chief risk manager,
David Andrukonis, when Syron was considering whether to authorize a “Ninja” (no
income/no jobs/no assets) product that he ultimately approved. Andrukonis argued
against authorizing Freddie’s purchase: “The potential for the perception and reality
121
Fannie Mae, “Costs and Benefits of Mission Activities, Project Phineas,” June 14, 2005.
122
Barry Zigas, “Housing Goals and Minority Lending,” September 30, 2005.
123
Fannie Mae, “Update on Fannie Mae’s Housing Goals Performance,” Presentation to the U.S.
Department of Housing and Development, October 31, 2005.
 Peter J. Wallison 513

of predatory lending, with this product is great.”124 But the product was approved
by Freddie, probably for the reason stated by another Freddie employee: “The Alt-A
[(low doc/no doc)] business makes a contribution to our HUD goals.”125
On May 5, 2006, a Fannie staff memo to the Single Family Business Credit
Committee revealed the serious credit and financial problems Fannie was facing
when acquiring subprime mortgages to meet the AH goals. The memo describes
the competitive landscape, in which “product enhancements from Freddie Mac,
FHA, Alt-A and subprime lenders have all contributed to increased competition
for goals rich loans…On the issue of seller contributions [in which the seller of the
home pays cash expenses for the buyer] even FHA has expanded their guidelines
by allowing 6% contributions for LTVs up to 97% that can be used toward closing,
prepaid expenses, discount points and other financing concessions.”126
The memorandum is eye-opening for what it says about the credit risks
Fannie had to take in order to get the goals-rich loans it needed to meet HUD’s
AH requirements for 2006. Table 11 below shows the costs of NTMs in terms of the
guarantee fee (G-fee) “gap.” (In order to determine whether a loan contributed to a
return on equity, Fannie used a G-fee pricing model that took into account credit
risk as well as a number of other factors; a G-fee “gap” was the difference between
the G-fees required by the pricing model for a particular loan to contribute to a
return on equity and a loan that did not.) The table in this memo shows the results
for three subprime products under consideration, a 30 year fixed rate mortgage
(FRM), a 5 year ARM, and 35 and 40 year fixed rate mortgages. For simplicity, this
analysis will discuss only the 30 year fixed rate product. The table shows that the base
product, the 30 year FRM, with a zero downpayment should be priced according to
the model at a G-fee of 106 basis points. However, the memo reports that Fannie is
actually buying loans like that at a price consistent with an annual fee of 37.50 basis
points, producing a gap (or loss from the model) of 68.50 basis points. The reason
the gap is so large is shown in the table: the anticipated default rate on that zero-
down mortgage was 34 percent. The table then goes on to look at other possible loan
alternatives, with the following results:

124
Freddie Mac, internal email, Donna Cogswell on behalf of David Andrukonis to Dick Syron, “RE: No
Income/No Asset (NINA) Mortgages,” September 7, 2004.
125
Freddie Mac, internal email from Mike May to Dick Syron, “FW: FINAL NINA Memo,” October 6, 2004.
126
Fannie Mae, internal memo, Single Family Business Product Management and Development to Single
Family Business Credit Committee, “RE: PMD Proposal for Increasing Housing Goal Loans,” May 5,
2006, p.6.
514 Dissenting Statement

Table 11.127 Fannie Mae Took Losses on Higher Risk Mortgages

Necessary to Meet the Affordable Housing Goals

Individual Enhancements 30 YR FRM

(cost analysis for “base” MCM Model Fee Average Gap
enhancement-not layered) Default %
Base: 100% LTV, 20% MI 106 34 -68.50
Interest First (IF) 129 40 -91.50
Seller Contribution (SC) 115 23 -77.50
Temporary B/D (BD) 118 37 -80.50
Zero Down (ZD) 106 34 -68.50
Manufactured Housing (MH) 227 42 -189.50

From this report, it is clear that in order to meet the AH goals Fannie had to
pay up for goals-rich mortgages, taking a huge credit risk along the way.
The dismal financial results that were developing at Fannie as a result of the
AH goals were also described in Fannie’s 10-K report for 2006, which anticipated
both losses of revenue and higher credit losses as a result of acquiring the mortgages
required by the AH goals:
[W]e have made, and continue to make, significant adjustments to our mortgage
loan sourcing and purchase strategies in an effort to meet HUD’s increased housing
goals and new subgoals. These strategies include entering into some purchase and
securitization transactions with lower expected economic returns than our typical
transactions. We have also relaxed some of our underwriting criteria to obtain goals-
qualifying mortgage loans and increased our investments in higher-risk mortgage
loan products that are more likely to serve the borrowers targeted by HUD’s goals and
subgoals, which could increase our credit losses. [emphasis supplied]128
The underlying reasons for the “lower expected returns” were reported in
February 2007 in a document the FCIC received from Fannie, which noted that
for 2006 the “cash flow cost” of meeting the housing goals was $140 million while
the “opportunity cost” was $470 million.129 In a report to HUD on the AH goals,
dated April 11, 2007, Fannie described these costs as follows: “The largest costs [of
meeting the goals] are opportunity costs of foregone revenue. In 2006, opportunity
cost was about $400 million, whereas the cash flow cost was about $134 million. If
opportunity cost was $0, our shareholders would be indifferent to the deal. The cash
flow cost is the implied out of pocket cost.”130
By this time, “Alignment Meetings”—in which Fannie staff considered how
they would meet the AH goals—were taking place almost monthly (according
to the frequency with which presentations to Alignment meetings occur in the
documentary record). In an Alignment Meeting on June 22, 2007, on a “Housing
Goals Forecast,” three plans were considered for meeting the 2007 AH goals, even
127
Id., p.8.
128
Fannie Mae, 2006 10-K, p.146.
129
Fannie Mae, “Business Update,” presentation. “Cash flow cost” equals expected revenue minus
expected loss. Expected revenue is what will be received in G-fees; expected loss includes G&A and
credit losses. “Opportunity cost” is the G-fee actually charged minus the model fee—the fee that Fannie’s
model would impose to guarantee a mortgage of the same quality in order to earn a fair market return
on capital.
130
Fannie Mae, “Housing Goals Briefing for HUD,” April 11, 2007.
 Peter J. Wallison 515

though half the year was already gone. One of the plans was forecast to result in
opportunity costs of $767.7 million, while the other two plans resulted in opportunity
costs of $817.1 million.131 In a Forecast meeting on July 27, 2007, a “Plan to Meet
Base Goals,” which probably meant the topline LMI goal including all subgoals, was
placed at $1.156 billion for 2007.132
Finally, in a December 21, 2007, letter to Brian Montgomery, Assistant
Secretary of Housing, Fannie CEO Daniel Mudd asked that, in light of the financial
and economic conditions then prevailing in the country—particularly the absence of
a PMBS market and the increasing number of mortgage delinquencies and defaults—
HUD’s AH goals for 2007 be declared “infeasible.” He noted that HUD also has an
obligation to “consider the financial condition of the enterprise when determining
the feasibility of goals.” Then he continued: “Fannie Mae submits that the company
took all reasonable actions to meet the subgoals that were both financially prudent
and likely to contribute to the achievement of the subgoals….In 2006, Fannie Mae
relaxed certain underwriting standards and purchased some higher risk mortgage loan
products in an effort to meet the housing goals. The company continued to purchase
higher risk loans into 2007, and believes these efforts to acquire goals-rich loans are
partially responsible for increasing credit losses.”133 [emphasis supplied]
This statement confirms two facts that are critical on the question of why
Fannie (and Freddie) acquired so many high risk loans in 2006 and earlier years:
first, the companies were trying to meet the AH goals established by HUD and not
because these loans were profitable. It also shows that the efforts of HUD and others—
including the Commission majority in its report—to blame the managements
of Fannie and Freddie for purchasing the loans that ultimately dragged them to
insolvency is misplaced.
Finally, in a July 2009 report, the Federal Housing Finance Agency (FHFA,
the GSEs’ new regulator, replacing OFHEO), noted that Fannie and Freddie both
followed the practice of cross-subsidizing the subprime and Alt-A loans that they
acquired:
Although Fannie Mae and Freddie Mac consider model-derived estimates of cost
in determining the single-family guarantee fees they charge, their pricing often
subsidizes their guarantees on some mortgages using higher returns they expect to
earn on guarantees of other loans. In both 2007 and 2008, cross-subsidization in
single-family guarantee fees charged by the Enterprises was evident across product
types, credit score categories, and LTV ratio categories. In each case, there were cross-
subsidies from mortgages that posed lower credit risk on average to loans that posed
higher credit risk. The greatest estimated subsidies generally went to the highest-risk
mortgages.134
The higher risk mortgages were the ones most needed by Fannie and Freddie
to meet the AH goals. Needless to say, there is no need to cross-subsidize the G-fees
of loans that are acquired because they are profitable.
Accordingly, both market share and profitability must be excluded as reasons
that Fannie (and Freddie) acquired subprime and Alt-A loans between 2004 and
131
Fannie Mae, “Housing Goals Forecast,” Alignment Meeting, June 22, 2007.
132
Fannie Mae, Forecast Meeting, July 27, 2007 slide 4.
133
Fannie Mae letter, Daniel Mudd to Asst. Secretary Brian Montgomery, December 21, 2007, p.6.
134
FHFA, Fannie Mae and Freddie Mac Single Family Guarantee Fees in 2007 and 2008, p.33.
516 Dissenting Statement

2007. The only remaining motive—and the valid one—was the effect of the AH
goals imposed by HUD.
In 2008, after its takeover by the government, Fannie Mae finally published a
credit supplement to its 2008 10-K, which contained an accounting of its subprime
and Alt-A credit exposure. The table is reproduced below in order to provide a
picture of the kinds of loans Fannie acquired in order to meet the AH goals. Loans
may appear in more than one category, so the table does not reveal Fannie’s total
net exposure to each category, nor does it include Fannie’s holdings of non-Fannie
MBS or PMBS, for which it did not have loan level data. Note the reference to
$8.4 billion in the column for subprime loans. As noted earlier, Fannie classified
as subprime only those loans that it purchased from subprime lenders. However,
Fannie included loans with FICO scores of less than 660 in the table, indicating that
they are not prime loans but without classifying them formally as subprime.
In a later credit supplement, filed in August 2009, Fannie eliminated the
duplications among the loans in Table 12, and reported that as of June 30, 2009, it
held the credit risk on NTMs with a total unpaid principal amount of $2.7 trillion.
The average loan amount was $151,000, for a total of 5.73 million NTM loans.135
This number does not include Fannie’s holdings of subprime PMBS as to which it
does not have loan level data.

135
http://www.fanniemae.com/ir/pdf/sec/2009/q2credit_summary.pdf, p.5.
 Table 12. Fannie Mae Credit Profile by Key Product Features: Credit Characteristics of Single-Family Conventional Mortgage Credit Book of Business136

As of Dec 31, 2008 Overall Book Negative- Interest-Only Loans with Loans with Loans with Loans with Alt-A Subprime Jumbo
Amortizing Loans FICO <620 FICO ≥ 620 and Original LTV FICO < 620 and Loans (1) Loans (1) Conforming
Loans < 660 Ratio Original LTV Loans (1)
>90% Ratio > 90%
Unpaid Principal Balance (billions)* $2,730.9 $17.3 $212.9 $ 123.0 $ 256.1 $ 278.3 $ 27.3 $ 292.4 $ 8.4 $ 19.9
Share of Single-Family Conventional Credit Book (1) 100.0% 0.6% 7.8% 4.5% 9.4% 10.2% 1.0% 10.1% 0.3% 0.7%
Average Unpaid Principal Balance $148,824 $142,502 $241,943 $126,604 $141,746 $141,569 $119,607 $170,250 $150,445 $579,528
Serious Delinquency Rate 2.42% 5.61% 8.42% 9.03% 5.64% 6.33% 15.97% 7.03% 14.29% 0.12%
Origination Years 2005-2007 46.5% 62.0% 80.9% 56.3% 55.0% 58.8% 69.8% 72.7% 80.7% 1.4%
Weighted Average Original Loan-to-value Ratio 71.8% 71.1% 75.4% 76.7% 77.5% 97.3% 98.1% 72.6% 77.2% 68.4%
Original Loan-to-Value Ratio >90 10.2% 0.3% 9.1% 22.2% 21.1% 100.0% 100.0% 5.3% 6.8% 0.0%
Weighted Average Mark-to Market Loan-to-Value Ratio 70.0% 87.2% 93.4% 76.3% 77.5% 97.6% 97.7% 81.0% 87.3% 69.9%
Mark-to-Mark Loan-to-Value Ratio >100 11.6% 42.8% 35.6% 15.9% 17.6% 38.2% 38.5% 23.2% 24.5% 0.4%
Weighted Average FICO 724 698 725 588 641 694 592 719 623 762
FICO < 620 4.5% 10.7% 1.3% 100.0% 0.0% 9.8% 100.0% 0.7% 47.6% 0.6%
FICO ≥ 620 and <660 9.4% 10.1% 7.7% 0.0% 100.0% 19.4% 0.0% 8.7% 27.8% 0.2%
Fixed-rate 90.0% 0.1% 39.6% 93.6% 92.3% 94.2% 96.5% 72.3% 73.1% 95.2%
Peter J. Wallison

Principal Residence 89.7% 70.4% 84.9% 96.8% 94.4% 97.1% 99.4% 77.8% 96.6% 98.2%
Condo/Co-op 9.4% 13.5% 16.2% 4.9% 6.6% 9.8% 5.9% 10.8% 4.7% 11.5%
Credit Enhanced (2) 20.9% 76.3% 35.0% 35.0% 36.3% 92.5% 94.1% 38.6% 63.4% 11.3%

% of 2007 Credit Losses (3) 100.0% 0.9% 15.0% 18.8% 21.9% 17.4% 6.4% 29.2% 1.0% 0.0%
% of 2008 Q3 Credit Losses (3) 100.0 % 3.8% 36.2% 11.3% 16.8% 21.5% 5.4% 47.6% 2.1% 0.2%
% of 2008 Q4 Credit Losses (3) 100.0% 2.2% 33.1% 11.5% 17.2% 23.1% 5.2% 43.2% 2.0% 1.1%
% of 2008 Credit Losses (3) 100.0% 2.9% 34.2% 11.8% 17.4% 21.3% 5.4% 45.6% 2.0% 0.4%

(1)
Alt-A, Subprime, and Jumbo Conforming Loans are calculated as a percentage of the single-family mortgage credit book of business, which includes government loans.
Government loans are guaranteed or insured by the U.S. Government or its agencies, such as the Department of Veterans Affairs (VA), the Federal Housing Administration
(FHA) or the Rural Housing and Community Facilities Program and the Department of Agriculture.
(2)
Unpaid principal balance of all loans with credit enhancement as a percentage of unpaid principal balance of single-family conventional mortgage credit book of business.
Includes primary mortgage insurance, pool insurance, lender recourse and other credit enhancement.
(3)
517

Expressed as a percentage of credit losses for the single-family mortgage credit book of business. For information on total credit losses, refer to Fannie Mae’s 2008 Form 10-K.
518 Dissenting Statement

Freddie Mac. As noted earlier, in its limited review of the role of the GSEs
in the financial crisis, the Commission spent most of its time and staff resources
on a review of Fannie Mae, and for that reason this dissent focuses primarily on
documents received from Fannie. However, things were not substantially different
at Freddie Mac. In a document dated June 4, 2009, entitled “Cost of Freddie Mac’s
Affordable Housing Mission,” a report to the Business Risk Committee, of the Board
of Directors,136 several points were made that show the experience of Freddie was no
different than Fannie’s:
• Our housing goals compliance required little direct subsidy prior to 2003, but
since then subsidies have averaged $200 million per year.
• Higher credit risk mortgages disproportionately tend to be goal-qualifying.
Targeted affordable lending generally requires ‘accepting’ substantially higher
credit risk.
• We charge more for targeted (and baseline) affordable single-family loans, but not
enough to fully offset their higher incremental risk.
• Goal-qualifying single-family loans accounted for the disproportionate share of
our 2008 realized losses that was predicted by our models. (slide 2)
• In 2007 Freddie Mac failed two subgoals, but compliance was subsequently
deemed infeasible by the regulator due to economic conditions. In 2008 Freddie
Mac failed six goals and subgoals, five of which were deemed infeasible. No
enforcement action was taken regarding the sixth missed goal because of our
financial condition. (slide 3)
• Goal-qualifying loans tend to be higher risk. Lower household income correlates
with various risk factors such as less wealth, less employment stability, higher
loan-to-value ratios, or lower credit scores. (slide 7)
• Targeted affordable loans have much higher expected default probabilities... Over
one-half of targeted affordable loans have higher expected default probabilities
than the highest 5% of non-goal-qualifying loans. (Slide 8)
The use of the affordable housing goals to force a reduction in the GSEs’
underwriting standards was a major policy error committed by HUD in two
successive administrations, and must be recognized as such if we are ever to
understand what caused the financial crisis. Ultimately, the AH goals extended the
housing bubble, infused it with weak and high risk NTMs, caused the insolvency of
Fannie and Freddie, and—together with other elements of U.S. housing policy—was
the principal cause of the financial crisis itself.
When Congress enacted the Housing and Economic Recovery Act of 2008
(HERA), it transferred the responsibility for administering the affordable housing
goals from HUD to FHFA. In 2010, FHFA modified and simplified the AH goals,
and eliminated one of their most troubling elements. As Fannie had noted, if the AH
goals exceed the number of goals-eligible borrowers in the market, they were being
forced to allocate credit, taking it from the middle class and providing it to low-
income borrowers. In effect, there was a conflict between their mission to advance
affordable housing and their mission to maintain a liquid secondary mortgage
136
Freddie Mac, “Cost of Freddie Mac’s Affordable Housing Mission,” Business Risk Committee, Board
of Directors, June 4, 2009.
 Peter J. Wallison 519

market for most mortgages in the U.S. The new FHFA rule does not require the
GSEs to purchase more qualifying loans than the percentage of the total market that
these loans constitute.137
This does not solve all the major problems with the AH goals. In the sense
that the goals enable the government to direct where a private company extends
credit, they are inherently a form of government credit allocation. More significantly,
the competition among the GSEs, FHA and the banks that are required under the
CRA to find and acquire the same kind of loans will continue to cause the same
underpricing of risk on these loans that eventually brought about the mortgage
meltdown and the financial crisis. This is discussed in the next section and the
section on the CRA.

4. Competition Between the GSEs and FHA

for Subprime and Alt-A Mortgages
One of the important facts about HUD’s management of the AH goals
was that it placed Fannie and Freddie in direct competition with FHA, an agency
within HUD. This was already noted in some of the Fannie documents cited above.
Fannie treated this as a conflict of interest at HUD, but there is a strong case that
this competition is exactly what HUD and Congress wanted. It is important to
recall the context in which the GSE Act was enacted in 1992. In 1990, Congress had
enacted the Federal Credit Reform Act.138 One of its purposes was to capture in the
government’s budget the risks to the government associated with loan guarantees,
and in effect it placed a loose budgetary limit on FHA guarantees. For those in
Congress and at HUD who favored increased mortgage lending to low income
borrowers and underserved communities, this consequence of the FCRA may have
been troubling. What had previously been a free way to extend support to groups
who were not otherwise eligible for conventional mortgages—which generally
required a 20 percent downpayment and the indicia of willingness and ability to
pay—now appeared to be potentially restricted. Requiring the GSEs to take up the
mantle of affordable housing would have looked at the time like a solution, since
Fannie and Freddie had unlimited access to funds in the private markets and were
off-budget entities.
Looked at from this perspective, it would make sense for Congress and HUD
to place the GSEs and FHA in competition, just as it made sense to put Fannie and
Freddie in competition with one another for affordable loans. With all three entities
competing for the same kinds of loans, and with HUD’s control of both FHA’s
lending standards and the GSEs’ affordable housing requirements, underwriting
requirements would inevitably be reduced. HUD’s explicit and frequently expressed
interest in reducing mortgage underwriting standards, as a means of making
mortgage credit available to low income borrowers, provides ample evidence of
HUD’s motives for creating this competition.
137
Federal Housing Finance Agency, 2010-2011 Enterprise Housing Goals; Enterprise Book-Entry
Procedures; Final Rule, 12 CFR Parts 1249 and 1282, Federal Register, September 14, 2010, p.55892.
138
Title V of the Congressional Budget Act of 1990. Under the FCRA, HUD must estimate the annual
cost of FHA’s credit subsidy for budget purposes. The credit subsidy is the net of its estimated receipts
reduced by its estimated payments.
520 Dissenting Statement

Established in 1934, now a part of HUD and administered by the Federal

Housing Administrator (who is also the Assistant Secretary of Housing), FHA
insures 100 percent of an eligible mortgage. It was established to provide financing
to people who could not meet the standards for a bank-originated conventional
loan. The loans it insured had a maximum LTV of 80 percent in 1934. This went to
95 percent in 1950, and 97 percent in 1961.139 With its maximum LTV remaining at
97 percent, FHA maintained average FICO scores for its borrowers just below 660
from 1996 to 2006. During this period, the average FICO score for a conventional
subprime borrower was somewhat lower.140 Beginning in 1993, shortly after Fannie
and Freddie were introduced as competitors, FHA began to increase its percentage
of loans with low downpayments. This had the predictable effect on its delinquency
rates, as shown in the figure below prepared by Edward Pinto with data from FHA,
the FDIC, and the MBA:
Figure 6.

Despite its reductions in required downpayments, FHA’s market share vis-a

vis the GSEs began to decline. According to GAO data, in 1996, FHA’s market
share among lower-income borrowers was 26 percent while the GSEs’ share was
23.8 percent. By 2005, FHA’s share was 9.8 percent, while the GSEs’ share was 31.9
percent. It appears that early on Fannie Mae deliberately targeted FHA borrowers
with its Community Homebuyer Program (CHBP). In a memorandum prepared
in 1993, Fannie’s Credit Policy group compared Fannie’s then-proposed CHBP
program to FHA’s requirements under its 1-to-4 family loan program (Section
203(b)) and showed that most of Fannie’s requirements were competitive or better.

139
Kerry D. Vandell, “FHA Restructuring Proposals: Alternatives and Implications,” Fannie Mae Housing
Policy Debate, vol. 6, Issue 2, 1995, pp. 308-309
140
GAO, “Federal Housing Administration: Decline in Agency’s Market Share Was Associated with
Product and Process Developments of Other Mortgage Market Participants,” GAO-07-645, June 2007,
pp. 42 and 44.
 Peter J. Wallison 521

FHA also appears to have tried to lead the GSEs. In 1999—just before the
AH goals for Fannie and Freddie were to be raised—FHA almost doubled its
originations of loans with LTVs equal to or greater than 97 percent, going from 22.9
percent in 1998 to 43.84 percent in 1999.141 It also offered additional concessions on
underwriting standards in order to attract subprime business. The following is from
a Quicken ad in January 2000 (emphasis in the original),142 which is likely to have
been based on an FHA program as it existed in 1999:
Borrowers can purchase with a minimum down payment. Without FHA insurance,
many families can’t afford the homes they want because down payments are a major
roadblock. FHA down payments range from 1.25% to 3% of the sale price and are
significantly lower than the minimum that many lenders require for conventional or
sub-prime loans.
With FHA loans, borrowers need as little as 3% of the “total funds” required. In
addition to the funds needed for the down payment, borrowers also have to pay
closing costs, prepaid fees for insurance and interest, as well as escrow fees which
include mortgage insurance, hazard insurance, and months worth of property taxes.
A FHA-insured home loan can be structured so borrowers don’t pay more than 3% of
the total out-of-pocket funds, including the down payment.
The combined total of out-of-pocket funds can be a gift or loan from family
members. FHA allows homebuyers to use gifts from family members and non-profit
groups to cover their down payment and additional closing costs and fees. In fact,
even a 100% gift or a personal loan from a relative is acceptable.
FHA’s credit requirements are flexible. Compared to credit requirements established
by many lenders for other types of home loans, FHA focuses only on a borrower’s last
12-24 month credit history. In addition, there is no minimum FICO score - mortgage
bankers look at each application on a case-by-case basis. It is also perfectly acceptable
for people with NO established credit to receive a loan with this program.
FHA permits borrowers to have a higher debt-to-income ratio than most insurers
typically allow. Conventional home loans allow borrowers to have 36% of their gross
income attributed to their new monthly mortgage payment combined with existing
debt. FHA program allows borrowers to carry 41%, and in some circumstances, even
more.
It is important to remember that 1999 is the year that HUD was planning a
big step-up in the AH goals for the GSEs—from 42 percent LMI to 50 percent, with
even larger percentage increases in the special affordable category that would be most
competitive with FHA. The last major increase in the percent of FHA’s loans with
LTVs equal to or greater than 97 percent had occurred in 1991, the year before the
GSE Act imposed the AH goals on Fannie and Freddie, and in effect directed them
to consider downpayments of 5 percent or less. In 1991, FHA’s percentage of loans

141
Integrated Financial Engineering, “Actuarial Review of the Federal Housing Administration Mutual
Mortgage Insurance Fund (Excluding HECMs) for Fiscal Year 2009,” prepared for U.S. Department of
Housing and Urban Development, November 6, 2009, p.42.
142
Quicken press release, “Quicken Loans First To Offer FHA Home Mortgages Nationally On The
Internet With HUD´s approval, Intuit expands home ownership nationwide, offering consumers
widest variety of home loan options”, January 20, 2000, http://web.intuit.com/about_intuit/press_
releases/2000/01-20.html.
522 Dissenting Statement

equal to or greater than 97 percent rose suddenly from 4.4 percent to 17.1 percent.143
Again, FHA, under the control of HUD, appears to be offering competition to the
GSEs that would lead them to reduce their underwriting standards. Since FHA is a
government agency, its actions cannot be explained by a profit motive. Instead, it
seems clear that FHA reduced its lending standards as part of a HUD policy to lead
Fannie and Freddie in the same direction.
The result of Fannie’s competition with FHA in high LTV lending is shown in
the following figure, which compares the respective shares of FHA and Fannie in the
category of loans with LTVs equal to or greater than 97 percent, including Fannie
loans with a combined LTV equal to or greater than 97 percent.
Figure 7.

Whether a conscious policy of HUD or not, competition between the GSEs

and FHA ensued immediately after the GSEs were given their affordable housing
mission in 1992. The fact that FHA, an agency controlled by HUD, substantially
increased the LTVs it would accept in 1991 (just before the GSEs were given their
affordable housing mission) and again in 1999 (just before the GSEs were required
to increase their affordable housing efforts) is further evidence that HUD was
coordinating these policies in the interest of creating competition between FHA
and the GSEs. The effect was to drive down underwriting standards, which HUD
had repeatedly described as its goal.

5. Enlisting Mortgage Bankers and Subprime

Lenders in Affordable Housing
In 1994, HUD began a program to enlist other members of the mortgage
financing community in the effort to reduce underwriting standards. In that year,

143
GAO, “Federal Housing Administration: Decline in Agency’s Market Share Was Associated with
Product and Process Developments of Other Mortgage Market Participants,” GAO-07-645, June 2007,
pp. 42 and 44.
 Peter J. Wallison 523

the Mortgage Bankers Association (MBA)—a group of mortgage financing firms

not otherwise regulated by the federal government and not subject to HUD’s legal
authority—agreed to join a HUD program called the “Best Practices Initiative.”144
The circumstances surrounding this agreement are somewhat obscure, but at least
one contemporary account suggests that the MBA signed up to avoid an effort by
HUD to cover mortgage bankers under the Community Reinvestment Act (CRA),
which up to that point had only applied only to government-insured banks.
In mid-September [1994], the Mortgage Bankers Association of America-
whose membership includes many bank-owned mortgage companies, signed a
three-year master best-practices agreement with HUD. The agreement consisted
of two parts: MBA’s agreement to work on fair-lending issues in consultation
with HUD and a model best-practices agreement that individual mortgage banks
could use to devise their own agreements with HUD. The first such agreement,
signed by Countrywide Funding Corp., the nation’s largest mortgage bank, is
summarized [below]. Many have seen the MBA agreement as a preemptive strike
against congressional murmurings that mortgage banks should be pulled under the
umbrella of the CRA.145
As the first member of the MBA to sign, Countrywide probably realized that
there were political advantages in being seen as assisting low-income mortgage
lending, and it became one of a relatively small group of subprime lenders who
were to prosper enormously as Fannie and Freddie began to look for sources of
the subprime loans that would enable them to meet the AH goals. By 1998, there
were 117 MBA signatories to HUD’s Best Practices Initiative, which was described
as follows:
The companies and associations that sign “Best Practices” Agreements not only
commit to meeting the responsibilities under the Fair Housing Act, but also make
a concerted effort to exceed those requirements. In general, the signatories agree to
administer a review process for loan applications to ensure that all applicants have
every opportunity to qualify for a mortgage. They also assent to making loans of
any size so that all borrowers may be served and to provide information on all loan
programs for which an applicant qualifies…. The results of the initiative are promising.
As lenders discover new, untapped markets, their minority and low-income loans
applications and originations have risen. Consequently, the homeownership rate for
low-income and minority groups has increased throughout the nation.146
Countrywide was by far the most important participant in the HUD
program. Under that program, it made a series of multi-billion dollar commitments,
culminating in a “trillion dollar commitment” to lend to minority and low income
144
HUD’s Best Practices Initiative was described this way by HUD: “Since 1994, HUD has signed Fair
Lending Best Practices (FLBP) Agreements with lenders across the nation that are individually tailored
to public-private partnerships that are considered on the leading edge. The Agreements not only offer
an opportunity to increase low-income and minority lending but they incorporate fair housing and
equal opportunity principles into mortgage lending standards. These banks and mortgage lenders,
as represented by Countrywide Home Loans, Inc., serve as industry leaders in their communities by
demonstrating a commitment to affirmatively further fair lending.” Available at: http://www.hud.gov/
local/hi/working/nlwfal2001.cfm.
145
Steve Cocheo, “Fair-Lending Pressure Builds”, ABA Banking Journal, vol. 86, 1994, http://www.
questia.com/googleScholar.qst?docId=5001707340.
146
HUD, “Building Communities and New Markets for the 21st Century,” FY 1998 Report , p.75, http://
www.huduser.org/publications/polleg/98con/NewMarkets.pdf.
524 Dissenting Statement

families, which in part it fulfilled by selling subprime and other NTMs to Fannie and
Freddie. In a 2000 report, the Fannie Mae Foundation noted: “FHA loans constituted
the largest share of Countrywide’s activity, until Fannie Mae and Freddie Mac began
accepting loans with higher LTVs and greater underwriting flexibilities.”147 In late
2007, a few months before its rescue by Bank of America, Countrywide reported that
it had made $789 billion in mortgage loans toward its trillion dollar commitment.148

6. The Community Reinvestment Act

The most controversial element of the vast increase in NTMs between 1993
and 2008 was the role of the CRA.149 The act, which is applicable only to federally
insured depository institutions, was originally adopted in 1977. Its purpose in part
was to “require each appropriate Federal financial supervisory agency to use its
authority when examining financial institutions to encourage such institutions to
help meet the credit needs of the local communities in which they are chartered
consistent with the safe and sound operations of such institutions.” The enforcement
provisions of the Act authorized the bank regulators to withhold approvals for such
transactions as mergers and acquisitions and branch network expansion if the
applying bank did not have a satisfactory CRA rating.
CRA did not have a substantial effect on subprime lending in the years after
its enactment until the regulations under the act were tightened in 1995. The 1995
regulations required insured banks to acquire or make “flexible and innovative”
mortgages that they would not otherwise have made. In this sense, the CRA and
Fannie and Freddie’s AH goals are cut from the same cloth.
There were two very distinct applications of the CRA. The first, and the one
with the broadest applicability, is a requirement that all insured banks make CRA
loans in their respective assessment areas. When the Act is defended, it is almost
always discussed in terms of this category—loans in bank assessment areas. Banks
(usually privately) complain that they are required by the regulators to make
imprudent loans to comply with CRA. One example is the following statement by a
local community bank in a report to its shareholders:
Under the umbrella of the Community Reinvestment Act (CRA), a tremendous
amount of pressure was put on banks by the regulatory authorities to make loans,
especially mortgage loans, to low income borrowers and neighborhoods.  The
regulators were very heavy handed regarding this issue.  I will not dwell on it here
but they required [redacted name] to change its mortgage lending practices to meet
certain CRA goals, even though we argued the changes were risky and imprudent.150
On the other hand, the regulators defend the act and their actions under it,
and particularly any claim that the CRA had a role in the financial crisis. The most
frequently cited defense is a speech by former Fed Governor Randall Kroszner on

147
Fannie Mae Foundation, “Making New Markets: Case Study of Countrywide Home Loans,” 2000,
http://content.knowledgeplex.org/kp2/programs/pdf/rep_newmortmkts_countrywide.pdf.
148
“Questions and Answers from Countrywide about Lending,” December 11, 2007, available at http://
www.realtown.com/articles/article/print/id/768.
149
12 U.S.C. 2901.
150
Original letter in author’s files.
 Peter J. Wallison 525

December 3, 2008,151 in which he said in pertinent part:

Only 6 percent of all the higher-priced loans [those that were considered CRA loans
because they bore high interest rates associated with their riskier character] were
extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their
assessment areas, the local geographies that are the primary focus for CRA evaluation
purposes. This result undermines the assertion by critics of the potential for a
substantial role for the CRA in the subprime crisis. [emphasis supplied]
There are two points in this statement that require elaboration. First, it
assumes that all CRA loans are high-priced loans. This is incorrect. Many banks, in
order to be sure of obtaining the necessary number of loans to attain a satisfactory
CRA rating, subsidized the loans by making them at lower interest rates than
their risk characteristics would warrant. This is true, in part, because CRA loans
are generally loans to low income individuals; as such, they are more likely than
loans to middle income borrowers to be subprime and Alt-A loans and thus sought
after by FHA, Fannie and Freddie and subprime lenders such as Countrywide; this
competition is another reason why their rates are likely to be lower than their risk
characteristics. Second, while bank lending under CRA in their assessment areas
has probably not had a major effect on the overall presence of subprime loans in the
U.S. financial system, it is not the element about CRA that raises the concerns about
how CRA operated to increase the presence of NTMs in the housing bubble and in
the U.S. financial system generally. There is another route through which CRA’s role
in the financial crisis likely to be considerably more significant.
In 1994, the Riegle-Neal Interstate Banking and Branching Efficiency Act for
the first time allowed banks to merge across state lines under federal law (as distinct
from interstate compacts). Under these circumstances, the enforcement provisions
of the CRA, which required regulators to withhold approvals of applications for
banks that did not have satisfactory CRA ratings, became particularly relevant
for large banks that applied to federal bank regulators for merger approvals. In a
2007 speech, Fed Chairman Ben Bernanke stated that after the enactment of the
Riegle-Neal legislation, “As public scrutiny of bank merger and acquisition activity
escalated, advocacy groups increasingly used the public comment process to protest
bank applications on CRA grounds. In instances of highly contested applications,
the Federal Reserve Board and other agencies held public meetings to allow the
public and the applicants to comment on the lending records of the banks in
question. In response to these new pressures, banks began to devote more resources
to their CRA programs.”152 This modest description, although accurate as far as it
goes, does not fully describe the effect of the law and the application process on
bank lending practices.
In 2007, the umbrella organization for many low-income or community
“advocacy groups,” the National Community Reinvestment Coalition, published a
report entitled “CRA Commitments” which recounted the substantial success of its
members in using the leverage provided by the bank application process to obtain
trillions of dollars in CRA lending commitments from banks that had applied to

151
Randall Kroszner, Speech at the Confronting Concentrated Poverty Forum, December 3, 2008.
152
Ben S. Bernanke, “The Community Reinvestment Act: Its Evolution and New Challenges,” March 30,
2007, p2.
526 Dissenting Statement

federal regulators for merger approvals. The opening section of the report states
(bolded language in the original):153
Since the passage of CRA in 1977, lenders and community organizations have
signed over 446 CRA agreements totaling more than $4.5 trillion in reinvestment
dollars flowing to minority and lower income neighborhoods.
Lenders and community groups will often sign these agreements when a lender has
submitted an application to merge with another institution or expand its services.
Lenders must seek the approval of federal regulators for their plans to merge or
change their services. The four federal financial institution regulatory agencies will
scrutinize the CRA records of lenders and will assess the likely future community
reinvestment performance of lenders. The application process, therefore, provides an
incentive for lenders to sign CRA agreements with community groups that will improve
their CRA performance. Recognizing the important role of collaboration between lenders
and community groups, the federal agencies have established mechanisms in their
application procedures that encourage dialogue and cooperation among the parties in
preserving and strengthening community reinvestment. [emphasis supplied]
A footnote to this statement reports:
The Federal Reserve Board will grant an extension of the public comment period
during its merger application process upon a joint request by a bank and community
group. In its commentary to Regulation Y, the Board indicates that this procedure
was added to facilitate discussions between banks and community groups regarding
programs that help serve the convenience and needs of the community. In its
Corporate Manual, the Office of the Comptroller of the Currency states that it will
not offer the expedited application process to a lender that does not intend to honor a
CRA agreement made by the institution that it is acquiring.

153
See Note 12 supra.
 Peter J. Wallison 527

In its report, the NCRC listed all 446 commitments and includes the
following summary list of year-by-year commitments:
Table 13.

Year Annual Dollars Total Dollars

($ millions) ($ millions)
2007 12, 500 4,566,480
2006 258,000 4,553,980
2005 100,276 4,298,980
2004 1,631,140 4,195,704
2003 711,669 2,564,564
2002 152,859 1,852,895
2001 414,184 1,700,036
2000 13,681 1,285,852
1999 103,036 1,272,171
1998 812,160 1,169,135
1997 221,345 356,975
1996 49,678 135,630
1995 26,590 85,952
1994 6,128 59,362
1993 10,716 53,234
1992 33,708 42,518
1991 2,443 8,811
1990 1,614 6,378
1989 2,260 4,764
1988 1,248 2,504
1987 357 1,256
1986 516 899
1985 73 382
1984 219 309
1983 1 90
1982 6 89
1981 5 83
1980 13 78
1979 15 65
1978 0 50
1977 50 50

The size of these commitments, which far outstrip the CRA loans made in
assessment areas, suggests the potential significance of the CRA as a cause of the
financial crisis. It is noteworthy that the Commission majority was not willing even
to consider the significance of the NCRC’s numbers. In connection with its only
hearing on the housing issue, and before any research had been done on the NCRC
statements, the Commission published a report absolving CRA of any responsibility
for the financial crisis.154
154
FCIC, “The Community Reinvestment Act and the Mortgage Crisis.” Preliminary Staff Report, http://
www.fcic.gov/reports/pdfs/2010-0407-Preliminary_Staff_Report_-_CRA_and_the_Mortgage_Crisis.
pdf.
528 Dissenting Statement

To understand CRA’s role in the financial crisis, the relevant statistic is the $4.5
trillion in bank CRA lending commitments that the NCRC cited in its 2007 report.
(This document and others that are relevant to this discussion were removed from
the NCRC website, www.ncrc.org, after they received publicity but can still be found
on the web155). One important question is whether the bank regulators cooperated
with community groups by withholding approvals of applications for mergers and
acquisitions until an agreement or commitment for CRA lending satisfactory to
the community groups had been arranged. It is not difficult to imagine that the
regulators did not want the severe criticism from Congress that would have followed
their failure to assist community groups in reaching agreements with and getting
commitments from banks that had applied for these approvals. In statements in
connection with mergers it has approved the Fed has said that commitments by
the bank participants about future CRA lending have no influence on the approval
process. A Fed official also told the Commission’s staff that the Fed did not consider
these commitments in connection with merger applications. The Commission did
not attempt to verify this statement, but accepted it at face value from a Fed staff
official. Nevertheless, there remains no explanation for why banks have been making
these enormous commitments in connection with mergers, but not otherwise.
The largest of the commitments, in terms of dollars, were made by four banks
or their predecessors—Bank of America, JPMorgan Chase, Citibank, and Wells
Fargo—in connection with mergers or acquisitions as shown in Table 14 below.

155
http://www.community-wealth.org/_pdfs/articles-publications/cdfis/report-silver-brown.pdf.
 Peter J. Wallison 529

Table 14. Announced CRA Commitments in Connection

with a Merger or Acquisition by Four Largest Banks and Their Predecessors

Final bank Acquired or merged bank/entity CRA commitment (year

with a corresponding announced and dollar amount)
announcement of a CRA commitment
Wells Fargo First Union acquired by Wachovia 2001 ($35 b.)
SouthTrust acquired by 2004 ($75 b.)
Wachovia
JPMorgan Chemical merges with 1991 ($72.5 m.)
Chase Manufacturers Hanover
NBD acquired by First Chicago 1995 ($2 b.)
Home Savings acquired by 1998 ($120 b.)
Washington Mutual
Dime acquired by 2001 ($375 b.)
Washington Mutual
Bank One acquired by JPMorgan Chase 2004 ($800 b.)
Bank of Continental acquired by Bank of America 1994 ($1 b.)
America
Bank of America (acquired by NationsBank, 1998 ($350 b.)
which kept the Bank of America name).
Bank of Boston 1999 ($14.6 b.)
acquired by Fleet
Fleet 2004 ($750 b.)

Citibank Travelers 1998 ($115 b.)

1998 ($115 b.)
Cal Fed 2002 ($120 b.)

Compiled by Edward Pinto from the NCRC 2007 report CRA Commitments, found at http://www.
community-wealth.org/_pdfs/articles-publications/cdfis/report-silver-brown.pdf , NCRC testimony
regarding Bank of America’s $1.5 trillion in CRA agreements and commitments in conjunction with its
2008 acquisition of Countrywide found at http://www.house.gov/apps/list/hearing/financialsvcs_dem/
taylor_testimony_-_4.15.10.pdf.

Given the enormous size of the commitments reported by NCRC, the key
questions are: (i) how many of these commitments were actually fulfilled by the
banks that made them, (ii) where are these loans today, and (iii) how are these loans
performing?
Currently, in light of the severely limited Commission investigation of this
issue, there are only partial answers to these questions.
Were the loans actually made? The banks that made these commitments
apparently came under pressure from community groups to fulfill them. In an
interview by Brad Bondi of the Commission’s staff, Josh Silver of the NCRC noted
that community groups did follow up these commitments.
Bondi: Who follows up…to make sure that these banks honor their voluntary
agreements or their unilateral commitments?
530 Dissenting Statement

Silver: Actually part of some of these CRA agreements was meeting with the bank two
or three times a year and actually going through, ‘Here’s what you’ve promised. Here’s
what you’ve loaned.’ That would happen on a one-on-one basis with the banks and the
community organizations.156
Nevertheless, when the Commission staff asked the four largest banks (Bank
of America, Citibank, JPMorgan Chase and Wells Fargo) for data on whether the
merger-related commitments were fulfilled and in what amount, most of the banks
supplied only limited information. They contended that they did not have the
information or that it was too difficult to get, and the information they supplied was
sketchy at best.
In some cases, the information supplied to the Commission by the banks,
in letters from their counsel, reflected fewer loans than they had claimed in press
releases to have made in fulfillment of their commitments. The press release
amounts were JPMorgan Chase (including WaMu, $835 billion), Citi ($274 billion),
and Bank of America ($229 billion), totaled $1.3 trillion in CRA loans between
2001 and 2008, and had been presented to the Commission by Edward Pinto in the
Triggers memo.157 No Wells Fargo press releases could be found, but in response
to questions from the Commission Wells provided a great deal of data in spread
sheets that could not be interpreted or understood without further discussion with
representatives of the bank. However, the Commission terminated the investigation
of the merger-related CRA commitments in August 2010, before the necessary data
could be gathered. For this reason, the Wells data could not be unpacked, interpreted
in discussion with Wells officials, and analyzed.
After I protested the limited efforts of the Commission on this issue in
October 2010, the Commission made a belated attempt to restart the investigation
of the merger-related CRA commitments in November. However, only one bank
had responded by the deadline for submission of this dissenting statement. As with
the bank responses, additional work was required to understand the information
received, and there was no time, and no Commission staff, to follow up.
As a result of the dilatory nature of the Commission’s investigation, it was
impossible to determine how many loans were actually made under their merger-
related CRA commitments by the four banks and their predecessors. This in
turn impeded any effort to find out where these loans are today and hence their
delinquency rates. It appears that in many instances the Commission management
constrained the staff in their investigation into CRA by limiting the number of
document requests and interviews and by preventing the staff from following up
with the institutions that failed to respond adequately to requests for data.
Where are these mortgages today? Where these loans are today must necessarily
be a matter of speculation. Some of the banks told the FCIC staff that they do not
distinguish between CRA loans and other loans, and so could not provide this
information. Under the GSE Act, Fannie and Freddie had an affirmative obligation
to help banks to meet their CRA obligations, and they undoubtedly served as a
buyer for the loans made by the largest banks and their predecessors pursuant to

156
Interview of Josh Silver of the National Community Reinvestment Coalition, June 16, 2010.
157
Edward Pinto, Exhibit 2 to the Triggers memo, dated April 21, 2010, http://www.aei.org/docLib/
Pinto-Sizing-Total-Federal-Contributions.pdf.
 Peter J. Wallison 531

the commitments. In a press release in 2003, for example, Fannie reported that it
had acquired $394 billion in CRA loans, about $201 billion of which occurred in
2002.158 This amounted to approximately 50 percent of Fannie’s AH acquisitions for
that year.
In the Triggers memo, based on his research, Pinto estimated that Fannie and
Freddie purchased about 50 percent of all CRA loans over the period from 2001
to 2007 and that, of the balance, about 10-15 percent were insured by FHA, 10-15
percent were sold to Wall Street, and the rest remain on the books of the banks that
originated the loans.159 Many of these loans are likely unsaleable in the secondary
market because they were made at rates that did not compensate for risk or lacked
mortgage insurance—again, the competition for these loans among the GSEs, FHA
and the banks operating under CRA requirements inevitably raised their prices and
thus underpriced their risk. To sell these loans, the banks holding them would have
to take losses, which many are unwilling to do.
What are the delinquency rates? Under the Home Mortgage Disclosure Act
HMDA), banks are required to provide data to the Fed from which the delinquency
rates on loans that have high interest rates can be calculated. It was assumed that
these were the loans that might bear watching as potentially predatory. When Fannie
and Freddie, FHA, Countrywide and other subprime lenders and banks under CRA
are all seeking the same loans—roughly speaking, loans to borrowers at or below
the AMI—it is likely that these loans when actually made will bear concessionary
interest rates so that their rate spread is not be reportable under HMDA. It’s just
supply and demand. Accordingly, the banks that made CRA loans pursuant to their
commitments have no obligation to record and report their delinquency rates, and
as noted above several of the large banks that made major commitments recorded
by the NCRC told FCIC staff that they don’t keep records about the performance of
CRA loans apart from other mortgages.
However, in the past few years, Bank of America has been reporting the
performance of CRA loans in its annual report to the SEC on form 10-K. For
example, the bank’s 10-K for 2009 contained the following statement: “At December
31, 2009, our CRA portfolio comprised six percent of the total residential mortgage
balances, but comprised 17 percent of nonperforming residential mortgage loans.
This portfolio also comprised 20 percent of residential net charge-offs during 2009.
While approximately 32 percent of our residential mortgage portfolio carries risk
mitigation protection, only a small portion of our CRA portfolio is covered by
this protection.”160 This could be an approximation for the delinquency rate on the
merger-related CRA loans that the four banks made in fulfilling their commitments,
but without definitive information on the number of loans made and the banks’
current holdings it is impossible to make this estimate with any confidence. In a
letter from its counsel, another bank reported serious delinquency rates on the loans
made pursuant to its merger-related commitments ranging from 5 percent to 50
percent, with the largest sample showing a 25 percent delinquency rate.
158
“Fannie Mae Passes Halfway Point in $2 Trillion American Dream Commitment; Leads Market in
Bringing Housing Boom to Underserved Families, Communities” http://findarticles.com/p/articles/
mi_m0EIN/is_2003_March_18/ai_98885990/pg_3/?tag=content;col1.
159
Triggers memo, p.47.
160
Bank of America, 2009 10-K, p.57.
532 Dissenting Statement

Further investigation of this issue is necessary, including on the role of

the bank regulators, in order to determine what effect, if any, the merger-related
commitments to make CRA loans might have had on the number of NTMs in the
U.S. financial system before the financial crisis.
 IV. CONCLUSION

This dissenting statement argues that the U.S. government’s housing policies
were the major contributor to the financial crisis of 2008. These policies fostered the
development of a massive housing bubble between 1997 and 2007 and the creation
of 27 million subprime and Alt-A loans, many of which were ready to default
as soon as the housing bubble began to deflate. The losses associated with these
weak and high risk loans caused either the real or apparent weakness of the major
financial institutions around the world that held these mortgages—or PMBS backed
by these mortgages—as investments or as sources of liquidity. Deregulation, lack of
regulation, predatory lending or the other factors that were cited in the report of the
FCIC’s majority were not determinative factors.
The policy implications of this conclusion are significant. If the crisis could
have been prevented simply by eliminating or changing the government policies
and programs that were primarily responsible for the financial crisis, then there
was no need for the Dodd-Frank Wall Street Reform and Consumer Protection Act
of 2010, adopted by Congress in July 2010 and often cited as one of the important
achievements of the Obama administration and the 111th Congress.
The stringent regulation that the Dodd-Frank Act imposes on the U.S.
economy will almost certainly have a major adverse effect on economic growth
and job creation in the United States during the balance of this decade. If this was
the price that had to be paid for preventing another financial crisis then perhaps
it’s one that will have to be borne. But if it was not necessary to prevent another
crisis—and it would not have been necessary if the crisis was caused by actions of
the government itself—then the Dodd-Frank Act seriously overreached.
Finally, if the principal cause of the financial crisis was ultimately the
government’s involvement in the housing finance system, housing finance policy in
the future should be adjusted accordingly.

533
534 Dissenting Statement
 APPENDIX 1

Hypothetical Losses in Two Scenarios (No feedback)

Scenario 1 is what was known to market professional during the 2nd
half of 2007; Scenario 2 is the actual condition of the mortgage market. Second
mortgage/home equity loan losses are excluded.
Assumptions used:
Number of mortgages= 53 million;
Total value of first mortgages=$9.155 trillion;
Losses on Prime=1.2%% (assumes 3% foreclosure rate & 40% severity);
Losses on Subprime/Alt-A=12% (assumes 30% foreclosure rate & 40%
severity);
Average size of mortgage: $173,000

Losses in Scenario 1
Number of mortgages: 53 million
Prime=40 million
Subprime/Alt-A = 13 million (7.7. PMBS million + FHA/VA=5.2 million)
Aggregate Value:
Prime =$6.9 trillion ($173,000 X 40 million);
Subprime/Alt-A=$2.25 trillion ($173,000 X 13 million)
Losses on foreclosures: $353 billion ($6.9 trillion prime X 1.2%=$83 billion
+ $2.25 trillion subprime/Alt-A X 12%=$270 billion
Overall loss percentage: 3.5%

Losses in Scenario 2
Number of mortgages: 53 million
Prime: 27 million
Subprime/Alt-A:
Original subprime/Alt-A: 13 million
Other subprime/Alt-A: 13 million (10.5 F&F (excludes 1.25 million already
counted in PMBS) + 2.5 million other loans not securitized (mostly held by the large
banks))
Aggregate Value:
Prime= $4.7 trillion ($173,000 X 27 million);
Subprime/Alt-A = $4.5 trillion ($173,000 X 26 million)
Losses on foreclosures: $596 billion ($4.7 trillion X 1.2%=$56 billion + $4.5
trillion X 12%=$540 billion)
Overall loss percentage: 6.5%, for an increase of 86%

Note: No allowance for feedback effect—that is, fall in home prices as a result
of larger number of foreclosures in Scenario 2. With feedback effect, losses would

535
536 Dissenting Statement

be even larger in Scenario 2 because a larger number of foreclosures would drive

down housing prices further and faster. This feedback effect will likely cause total
first mortgage losses to approach $1 trillion or 10% of outstanding first mortgages.
 APPENDIX 2

Hypothetical Losses in Two Scenarios (with feedback)

Scenario 1 is what was known to market professional during the 2nd

half of 2007; Scenario 2 is the actual condition of the mortgage market. Second
mortgage/home equity loan losses are excluded.
Assumptions used:
Number of mortgages= 53 million;
Total value of first mortgages=$9.155 trillion;

Scenario 1:
Losses on prime=1.2%% (assumes 3% foreclosure rate & 40% severity);
Losses on self-denominated subprime & Alt-A=14% ((assumes 35%
foreclosure rate & 40% severity);
Losses on FHA/VA=5.25% (assumes 15% foreclosure rate and 35% severity)

Scenario 2:
Losses on prime=1.6%% (assumes 3.5% foreclosure rate and 45% severity);
Losses on self-denominated subprime & Alt-A=25% (assumes 45%
foreclosure rate & 55% severity);
Losses on FHA/VA & unknown subprime/Alt-A=15% (assumes 30%
foreclosure rate & 50% severity)
Average size of mortgage:
Prime: $173,000 ($6.75 trillion/39 million)
Subprime/Alt-A/FHA/VA: $182,000 ($2.4 trillion/13 million

Losses in Scenario 1
Number of mortgages: 53 million
Prime=40 million
Subprime/Alt-A=7.7 million PMBS
FHA, and VA=5.2 million
Aggregate Value:
Prime =$6.9 trillion ($173,000 X 39 million);
Subprime/Alt-A=$1.7 trillion ($220,000 X 7.7 million)
FHA/VA= $700 billion ($130,000x5.2 million)
Total expected foreclosures: 4.7 million (3% X 39 million + 35% X 7.7 million
+ 15% X 5.2 million)
Losses on foreclosures: $360 billion ($6.9 trillion prime X 1.2%=$83 billion +
1.7 trillion subprime/Alt-A X 14%=$240 billion + $700 billion X 5.25%=37 billion)
Overall loss percentage: 3.9%

537
538 Dissenting Statement

Losses in Scenario 2
Number of mortgages: 53 million
Prime: 27 million
Original subprime/Alt-A: 7.7 million
FHA/VA: 5.2 million
Other subprime/Alt-A: 13 million (10.5 F&F (excludes 1.25 million already
counted in PMBS), 2.5 million other loans not securitized (mostly held by the large
banks))
Aggregate Value:
Prime= $4.7 trillion ($173,000 X 27 million);
Original Subprime/Alt-A = $1.7 trillion ($220,000 X 7.7 million)
FHA/VA= $700 billion ($130,000x5.2 million)
Other subprime/Alt-A: $2 trillion ($154,000X13 million
Total expected foreclosures: 8.4 million (3.5% X 27 million=0.95 million,
45% X 7.7 million=3.5 million, 30% X 13 million=3.9 million)
Losses on foreclosures: $890 billion ($4.7 trillion X 1.6%=$60 billion + $1.7
trillion X 25%=$425 billion + $700 billion X 15% = $105 billion + $2 trillion X 15%
= $300 billion)
Overall loss percentage: 9.8%, for an increase of 150%
 APPENDIX A: GLOSSARY

Italicized terms within definitions are defined separately.

ABCP see asset-backed commercial paper.

ABS see asset-backed security.
ABX.HE A series of derivatives indices constructed from the prices of  credit default swaps that
each reference individual subprime mortgage–backed securities; akin to an index like the Dow
Jones Industrial Average.
adjustable-rate mortgage A mortgage whose interest rate changes periodically over time.
affordable housing goals Goals originally set by the Department of Housing and Urban Develop-
ment (now by the Federal Housing Finance Agency) for Fannie Mae and Freddie Mac to allo-
cate a specified part of their mortgage business to serve low- and moderate-income borrowers.
ARM see adjustable-rate mortgage.
ARS see auction rate securities.
asset-backed commercial paper Short-term debt secured by assets.
asset-backed security Debt instrument secured by assets such as mortgages, credit card loans or
auto loans.
auction rate securities Long-term bonds whose interest rate may be reset at regular short-term
intervals by an auction process.
bank holding company Company that controls a bank.
broker-dealer A firm, often the subsidiary of an investment bank, that buys and sells securities
for itself and others.
capital Assets minus liabilities; what a firm owns minus what it owes. Regulators often require fi-
nancial firms to hold minimum levels of capital.
Capital Purchase Program TARP program providing financial assistance to -plus U.S. finan-
cial institutions through the purchase of senior preferred shares in the corporations on stan-
dardized terms.
CDO see collateralized debt obligation.
CDO squared CDO that holds other CDOs.
CDS see credit default swap.
CFTC see Commodity Futures Trading Commission.
collateralized debt obligation Type of security often composed of the riskier portions of mort-
gage-backed securities.
commercial paper Short-term unsecured corporate debt.
Commercial Paper Funding Facility Emergency program created by the Federal Reserve in  to
purchase three-month unsecured and asset-backed commercial paper from eligible companies.
Commodity Futures Trading Commission Independent federal agency that regulates trading in
futures and options.

539
540 Appendix A: Glossary

Community Reinvestment Act  federal law encouraging depository institutions to make
loans and provide services in the local communities in which they take deposits.
Consolidated Supervised Entities program A Securities and Exchange Commission program cre-
ated in  and terminated in  that provided voluntary supervision for the five largest in-
vestment bank conglomerates.
Counterparty A party to a contract.
CP see commercial paper.
CPP see Capital Purchase Program.
CRA see Community Reinvestment Act.
credit default swap A type of credit derivative allowing a purchaser of the swap to transfer loan
default risk to a seller of the swap. The seller agrees to pay the purchaser if a default event oc-
curs. The purchaser does not need to own the loan covered by the swap.
credit enhancement Insurance or other protection that may be purchased for a loan or pool of
loans to offset losses in the event of default.
credit loss Loss from delayed payments or defaults on loans.
credit rating agency Private company that evaluates the credit quality of securities and provides
ratings on those securities; the largest are Fitch Ratings, Moody’s Investors Service, and Stan-
dard & Poor’s.
credit risk Risk to a lender that a borrower will fail to repay the loan.
CSE Consolidated Supervised Entity (see Consolidated Supervised Entities program).
debt-to-income ratio One measure of a borrower’s ability to repay a loan, generally calculated by
dividing the borrower’s monthly debt payments by gross monthly income.
delinquency rate The number of loans for which borrowers fail to make timely loan payments di-
vided by total loans.
Department of Housing and Urban Development Cabinet-level federal department responsible
for housing policies and programs.
Department of Justice Cabinet-level federal department responsible for enforcement of laws and
administration of justice, led by the attorney general.
Department of Treasury Treasury of the federal government; prints and mints all currency and
coins, collects federal taxes, manages U.S. government debt instruments, supervises national
banks and thrifts, and advises on domestic and international fiscal policy. Its mission includes
protecting the integrity of the financial system.
depository institution Financial institution, such as a commercial bank, thrift (savings and loan),
or credit union, that accepts deposits, including deposits insured by the FDIC.
derivative Financial contract whose price is determined (derived) from the value of an underlying
asset, rate, index, or event.
Fannie Mae Nickname for the Federal National Mortgage Association (FNMA), a government-
sponsored enterprise providing financing for the home mortgage market.
FCIC Financial Crisis Inquiry Commission.
FDIC see Federal Deposit Insurance Corporation.
Federal Deposit Insurance Corporation Independent federal agency charged primarily with in-
suring deposits at financial institutions, examining and supervising some of those institutions,
and shutting down failing institutions.
Federal Housing Administration Part of the Department of Housing and Urban Development that
provides insurance on mortgage loans made by FHA-approved lenders.
Federal Housing Finance Agency Independent federal regulator of government-sponsored enter-
prises; created by the Housing and Economic Recovery Act of  as successor to the Office of
Federal Housing Enterprise Oversight and the Federal Housing Finance Board.
Federal Open Market Committee Its members are the Board of Governors of the Federal Reserve
 Appendix A: Glossary 541

System and certain of the presidents of the Federal Reserve Banks; oversees market conditions
and implements monetary policy through such means as setting interest rates.
Federal Reserve Bank of New York One of  regional Federal Reserve Banks, with responsibility
for regulating bank holding companies in New York State and nearby areas.
Federal Reserve U.S. central banking system created in  in response to financial panics, con-
sisting of the Federal Reserve Board in Washington, DC, and  Federal Reserve Banks around
the country; its mission is to implement monetary policy through such means as setting inter-
est rates, supervising and regulating banking institutions, maintaining the stability of the fi-
nancial system, and providing financial services to depository institutions.
FHA see Federal Housing Administration.
FHFA see Federal Housing Finance Agency.
FICO score A measure of a borrower’s creditworthiness based on the borrower’s credit data; de-
veloped by the Fair Isaac Corporation.
Financial Crimes Enforcement Network Treasury office that collects and analyzes information
about financial transactions to combat money laundering, terroristfinancing, and other finan-
cial crimes.
FinCEN see Financial Crimes Enforcement Network.
FOMC see Federal Open Market Committee.
foreclosure Legal process whereby a mortgage lender gains ownership of the real property secur-
ing a defaulted mortgage.
Freddie Mac Nickname for the Federal Home Loan Mortgage Corporation (FHLMC), a govern-
ment-sponsored enterprise providing financing for the home mortgage market.
Ginnie Mae Nickname for the Government National Mortgage Association (GNMA), a govern-
ment-sponsored enterprise; guarantees pools of VA and FHA mortgages.
Glass-Steagall Act Banking Act of  creating the FDIC to insure bank deposits; prohibited
commercial banks from underwriting or dealing in most types of securities, barred banks
from affiliating with securities firms, and introduced other banking reforms.  In , the
Gramm-Leach-Bliley Act repealed the provisions of the Glass-Steagall Act that prohibited affil-
iations between banks and securities firms.
government-sponsored enterprise A private corporation, such as Fannie Mae and Freddie Mac,
created by the federal government to pursue certain public policy goals designated in its
charter.
Gramm-Leach-Bliley Act  legislation that lifted certain remaining restrictions established by
the Glass-Steagall Act.
GSE see government-sponsored enterprise.
haircut The difference between the value of an asset and the amount borrowed against it.
hedge In finance, a way to reduce exposure or risk by taking on a new financial contract.
hedge fund A privately offered investment vehicle exempted from most regulation and oversight;
generally open only to high-net-worth investors.
HOEPA see Home Ownership and Equity Protection Act.
Home Ownership and Equity Protection Act  federal law that gave the Federal Reserve new
responsibility to address abusive and predatory mortgage lending practices.
Housing and Economic Recovery Act  law including measures to reform and regulate the
GSEs; created the Federal Housing Finance Agency.
HUD see Department of Housing and Urban Development.
hybrid CDO A CDO backed by collateral found in both cash CDOs and synthetic CDOs.
illiquid assets Assets that cannot be easily or quickly sold.
interest-only loan Loan that allows borrowers to pay interest without repaying principal until the
end of the loan term.
542 Appendix A: Glossary

leverage A measure of how much debt is used to purchase assets; for example, a leverage ratio of
: means that  of assets were purchased with  of debt and  of capital.
LIBOR London Interbank Offered Rate, an interest rate at which banks are willing to lend to each
other in the London interbank market.
liquidity Holding cash and/or assets that can be quickly and easily converted to cash.
liquidity put A contract allowing one party to compel the other to buy an asset under certain cir-
cumstances. It ensures that there will be a buyer for otherwise illiquid assets.
loan-to-value ratio Ratio of the amount of a mortgage to the value of the house, typically ex-
pressed as a percentage. “Combined” loan-to-value includes all debt secured by the house, in-
cluding second mortgages.
LTV ratio see loan-to-value ratio.
mark-to-market The process by which the reported amount of an asset is adjusted to reflect the
market value.
monoline Insurance company, such as AMBAC and MBIA, whose single line of business is to
guarantee financial products.
mortgage servicer Company that acts as an agent for mortgage holders, collecting and distribut-
ing payments from borrowers and handling defaults, modifications, settlements, and foreclo-
sure proceedings.
mortgage underwriting Process of evaluating the credit characteristics of a mortgage and bor-
rower.
mortgage-backed security Debt instrument secured by a pool of mortgages, whether residential
or commercial.
NAV see net asset value.
negative amortization loan Loan that allows a borrower to make monthly payments that do not
fully cover the interest payment, with the unpaid interest added to the principal of the loan.
net asset value Value of an asset minus any associated costs; for financial assets, typically changes
each trading day.
net charge-off rate Ratio of loan losses to total loans.
non-agency mortgage-backed securities Mortgage-backed securities sponsored by private compa-
nies other than a government-sponsored enterprise (such as Fannie Mae or Freddie Mac); also
known as private-label mortgage-backed securities.
notional amount A measure of the outstanding amount of over-the-counter derivatives contracts,
based on the amount of the underlying referenced assets.
novation A process by which counterparties may transfer derivatives positions.
OCC see Office of the Comptroller of the Currency.
Office of Federal Housing Enterprise Oversight Created in  to oversee financial soundness
of Fannie Mae and Freddie Mac; its responsibilities were assumed in  by its successor, the
Federal Housing Finance Agency.
Office of the Comptroller of the Currency Independent bureau within Department of Treasury
that charters, regulates, and supervises all national banks and certain branches and agencies of
foreign banks in the United States.
Office of Thrift Supervision Independent bureau within Treasury that regulates all federally
chartered and many state-chartered savings and loans/thrift institutions and their holding
companies.
OFHEO see Office of Federal Housing Enterprise Oversight.
originate-to-distribute When lenders make loans with the intention of selling them to other fi-
nancial institutions or investors, as opposed to holding the loans through maturity.
originate-to-hold When lenders make loans with the intention of holding them through maturity,
as opposed to selling them to other financial institutions or investors.
 Appendix A: Glossary 543

origination Process of making a loan, including underwriting, closing, and providing the funds.
OTS see Office of Thrift Supervision.
par Face value of a bond.
payment-option adjustable-rate mortgage (also called payment ARM or option ARM) Mort-
gages that allow borrowers to pick the amount of payment each month, possibly low enough to
increase the principal balance.
PDCF see Primary Dealer Credit Facility.
PLS see private-label mortgage-backed securities.
pooling Combining and packaging a group of loans to be held by a single entity.
Primary Dealer Credit Facility Program established by the Federal Reserve in March  that al-
lowed eligible companies to borrow cash overnight to finance their securities.
principal Amount borrowed.
private mortgage insurance Insurance on the payment of a mortgage provided by a private firm
at additional cost to the borrower to protect the lender.
private-label mortgage-backed securities see non-agency mortgage-backed securities.
repurchase agreement (repo) A method of secured lending where the borrower sells securities to
the lender as collateral and agrees to repurchase them at a higher price within a short period,
often within one day.
SEC see Securities and Exchange Commission.
section () Section of the Federal Reserve Act under which the Federal Reserve may make se-
cured loans to nondepository institutions, such as investment banks, under “unusual and exi-
gent” circumstances.
Securities and Exchange Commission Independent federal agency responsible for protecting in-
vestors by enforcing federal securities laws, including regulating stock and security options ex-
changes and other electronic securities markets, the issuance and sale of securities,
broker-dealers, other securities professionals, and investment companies.
securitization Process of pooling debt assets such as mortgages, car loans, and credit card debt
into a separate legal entity that then issues a new financial instrument or security for sale to in-
vestors.
shadow banking Financial institutions and activities that in some respects parallel banking activi-
ties but are subject to less regulation than commercial banks. Institutions include mutual
funds, investment banks, and hedge funds.
short sale The sale of a home for less than the amount owed on the mortgage.
short selling To sell a borrowed security in the expectation of a decline in value.
SIV see structured investment vehicle.
special purpose vehicle Entity created to fulfill a narrow or temporary objective; typically holds a
portfolio of assets such as mortgage-backed securities or other debt obligations; often used be-
cause of regulatory and bankruptcy advantages.
SPV see special purpose vehicle.
structured investment vehicle Leveraged special purpose vehicle, funded through medium-term
notes and asset-backed commercial paper, that invested in highly rated securities.
synthetic CDO A CDO that holds credit default swaps that reference assets (rather than holding
cash assets), allowing investors to make bets for or against those referenced assets.
systemic risk In financial terms, that which poses a threat to the financial system.
systemic risk exception Clause in the Federal Deposit Insurance Corporation Improvement Act
(FDICIA) under which the FDIC may commit its funds to rescue a financial institution.
TAF see Term Auction Facility.
TALF see Term Asset-Backed Securities Loan Facility.
TARP see Troubled Asset Relief Program.
544 Appendix A: Glossary

Term Asset-Backed Securities Loan Facility Federal Reserve program, supported by TARP funds,
to aid securitization of asset-based loans such as auto loans, student loans, and small business
loans.
Term Auction Facility Program in which the Federal Reserve made funds available to all deposi-
tory institutions at once through a regular auction.
Term Securities Lending Facility Emergency program in which the Federal Reserve made up to
 billion in Treasury securities available to banks or broker/dealers that traded directly
with the Federal Reserve.
tranche From the French, meaning a slice; used to refer to the different types of mortgage-backed
securities and CDO bonds that provide specified priorities and amounts of returns: “senior”
tranches have the highest priority of returns and therefore the lowest risk/interest rate; mezza-
nine tranches have mid levels of risk/return; and “equity” (also known as “residual” or “first
loss”) tranches typically receive any remaining cash flows.
Troubled Asset Relief Program Government program to address the financial crisis, signed into
law in October  to purchase or insure up to  billion in assets and equity from finan-
cial and other institutions.
TSLF see Term Securities Lending Facility.
undercapitalized Condition in which a business does not have enough capital to meet its needs,
or to meet its capital requirements if it is a regulated entity.
Write-downs Reducing the value of an asset as it is carried on a firm’s balance sheet because the
market value has fallen.
 APPENDIX B:
LIST OF HEARINGS AND WITNESSES

Public Meeting of the FCIC, Washington, DC, September , 

Statements by commissioners

Roundtable Discussion, Washington, DC, October , 

Martin Baily, Senior Fellow in Economic Studies, Brookings Institution
Simon Johnson, Ronald A. Kurtz Professor of Entrepreneurship, Sloan School of Management,
Massachusetts Institute of Technology
Hal S. Scott, Nomura Professor and Director of the Program on International Financial Sys-
tems, Harvard Law School
Joseph Stiglitz, Professor, Columbia Business School, Graduate School of Arts and Sciences
(Department of Economics) and the School of International and Public Affairs
John B. Taylor, Mary and Robert Raymond Professor of Economics and the Bowen H. and Jan-
ice Arthur McCoy Senior Fellow at the Hoover Institution, Stanford University
Luigi Zingales, Robert C. McCormack Professor of Entrepreneurship and Finance and the
David G. Booth Faculty Fellow, University of Chicago Booth School of Business

Roundtable Discussion, Washington, DC, November , 

David A. Moss, The John G. McLean Professor, Harvard Business School
Carmen M. Reinhart, Professor of Economics and Director of the Center for International Eco-
nomics, University of Maryland

Public Hearing, Washington, DC, Day , January , 

Session : Financial Institution Representatives
Lloyd C. Blankfein, Chairman of the Board and Chief Executive Officer, Goldman Sachs
Group, Inc.
James Dimon, Chairman of the Board and Chief Executive Officer, JPMorgan Chase & Co.
John J. Mack, Chairman of the Board, Morgan Stanley
Brian T. Moynihan, Chief Executive Officer and President, Bank of America Corporation
Session : Financial Market Participants
Michael Mayo, Managing Director and Financial Services Analyst, Calyon Securities
(USA) Inc.
J. Kyle Bass, Managing Partner, Hayman Advisors, LP
Peter J. Solomon, Founder and Chairman, Peter J. Solomon Company
Session : Financial Crisis Impacts on the Economy

545
546 Appendix B: List of Hearings and Witnesses

Mark Zandi, Chief Economist and Co-founder, Moody’s Economy.com

Kenneth T. Rosen, Chair, Fisher Center for Real Estate and Urban Economics, University of
California, Berkeley
Julia Gordon, Senior Policy Counsel, Center for Responsible Lending
C. R. “Rusty” Cloutier, President and Chief Executive Officer, MidSouth Bank, N.A., Past
Chairman, Independent Community Bankers Association

Public Hearing, Washington, DC, Day , January , 

Session : Current Investigations into the Financial Crisis—Federal Officials
Eric H. Holder Jr., Attorney General, U.S. Department of Justice
Lanny A. Breuer, Assistant Attorney General, Criminal Division, U.S. Department of Justice
Sheila C. Bair, Chairman, U.S. Federal Deposit Insurance Corporation
Mary L. Schapiro, Chairman, U.S. Securities and Exchange Commission
Session : Current Investigations into the Financial Crisis—State and Local Officials
Lisa Madigan, Attorney General, State of Illinois
John W. Suthers, Attorney General, State of Colorado
Denise Voigt Crawford, Commissioner, Texas Securities Board, and President, North American
Securities Administrators Association, Inc.
Glenn Theobald, Chief Counsel, Miami-Dade County Police Department; Chairman, Mayor
Carlos Alvarez Mortgage Fraud Task Force

Forum to Explore the Causes of the Financial Crisis, American University Washing-
ton College of Law, Washington, DC, Day , February , 
Session : Interconnectedness of Financial Institutions; “Too Big to Fail”
Randall Kroszner, Norman R. Bobins Professor of Economics, University of Chicago
Session : Macroeconomic Factors and U.S. Monetary Policy
Pierre-Olivier Gourinchas, Associate Professor of Economics, University of California, Berkeley
Session : Risk Taking and Leverage
John Geanakoplos, James Tobin Professor of Economics, Yale University
Session : Household Finances and Financial Literacy
Annamaria Lusardi, Joel Z. and Susan Hyatt Professor of Economics, Dartmouth University;
Research Associate at the National Bureau of Economic Research

Forum to Explore the Causes of the Financial Crisis, American University Washing-
ton College of Law, Washington, DC, Day , February , 
Session : Mortgage Lending Practices and Securitization
Chris Mayer, Paul Milstein Professor of Real Estate, Columbia University; Visiting Scholar at
the Federal Reserve Bank of New York and Research Associate at the National Bureau of Economic
Research
Session : Government-Sponsored Enterprises and Housing Policy
Dwight Jaffee, Willis Booth Professor of Banking, Finance, and Real Estate; Co-chair, Fisher
Center for Real Estate and Urban Economics, University of California, Berkeley
Session : Derivatives and Other Complex Financial Instruments
Markus Brunnermeier, Edwards S. Sanford Professor of Economics, Princeton University
 Appendix B: List of Hearings and Witnesses 547

Session : Firm Structure and Risk Management

Anil Kashyap, Edward Eagle Brown Professor of Economics and Finance and Richard N. Rosett
Faculty Fellow, University of Chicago
Session : Shadow Banking
Gary Gorton, Professor of Finance, School of Management, Yale University

Public Hearing on Subprime Lending and Securitization and Government-Spon-

sored Enterprises (GSEs), Rayburn House Office Building, Room , Washington,
DC, Day , April , 
Session : The Federal Reserve
Alan Greenspan, Former Chairman, Board of Governors of the Federal Reserve System
Session : Subprime Origination and Securitization
Richard Bitner, Managing Director of Housingwire.com; Author, Confessions of a Subprime
Lender: An Insider’s Tale of Greed, Fraud, and Ignorance
Richard Bowen, Former Senior Vice President and Business Chief Underwriter, CitiMortgage,
Inc.
Patricia Lindsay, Former Vice President, Corporate Risk, New Century Financial Corporation
Susan Mills, Managing Director of Mortgage Finance, Citi Markets & Banking, Global Securi-
tized Markets
Session : Citigroup Subprime-Related Structured Products and Risk Management
Murray C. Barnes, Former Managing Director, Independent Risk, Citigroup, Inc.
David C. Bushnell, Former Chief Risk Officer, Citigroup, Inc.
Nestor Dominguez, Former Co-head, Global Collateralized Debt Obligations, Citi Markets &
Banking, Global Structured Credit Products
Thomas G. Maheras, Former Co-chief Executive Officer, Citi Markets & Banking

Public Hearing on Subprime Lending and Securitization and Government-Spon-

sored Enterprises (GSEs), Rayburn House Office Building, Room , Washington,
DC, Day , April , 
Session : Citigroup Senior Management
Charles O. Prince, Former Chairman of the Board and Chief Executive Officer, Citigroup, Inc.
Robert Rubin, Former Chairman of the Executive Committee of the Board of Directors, Citi-
group, Inc.
Session : Office of the Comptroller of the Currency
John C. Dugan, Comptroller, Office of the Comptroller of the Currency
John D. Hawke Jr., Former Comptroller, Office of the Comptroller of the Currency

Public Hearing on Subprime Lending and Securitization and Government-Spon-

sored Enterprises (GSEs), Rayburn House Office building, Room , Washington,
DC, Day , April , 
Session : Fannie Mae
Robert J. Levin, Former Executive Vice President and Chief Business Officer, Fannie Mae
Daniel H. Mudd, Former President and Chief Executive Officer, Fannie Mae
Session : Office of Federal Housing Enterprise Oversight
Armando Falcon Jr., Former Director, Office of Federal Housing Enterprise Oversight
James Lockhart, Former Director, Office of Federal Housing Enterprise Oversight
548 Appendix B: List of Hearings and Witnesses

Public Hearing on the Shadow Banking System, Dirksen Senate Office Building,
Room , Washington DC, Day , May , 
Session : Investment Banks and the Shadow Banking System
Paul Friedman, Former Senior Managing Director, Bear Stearns
Samuel Molinaro Jr., Former Chief Financial Officer and Chief Operating Officer, Bear Stearns
Warren Spector, Former President and Co-chief Operating Officer, Bear Stearns
Session : Investment Banks and the Shadow Banking System
James E. Cayne, Former Chairman and Chief Executive Officer, Bear Stearns
Alan D. Schwartz, Former Chief Executive Officer, Bear Stearns
Session : SEC Regulation of Investment Banks
Charles Christopher Cox, Former Chairman, U.S. Securities and Exchange Commission
William H. Donaldson, Former Chairman, U.S. Securities and Exchange Commission
H. David Kotz, Inspector General, U.S. Securities and Exchange Commission
Erik R. Sirri, Former Director Division of Trading & Markets, U.S. Securities and Exchange
Commission

Public Hearing on the Shadow Banking System, Dirksen Senate Office Building,
Room , Washington DC, Day , May , 
Session : Perspective on the Shadow Banking System
Henry M. Paulson Jr., Former Secretary, U.S. Department of the Treasury
Session : Perspective on the Shadow Banking System
Timothy F. Geithner, Secretary, U.S. Department of the Treasury; Former President, Federal
Reserve Bank of New York
Session : Institutions Participating in the Shadow Banking System
Michael A. Neal, Vice Chairman, General Electric; Chairman and Chief Executive Officer, GE
Capital
Mark S. Barber, Vice President and Deputy Treasurer, GE Capital
Paul A. McCulley, Managing Director, PIMCO
Steven R. Meier, Chief Investment Officer, State Street

Public Hearing on Credibility of Credit Ratings, the Investment Decisions Made

Based on Those Ratings, and the Financial Crisis, The New School Arnhold Hall,
Theresa Lang Community & Student Center,  West th Street, nd Floor, New
York, NY, June , 
Session : The Ratings Process
Eric Kolchinsky, Former Team Managing Director, US Derivatives, Moody’s Investors Service
Jay Siegel, Former Team Managing Director, Moody’s Investors Service
Nicolas S. Weill, Group Managing Director, Moody’s Investors Service
Gary Witt, Former Team Managing Director, US Derivatives, Moody’s Investors Service
Session : Credit Ratings and the Financial Crisis
Warren E. Buffett, Chairman and Chief Executive Officer, Berkshire Hathaway
Raymond W. McDaniel, Chairman and Chief Executive Officer, Moody’s Corporation
Session : The Credit Rating Agency Business Model
Brian M. Clarkson, Former President and Chief Operating Officer, Moody’s Investors Service
(written testimony only due to a medical emergency)
Mark Froeba, Former Senior Vice President, US Derivatives, Moody’s Investors Service
Richard Michalek, Former Vice President/Senior Credit Officer, Moody’s Investors Service
 Appendix B: List of Hearings and Witnesses 549

Public Hearing on the Role of Derivatives in the Financial Crisis, Dirksen Senate Of-
fice Building, Room , Washington, DC, Day , June , 
Session : Overview of Derivatives
Michael Greenberger, Professor, University of Maryland School of Law
Steve Kohlhagen, Former Professor of International Finance, University of California, Berkeley,
and former Wall Street derivatives executive
Albert “Pete” Kyle, Charles E. Smith Chair Professor of Finance, University of Maryland
Michael Masters, Chief Executive Officer, Masters Capital Management, LLC
Session : American International Group, Inc. and Derivatives
Joseph J. Cassano, Former Chief Executive Officer, American International Group, Inc. Finan-
cial Products
Robert E. Lewis, Senior Vice President and Chief Risk Officer, American International Group,
Inc.
Martin J. Sullivan, Former Chief Executive Officer, American International Group, Inc.
Session : Goldman Sachs Group, Inc. and Derivatives
Craig Broderick, Managing Director, Head of Credit, Market, and Operational Risk, Goldman
Sachs Group, Inc.
Gary D. Cohn, President and Chief Operating Officer, Goldman Sachs Group, Inc.

Public Hearing on the Role of Derivatives in the Financial Crisis, Dirksen Senate Of-
fice Building, Room , Washington DC, Day , July , 
Session : American International Group, Inc. and Goldman Sachs Group, Inc.
Steven J. Bensinger, Former Executive Vice President and Chief Financial Officer, American In-
ternational Group, Inc.
Andrew Forster, Former Senior Vice President and Chief Financial Officer, American Interna-
tional Group, Inc. Financial Services
Elias F. Habayeb, Former Senior Vice President and Chief Financial Officer, American Interna-
tional Group, Inc. Financial Services
David Lehman, Managing Director, Goldman Sachs Group, Inc
David Viniar, Executive Vice President and Chief Financial Officer, Goldman Sachs Group, Inc.
Session : Derivatives: Supervisors and Regulators
Eric R. Dinallo, Former Superintendant, New York State Insurance Department
Gary Gensler, Chairman, Commodity Futures Trading Commission
Clarence K. Lee, Former Managing Director for Complex and International Organizations, Of-
fice of Thrift Supervision

Public Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Gov-
ernment Intervention and the Role of Systemic Risk in the Financial Crisis, Dirksen
Senate Office Building, Room , Washington DC, Day , September , 
Session : Wachovia Corporation
Scott G. Alvarez, General Counsel, Board of Governors of the Federal Reserve System
John H. Corston, Acting Deputy Director, Division of Supervision and Consumer Protection,
U.S. Federal Deposit Insurance Corporation
Robert K. Steel, Former President and Chief Executive Officer, Wachovia Corporation
Session : Lehman Brothers
Thomas C. Baxter, Jr., General Counsel and Executive Vice President, Federal Reserve Bank of
New York
550 Appendix B: List of Hearings and Witnesses

Richard S. “Dick” Fuld Jr., Former Chairman and Chief Executive Officer, Lehman Brothers
Harvey R. Miller, Business Finance & Restructuring Partner, Weil, Gotshal & Manges, LLP
Barry L. Zubrow, Chief Risk Officer, JPMorgan Chase & Co.

Public Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Gov-
ernment Intervention and the Role of Systemic Risk in the Financial Crisis, Dirksen
Senate Office Building, Room , Washington DC, Day , September , 
Session : The Federal Reserve
Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System
Session : The Federal Deposit Insurance Corporation
Sheila C. Bair, Chairman, U.S. Federal Deposit Insurance Corporation

Public Hearing on the Impact of the Financial Crisis—Greater Bakersfield, Kern

County Board of Supervisors Chambers,  Truxtun Avenue, Bakersfield, CA,
September , 
Session : Welcome
Congressman Kevin McCarthy, California’s nd District
Ray Watson, Kern County Supervisor, District 
Irma Carson, Bakersfield City Councilwoman, Ward 
Session : Local Banking
Arnold Cattani, Chairman, Mission Bank
Steve Renock, President and CEO, Kern Schools Federal Credit Union
D. Linn Wiley, Vice Chairman, CVB Financial Corporation and Citizens Business Bank
Session : Residential and Community Real Estate
Gregory D. Bynum, President, Gregory D. Bynum and Associates, Inc.
Warren Peterson, Warren Peterson Construction, Inc.
Session : Local Housing Market
Gary Crabtree, Principal Owner, Affiliated Appraisers
Lloyd Plank, Lloyd E. Plank Real Estate Consultants
Session : Foreclosures and Loan Modifications
Brenda Amble, Escrow Manager, Ticor Title
Laurie McCarty, Coldwell Banker Preferred
Jeannie McDermott, Small Business Owner
Session : Forum for Public Comment
James Stephen Urner
Marvin Dean
Marie Vasile

Public Hearing on the Impact of the Financial Crisis—State of Nevada, University of

Nevada, Las Vegas, Student Union Building, Las Vegas, NV, September , 
Session : Economic Analysis of the Impact of the Financial Crisis on Nevada
Jeremy Aguero, Principal, Applied Analysis
Session : The Impact of the Financial Crisis on Businesses of Nevada
Steve Hill, Founder, Silver State Materials Corporation; Immediate Past Chairman, Las Vegas
Chamber of Commerce
William E. Martin, Vice Chairman and Chief Executive Officer, Service st Bank of Nevada
 Appendix B: List of Hearings and Witnesses 551

Wally Murray, President and Chief Executive Officer, Greater Nevada Credit Union
Philip G. Satre, Chairman, International Gaming Technology (IGT); Chairman, NV Energy,
Inc.
Session : The Impact of the Financial Crisis on Nevada Real Estate
Daniel G. Bogden, United States Attorney, State of Nevada
Gail Burks, President and Chief Executive Officer, Nevada Fair Housing Center
Brian Gordon, Principal, Applied Analysis
Jay Jeffries, Former Southwest Regional Sales Manager, Fremont Investment & Loan
Session : The Impact of the Financial Crisis on Nevada Public and Community Services
Andrew Clinger, Director of the Department of Administration, Chief of the Budget Division,
State of Nevada
Jeffrey Fontaine, Executive Director, Nevada Association of Counties
David Fraser, Executive Director, Nevada League of Cities
Dr. Heath Morrison, Superintendent, Washoe County School District
Session : Forum for Public Comment

Public Hearing on the Impact of the Financial Crisis—Miami, Florida, Florida Inter-
national University, Modesto A. Madique Campus, Miami, FL, September , 
Session : Overview of Mortgage Fraud
William K. Black, Associate Professor of Economics and Law, University of Missouri–Kansas
City
Ann Fulmer, Vice President of Business Relations, Interthinx; Co-founder, Georgia Real Estate
Fraud Prevention and Awareness Coalition
Henry N. Pontell, Professor of Criminology, Law & Society and Sociology, University of Cali-
fornia, Irvine
Session : Uncovering Mortgage Fraud in Miami
Dennis J. Black, President, D. J. Black & Company
Edward Gallagher, Executive Officer, Economic Crimes Bureau, Mortgage Fraud Task Force,
Miami-Dade Police Department
Jack Rubin, Senior Vice President, JPMorgan Chase Bank
Ellen Wilcox, Special Agent, Florida Department of Law Enforcement
Session : The Regulation, Oversight, and Prosecution of Mortgage Fraud in Miami
J. Thomas Cardwell, Commissioner, Office of Financial Regulation, State of Florida
Wilfredo A. Ferrer, United States Attorney, Southern District of Florida
R. Scott Palmer, Special Counsel and Chief of the Mortgage Fraud Task Force, Office of the At-
torney General, State of Florida

Public Hearing on the Impact of the Financial Crisis—Sacramento, California De-

partment of Education, Sacramento, CA, September , 
Session : Overview of the Sacramento Housing and Mortgage Markets and the Impact of
the Financial Crisis on the Region
Mark Fleming, Chief Economist, CoreLogic
Session : Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacra-
mento Region
Karen J. Mann, President and Chief Appraiser, Mann and Associates Real Estate Appraisers &
Consultants
Thomas C. Putnam, President, Putnam Housing Finance Consulting
552 Appendix B: List of Hearings and Witnesses

Kevin Stein, Associate Director, California Reinvestment Coalition

Benjamin B. Wagner, United States Attorney, Eastern District of California
Session : The Mortgage Securitization Chain: From Sacramento to Wall Street
Vicki Beal, Senior Vice President, Transaction Management, Clayton Holdings, LLC
Kurt Eggert, Professor of Law, Chapman University School of Law
D. Keith Johnson, Former President and Chief Executive Officer, Washington Mutual’s Long
Beach Mortgage
Session : The Impact of the Financial Crisis on Sacramento Neighborhoods and Families
Pam Canada, Chief Executive Officer, NeighborWorks Home Ownership Center–Sacramento
Region
Mona Tawatao, Regional Counsel, Legal Services of Northern California
Bruce Wagstaff, Agency Administrator, County of Sacramento Countywide Services Agency
Clarence Williams, President, California Capital Financial Development Corporation
Henry W. Wirz, President and Chief Executive Officer, SAFE Credit Union
Public Testimony Presented
Allen Carpenter
Lovie M. Hollis
Nia Lavulo
 NOTES

Unless otherwise specified, data come from the sources listed below.
Board of Governors of the Federal Reserve System, Flow of Funds Reports: Debt, international
capital flows, and the size and activity of various financial sectors
Bureau of Economic Analysis: Economic output (GDP), spending, wages, and sector profit
Bureau of Labor Statistics: Labor market statistics
BlackBox Logic and Standard & Poor’s: Data on loans underlying CMLTI 2006-NC2
CoreLogic: Home prices
Inside Mortgage Finance, 2009 Mortgage Market Statistical Annual: Data on origination of
mortgages, issuance of mortgage-backed securities and values outstanding
Markit Group: ABX-HE index
Mortgage Bankers Association National Delinquency Survey: Mortgage delinquency and fore-
closure rates
10-Ks, 10-Qs, and proxy statements filed with the Securities and Exchange Commission: Com-
pany-specific information
Many of the documents cited on the following pages, along with other materials, are available
on www.fcic.gov.

Chapter 1
1. Charles Prince, testimony before the FCIC, Hearing on Subprime Lending and Securitization and
Government-Sponsored Enterprises (GSEs), day 2, session 1: Citigroup Senior Management, April 8,
2010, transcript, p. 10.
2. Warren Buffett, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the In-
vestment Decisions Made Based on Those Ratings, and the Financial Crisis, session 2: Credit Ratings and
the Financial Crisis, June 2, 2010, transcript, p. 208; Warren Buffett, interview by FCIC, May 26, 2010.
3. Lloyd Blankfein, testimony before the First Public Hearing of the FCIC, day 1, panel 1: Financial
Institution Representatives, January 13, 2010, transcript, p. 36.
4. Ben S. Bernanke, closed-door session with FCIC, November 17, 2009; Ben S. Bernanke, testimony
before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government In-
tervention and the Role of Systemic Risk in the Financial Crisis, day 2, session 1: The Federal Reserve,
September 2, 2010, transcript, p. 27.
5. Alan Greenspan, written testimony for the FCIC, Subprime Lending and Securitization and Gov-
ernment-Sponsored Enterprises (GSEs), day 1, session 1: The Federal Reserve, April 7, 2010, p. 9.

553
554 Notes to Chapter 1

6. Richard C. Breeden, interview by FCIC, October 14, 2010.

7. Paul A. McCulley, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, ses-
sion 3: Institutions Participating in the Shadow Banking System, May 6, 2010, transcript, p. 249.
8. Arnold Cattani, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—Greater
Bakersfield, session 2: Local Banking, September 7, 2010, transcript pp. 25, 61.
9. William Martin, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—State
of Nevada, session 2: The Impact of the Financial Crisis on Businesses of Nevada, September 8, 2010,
transcript, p. 76.
10. Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 1, The Primary Mar-
ket (: Inside Mortgage Finance, 2009), p. 4, “Mortgage Product by Origination.”
11. Data provided to the FCIC by National Association of Realtors: national home price data from
sales of existing homes, comparing second-quarter 1998 ($135,800) and second-quarter 2006 ($227,100),
the national peak in prices.
12. Core-based statistical area house prices for Sacramento–Arden–Arcade–Roseville CA Metropoli-
tan Statistical Area, CoreLogic data.
13. Data provided by CoreLogic, Home Price Index for Urban Areas. FCIC staff calculated house
price growth from January 2001 to peak of each market. Prices increased at least 50% in 401 cities, at least
75% in 217 cities, at least 100% in 112 cities, at least 125% in 63 cities, and more than 150% in 16 cities.
14. Updated data provided by James Kennedy and Alan Greenspan, whose data originally appeared in
“Sources and Uses of Equity Extracted from Homes,” Finance and Economics Discussion Series, Federal
Reserve Board, 2007-20 (March 2007).
15. “Mortgage Originations Rise in First Half of 2005; Demand for Interest Only, Option ARM and
Alt-A Products Increases,” Mortgage Bankers Association press release, October 25, 2005.
16. In 2007, the weekly wage of New York investment banker was $16,849; of the average privately
employed worker, $841.
17. Federal Reserve Survey of Consumer Finances, tabulated by FCIC.
18. Angelo Mozilo, interview by FCIC, September 24, 2010.
19. Michael Mayo, testimony before the First Public Hearing of the FCIC, day 1, panel 2: Financial
Market Participants, January 13, 2010, transcript, p. 114.
20. “Mortgage Originations Rise in First Half of 2005,” MBA press release, October 27, 2005.
21. Yuliya Demyanyk and Yadav K. Gopalan, “Subprime ARMs: Popular Loans, Poor Performance,”
Federal Reserve Bank of St. Louis, Bridges (Spring 2007).
22. Ann Fulmer, vice president of Business Relations, Interthinx (session 1: Overview of Mortgage
Fraud), and Ellen Wilcox, special agent, Florida Department of Law Enforcement (session 2: Uncovering
Mortgage Fraud in Miami), testimony before the FCIC, Hearing on the Impact of the Financial Crisis—
Miami, September 21, 2010.
23. Julia Gordon and Michael Calhoun, Center for Responsible Lending, interview by FCIC, Septem-
ber 16, 2010.
24. Faith Schwartz, at Consumer Advisory Council meeting, Thursday, March 30, 2006.
25. Federal Reserve Board, “Mean Value of Mortgages or Home-Equity Loans for Families with Hold-
ings,” in SCF Chartbook, June 15, 2009, tables updated to February 18, 2010.
26. Christopher Cruise, interview by FCIC, August 24, 2010.
27. Ibid.
28. Robert Kuttner, interview by FCIC, August 5, 2010.
29. Timothy Geithner, testimony before the FCIC, Hearing on the Shadow Banking System, day 2,
session 2: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 146.
30. James Ryan, chief marketing officer at CitiFinancial and John Schachtel, executive vice president
of CitiFinancial, interview by FCIC, February 3, 2010.
31. These points were made to the FCIC by consumer advocates: e.g., Kevin Stein, associate director,
California Reinvestment Coalition, at the Hearing on the Impact of the Financial Crisis—Sacramento, ses-
sion 2: Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacramento Region, Septem-
ber 23, 2010; Gail Burks, president and CEO, Nevada Fair Housing Center, at the Hearing on the Impact of
the Financial Crisis—State of Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Estate,
September 8, 2010. See also Federal Reserve Consumer Advisory Council transcripts, March 25, 2004;
June 24, 2004; October 28, 2004; March 17, 2005; October 27, 2005; June 22, 2006; October 26, 2006.
 Notes to Chapter 1 555

32. Bob Gnaizda, interview by FCIC, March 25, 2010.

33. James Rokakis, interview by FCIC, November 8, 2010.
34. Ibid.
35. Fed Governor Edward M. Gramlich, “Tackling Predatory Lending: Regulation and Education,”
remarks at Cleveland State University, Cleveland, Ohio, March 23, 2001.
36. Rokakis, interview.
37. John Taylor, chairman and chief executive officer, National Community Reinvestment Coalition,
letter to Office of Thrift Supervision, July 3, 2000, provided to the FCIC.
38. Stein, testimony before the FCIC, transcript, pp. 73–74, 71.
39. U.S. Department of the Treasury and U.S Department of Housing and Urban Development, “Joint
Report on Recommendations to Curb Predatory Home Mortgage Lending” (June 1, 2000).
40. Federal Reserve Board press release, December 12, 2001.
41. Sheila C. Bair, written testimony for the FCIF, First Public Hearing of the FCIC, day 2, panel 1:
Current Investigations into the Financial Crisis—Federal Officials, January 14, 2010, p. 11.
42. Fed Governor Edward M. Gramlich, “Predatory Lending,” remarks at the Housing Bureau for
Seniors Conference, , January 18, 2002.
43. Sheila C. Bair, testimony before the FCIC, First Public Hearing of the FCIC, day 2, panel 1: Cur-
rent Investigations into the Financial Crisis—Federal Officials, January 14, 2010, transcript, p. 97.
44. Sheila C. Bair, interview by FCIC, March 29, 2010.
45. 2009 Mortgage Market Statistical Annual, 1:220, “Top B&C Lenders in 2000”; 1.223, “Top B&C
Lenders in 2003.”
46. Ibid., 1:237, “Subprime Origination by State in 2001”; and 1:235, “Subprime Originations by State
in 2003.”
47. Stein, testimony before the FCIC, September 23, 2010, transcript, p. 72.
48. Gail Burks, interview by FCIC, August 30, 2010.
49. Lisa Madigan, written testimony for the FCIC, First Public Hearing of the FCIC, day 1, panel 2:
Current Investigations into the Financial Crisis—State and Local Officials, January 14, 2010, p. 4–5;
“Home Mortgage Lender settled ‘Predatory Lending’ Charges,” Federal Trade Commission press release,
March 21, 2002.
50. 2009 Mortgage Market Statistical Annual, 1:220, “Top 25 B&C Lenders in 2003.”
51. Madigan, written testimony for the FCIC, January 14, 2010, pp. 4–5.
52. Ed Parker, interview by FCIC, May 26, 2010.
53. Prentiss Cox, interview by FCIC, October 15, 2010.
54. Ibid.
55. 2009 Mortgage Market Statistical Annual, 1:45, 47, 49, 51.
56. Alphonso Jackson, interview by FCIC, October 6, 2010.
57. Cox, interview; Madigan, written testimony for the FCIC, January 14, 2010, p. 11.
58. Cox, interview. Madigan, testimony before the FCIC, January 14, 2010, transcript, pp. 121–122.
59. John D. Hawke Jr. and John C. Dugan, written statements for the FCIC, Hearing on Subprime
Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 2, session 2: Office of
the Comptroller of the Currency, April 8, 2010, pp. 4–5 and pp. 4–8, respectively.
60. Madigan, written testimony for the FCIC, January 14, 2010, pp. 9, 10.
61. Cox, interview.
62. 2009 Mortgage Market Statistical Annual, 1:4, “Mortgage Originations by Product.” Nonprime =
Alt-A and subprime combined.
63. Marc S. Savitt, interview by FCIC, November 17, 2010.
64. Rob Barry, Matthew Haggman, and Jack Dolan, “Ex-convicts active in mortgage fraud,” Miami
Herald, January 29, 2009.
65. J. Thomas Cardwell, written testimony for the FCIC, Hearing on the Impact of the Financial Cri-
sis—Miami, session 3: The Regulation, Oversight, and Prosecution of Mortgage Fraud in Miami, Sep-
tember 21, 2010, p. 8.
66. Savitt, interview.
67. Gary Crabtree, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—
Greater Bakersfield, session 4: Local Housing Market, September 7, 2010, p. 6.
68. Ibid.
556 Notes to Chapter 1

69. Gary Crabtree, interview by FCIC, August 18, 2010. Crabtree, written testimony for the FCIC,
September 7, 2010, pp. 6–7.
70. “FBI Warns of Mortgage Fraud ‘Epidemic’ from Terry Frieden,” CNN news report, September 17,
2004.
71. Kirstin Downey, “FBI Vows to Crack Down on Mortgage Fraud; Hot Real Estate Market Drives
Reports of ‘Suspicious’ Activity, Agency Says,” Washington Post, February 15, 2005.
72. Financial Crimes Enforcement Network, Regulatory Policy and Programs Division, “Mortgage
Loan Fraud: An Industry Assessment Based upon Suspicious Activity Report Analysis,” November 2006.
See also Financial Crimes Enforcement Network, “Annual Report: Fiscal Year 2008.”
73. FinCEN response to FCIC interrogatories, October 14–15, 2010.
74. William K. Black, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—
Miami, session 1: Overview of Mortgage Fraud, September 21, 2010, p. 8.
75. Alberto Gonzales, interview by FCIC, November 1, 2010; Michael Mukasey, interview by FCIC,
October 20, 2010.
76. Federal Reserve Consumer Advisory Council Meeting, October 28, 2004, transcript, p. 44.
77. Ibid., p. 45.
78. Ruhi Maker, interview by FCIC, October 25, 2010.
79. Kirstin Downey, “Many Buyers Opt for Risky Mortgages,” Washington Post, May 28, 2005.
80. “After the Fall: Soaring house prices have given a huge boost to the world economy. What happens
when they drop?” The Economist, June 16, 2005.
81. Fed Chairman Alan Greenspan, “The Economic Outlook,” prepared testimony before the Joint
Economic Committee, 109th Cong., 1st sess., June 9, 2005.
82. Ibid.
83. Fed Chairman Ben S. Bernanke, “The Economic Outlook,” prepared testimony before the Joint
Economic Committee, U.S. Congress, 110th Cong., 1st sess., March 28, 2007.
84. Sheila Canavan, comments during of the Federal Reserve Consumer Advisory Council Meeting,
October 27, 2005, transcript, p. 52.
85. David Leonhardt, “Be Warned: Mr. Bubble’s Worried Again,” New York Times, August 21, 2005.
86. Raghuram Rajan, interview by FCIC, November 22, 2010.
87. Ibid.
88. Ibid.
89. Raghuram G. Rajan, Fault Lines: How Hidden Fractures Still Threaten The World Economy (Prince-
ton: Princeton University Press, 2010), p. 3.
90. Susan M. Wachter, interview by FCIC, October 6, 2010.
91. Mark Klipsch, quoted in “Blizzard Can’t Stop ASF 2005 Conference,” Asset Securitization Report,
January 31, 2005.
92. Dennis J. Black, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—
Miami, session 2: Uncovering Mortgage Fraud in Miami, September 21, 2010, p. 1; for the appraiser’s pe-
tition, see http://appraiserspetition.com/.
93. Karen Mann, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—
Sacramento, session 2: Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacramento
Region, September 23, 2010.
94. 2009 Mortgage Market Statistical Annual, vol. 2, The Secondary Market, p. 13, “Non-Agency MBS
Issuance by Type,” and FCIC staff estimates based on analysis of Moody’s SFDRS data.
95. Jamie Dimon, testimony before the FCIC, First Public Hearing of the FCIC, day 1, panel 1: Finan-
cial Institution Representatives, January 13, 2010, transcript, p. 78.
96. Madelyn Antoncic, interview by FCIC, July 14, 2010.
97. Anton R. Valukas, Report of Examiner, In re Lehman Brothers Holdings Inc., et al., Chapter 11
Case No. 08-13555 (JMP), (Bankr. S.D.N.Y.), March 11, 2010, 1:114, with n. 418.
98. Richard Bowen, interview by FCIC, February 27, 2010.
99. Richard Bowen, email to Robert Rubin, David Bushnell, Gary Crittenden, and Bonnie Howard,
November 3, 2007.
 Notes to Chapter 1 557

100. Robert Rubin, testimony before the FCIC, Hearing on Subprime Lending and Securitization and
Government-Sponsored Entities (GSEs), day 2, session 1: Citigroup Senior Management, April 8, 2010,
transcript, p. 30.
101. Brad S. Karp, counsel for Citigroup, letter to FCIC, November 1, 2010, in response to FCIC re-
quest of September 21, 2010, for information regarding Richard Bowen’s November 3, 2007, email, p. 2.
102. Bowen, interview.
103. J. Kyle Bass, testimony before the FCIC, First Public Hearing of the FCIC, day 1, panel 2: Finan-
cial Market Participants, January 13, 2010, transcript, pp. 143–44.
104. Herbert M. Sandler, “Comment on Joint ANPR for Proposed Revision to the Existing Risk-based
Capital Rule,” letter to Federal Reserve Board, Office of the Comptroller of the Currency, Federal Deposit
Insurance Corporation, and Office of Thrift Supervision, January 18, 2006.
105. Lewis Ranieri, interview by FDIC, July 30, 2010.
106. Angelo Mozilo, email to Eric Sieracki, April 13, 2006, re: 1Q2006 Earnings.
107. Angelo Mozilo, email to David Sambol, April 17, 2006, subject: sub-prime seconds.
108. David Sambol, email to Angelo Mozilo, April 17, 2006, re: Sub-prime seconds (cc Kurland,
McMurray, and Bartlett).
109. Angelo Mozilo, email to David Sambol, April 17, 2006, subject: re: Sub-prime seconds (cc Kur-
land, McMurray, and Bartlett).
110. Sabeth Siddique, interview by FCIC, September 9, 2010.
111. “Survey of Nontraditional Mortgages” (actual title redacted), confidential Federal Reserve docu-
ment obtained by FCIC, produced November 1, 2005, pp. 2, 3.
112. Susan Bies, interview by FDIC, October 11, 2010.
113. John Dugan, testimony before the FCIC, Hearing on Subprime Lending and Securitization and
Government-Sponsored Enterprises (GSEs), day 2, session 2: Office of the Comptroller of the Currency,
April 8, 2010, transcript,
114. Sabeth Siddique, interviews by FCIC, September 9, 2010, and October 25, 2010.
115. Bies, interview.
116. Mortgage Insurance Companies of America, quoted in Kirstin Downey, “Insurers Want Action
on Risky Mortgages; Firms Want More Loan Restrictions,” Washington Post, August 19, 2006.
117. William A. Sampson, Mortgage Insurance Companies of America, “MICA Testimony on Non-
Traditional Mortgages,” before the Senate Subcommittee on Housing and Transportation and the Sub-
committee on Economic Policy, 109th Cong., 2nd sess., September 20, 2006.
118. Siddique, interviews, October 25, 2010, and September 9, 2010.
119. Consumer Advisory Council Meeting, March 30, 2006, transcript.
120. Consumer Advisory Council Meeting, June 22, 2006, transcript.
121. Siddique, interview, October 25, 2010; Bies, interview.
122. There is no central clearinghouse to calculate structured finance assets. The FCIC’s estimate is
based on the amount of structured finance assets rated by Moody’s along with unrated agency RMBS,
along with an estimate for structured finance assets not rated by Moody’s, using as sources Fannie Mae
and Freddie Mac, Bloomberg, American CoreLogic Loan Performance, Fitch Ratings, Moody’s, S&P,
Thomson Reuters, and SIFMA.
123. Alan Greenspan, testimony before the FCIC, Hearing on Subprime Lending and Securitization
and Government-Sponsored Enterprises (GSEs), day 1, session 1: The Federal Reserve, April 7, 2010,
transcript, p. 29.
124. Mortgage Bankers Association, “National Delinquency Survey.”
125. CoreLogic, Inc., August 26, 2010, news release, second quarter, 2010. Second-quarter figures
were an improvement from 11.2 million residential properties (24%) in negative equity in the first quar-
ter of 2010.
126. Mark Zandi, written testimony for the FCIC, First Public Hearing of the FCIC, day 1, panel 3:
Financial Crisis Impacts on the Economy, January 13, 2010, pp. 14, 15.
127. Dean Baker, interview by FCIC, August 18, 2010.
128. Warren Peterson, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—
Greater Bakersfield, session 3: Residential and Community Real Estate, September 7, 2010, transcript,
pp. 106–7, 119–20, 107–8; Warren Peterson, interview by FCIC, August 24, 2010.
558 Notes to Chapter 2

Chapter 2
1. Ben Bernanke, written testimony before the FCIC, Hearing on Too Big to Fail: Expectations and
Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis,
day 1, session 1, September 2, 2010, p. 2.
2. Alan Greenspan, “The Evolution of Banking in a Market Economy,” remarks at the Annual Confer-
ence of the Association of Private Enterprise Education, Arlington, Virginia, April 12, 1997.
3. Charles Calomiris and Gary Gorton, “The Origins of Banking Panics: Models, Facts, and Bank
Regulation,” in Calomiris, U.S. Bank Deregulation in Historical Perspective (Cambridge: Cambridge Uni-
versity Press, 2000), pp. 98–100. Prior to the end of the Civil War, banks issued notes instead of holding
deposits. Runs on that system occurred in 1814, 1819, 1837, 1839, 1857, and 1861 (ibid., pp. 98–99).
4. R. Alton Gilbert, “Requiem for Regulation Q: What It Did and Why It Passed Away,” Federal Re-
serve Bank of St. Louis Review 68, no. 2 (February 1986): 23.
5. FCIC, “Preliminary Staff Report: Shadow Banking and the Financial Crisis,” May 4, 2010, pp. 18–
25.
6. Arthur E. Wilmarth Jr., “The Transformation of the U.S. Financial Services Industry, 1975–2000:
Competition, Consolidation, and Increased Risks,” University of Illinois Law Review (2002): 239–40.
7. Frederic S. Mishkin, “Asymmetric Information and Financial Crises: A Historical Perspective,” in
Financial Markets and Financial Crises, ed. R. Glenn Hubbard (Chicago: University of Chicago Press,
1991), p. 99; Wilmarth, “The Transformation of the U.S. Financial Services Industry, 1975–2000,” p. 236.
8. Federal Reserve Board Flow of Funds Release, table L.208. Accessed December 29, 2010.
9. Kenneth Garbade, “The Evolution of Repo Contracting Conventions in the 1980s,” Federal Reserve
Bank of New York Economic Policy Review 12, no. 1 (May 2006): 32–33, 38–39 (available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=918498). To implement monetary policy, the Fed-
eral Reserve Bank of New York uses the repo market: it sets interest rates by borrowing Treasuries from
and lending them to securities firms, many of which are units of commercial banks.
10. Alan Blinder, interview by FCIC, September 17, 2010.
11. Paul Volcker, interview by FCIC, October 11, 2010.
12. Fed Chairman Alan Greenspan, “International Financial Risk Management,” remarks before the
Council on Foreign Relations, November 19, 2002.
13. Richard C. Breeden, interview by FCIC, October 14, 2010.
14. Wilmarth, “The Transformation of the U.S. Financial Services Industry, 1975–2000,” p. 241 and
n. 102.
15. Thereafter, banks were only required to lend on collateral and set terms based upon what the mar-
ket was offering. They also could not lend more than 10% of their capital to one subsidiary or more than
20% to all subsidiaries. Order Approving Applications to Engage in Limited Underwriting and Dealing in
Certain Securities,” Federal Reserve Bulletin 73, no. 6 (Jul. 1987): 473–508; “Revenue Limit on Bank-Inel-
igible Activities of Subsidiaries of Bank Holding Companies Engaged in Underwriting and Dealing in Se-
curities,” Federal Register 61, no. 251 (Dec. 30, 1996), 68750–56.
16. Julie L. Williams and Mark P. Jacobsen, “The Business of Banking: Looking to the Future,” Busi-
ness Lawyer 50 (May 1995): 798.
17. Fed Chairman Alan Greenspan, prepared testimony before the House Committee on Banking and
Financial Services, H.R. 10, the Financial Services Competitiveness Act of 1997, 105th Cong., 1st sess., May
22, 1997.
18. FCIC staff calculations.
19. FCIC staff calculations.
20. FCIC staff calculations using First American/CoreLogic, National HPI Single-Family Combined
(SFC).
21. This data series is relatively new. Those series available before 2009 showed no year-over-year na-
tional house price decline. First American/CoreLogic, National HPI Single-Family Combined (SFC).
22. For a general overview of the banking and thrift crisis of the 1980s, see FDIC, History of the Eight-
ies: Lessons for the Future, vol. 1, An Examination of the Banking Crises of the 1980s and Early 1990s
(Washington, DC: Federal Deposit Insurance Corporation, 1997).
 Notes to Chapter 3 559

23. Specifically, between 1980 and 1994, 1,617 federally insured banks with $302.6 billion in assets
and 1,295 savings and loans with $621 billion in assets either closed or received FDIC or FSLIC assis-
tance. See Federal Deposit Insurance Corp., Managing the Crisis: The FDIC and RTC Experience, 1980–
1994 (Aug. 1998), pp. 4, 5.
24. William K. Black, Associate Professor of Economics and Law, University of Missouri–Kansas City,
written testimony for the FCIC, Hearing on the Impact of the Financial Crisis, session 1: Overview of
Mortgage Fraud, September 21, 2010, p. 4. And see Kitty Calavita, Henry N. Pontell, and Robert H. Till-
man, Big Money Crime: Fraud and Politics in the Savings and Loan Crisis (Berkeley: University of Califor-
nia Press, 1997), p. 28.
25. FDIC, History of the Eighties: Lessons for the Future, 1:39.
26. U.S. Treasury Department, “Modernizing the Financial System: Recommendations for Safer, More
Competitive Banks” (February 1991), p. 55.
27. Testimony of John LaWare, Governor, Federal Reserve Board, at Hearings before Subcommittee
on Economic Stabilization of the Committee on Banking, Finance, and Urban Affairs on the “Economic
Implications of the Too Big to Fail Policy,” May 9, 1991, p. 11, http://fraser.stlouisfed.org/
publications/tbtf/issue/3954/download/61094/housetbtf1991.pdf.
FDIC, History of the Eighties: Lessons for the Future, 1:251.
28. George G. Kaufman, “Too Big to Fail in U.S. Banking: Quo Vadis?” in Too Big to Fail: Policies and
Practices in Government Bailouts, ed. Benton E. Gup (Westport, CT: Praeger, 2004), p. 163.
29. FCIC, “Preliminary Staff Report: Too-Big-to-Fail Financial Institutions,” August 31, 2010, pp. 6–
9.(Rep. McKinney is quoted from the transcript of the hearing before the House Committee on Banking,
Housing, and Urban Affairs).
30. Ibid., pp. 10, 19.

Chapter 3
1. Federal National Mortgage Association, Federal National Mortgage Association, Background and
History (1975).
2. Department of Housing and Urban Development, 1986 Report to Congress on the Federal National
Mortgage Association (1987), p. 100.
3. See, e.g., Kenneth H. Bacon, “Privileged Position: Fannie Mae Expected to Escape Attempt at
Tighter Regulation,” Wall Street Journal, June 19, 1992, and Stephen Labaton, “Power of the Mortgage
Twins: Fannie and Freddie Guard Autonomy,” New York Times, November 12, 1991.
4. Armando Falcon Jr., written testimony for the FCIC, Hearing on Subprime Lending and Securitiza-
tion and Government-Sponsored Enterprises (GSEs), day 3, session 2: Office of Federal Housing Enter-
prise Oversight, April 9, 2010, p. 2.
5. Wayne Passmore, “The GSE Implicit Subsidy and the Value of Government Ambiguity,” Federal Re-
serve Board Staff Working Paper 2005–05. See also Congressional Budget Office, “Updated Estimates of
the Subsidies to the Housing GSEs,” April 8, 2004.
6. Federal Housing Finance Agency, Report to Congress, 2009 (2010), pp. 141, 158.
7. Fannie Mae Charter Act of 1968, §309(h), codified at 12 U.S.C. §1723a(h). The 1992 Federal Hous-
ing Enterprises Financial Safety and Soundness Act repealed this provision and replaced it with more
elaborate provisions. Currently, the GSEs typically define low- and moderate-income borrowers as those
with income at or below median income for a given area.
8. Department of Housing and Urban Development, “Regulations Implementing the Authority of the
Secretary of the Department of Housing and Urban Development over the conduct of the Secondary
market Operations of the Federal National Mortgage Association (FNMA),” Federal Register 43, no. 158
(August 15, 1978): 36199–226.
9. President William J. Clinton, “Remarks on the National Homeownership Strategy,” June 5, 1995.
10. President George W. Bush, “President’s Remarks to the National Association of Home Builders,”
Greater Columbus Convention Center, Columbus, Ohio, October 2, 2004.
11. Andrew Cuomo, interview by FCIC, December 17, 2010.
12. Daniel Mudd, testimony before the FCIC, Hearing on Subprime Lending and Securitization and
Government-Sponsored Enterprises (GSEs), day 3, session 1: Fannie Mae, April 9, 2010, transcript, pp.
18–19.
560 Notes to Chapter 3

13. Richard Syron, interview by FCIC, August 31, 2010.

14. Senate Lobbying Disclosure Act Database (www.senate.gov/legislative/Public_Disclosure/
LDA_reports.htm); figures on employees and PACs compiled by the Center for Responsive Politics from
Federal Elections Commission data.
15. Falcon, written testimony for the FCIC, April 9, 2010, p. 5.
16. James Lockhart, written testimony for the FCIC, Hearing on Subprime Lending and Securitiza-
tion and Government-Sponsored Enterprises (GSEs), day 3, session 2: Office of Federal Housing Enter-
prise Oversight, pp. 4–8, 17 (quotation).
17. Senator Mel Martinez, interview by FCIC, September 28, 2010.
18. June E. O’Neill, remarks before the Conference on Appraising Fannie Mae and Freddie Mac,
Washington, D.C., May 14, 1998, p. 8.
19. Federal Housing Finance Agency, Report to Congress, 2008 (2009), tables 3, 4, 12, and 13.
20. Lawrence Lindsey, interview by FCIC, September 20, 2010.
21. Jim Callahan, interview by FCIC, October 18, 2010.
22. Securities Industry and Financial Markets Association (SIFMA), US ABS Outstanding.
23. Scott Patterson, interview by FCIC, August 12, 2010.
24. Gillian Tett, Fool’s Gold: How the Bold Dream of a Small Tribe at J. P. Morgan Was Corrupted by
Wall Street Greed and Unleashed a Catastrophe (New York: Free Press, 2009), pp. 32–33, 49, 70, 115.
25. Emmanuel Derman, interview by FCIC, May 12, 2010.
26. Volcker, interview.
27. Vincent Reinhart, interview by FCIC, September 10, 2010.
28. Lindsey, interview.
29. A futures contract is a bilateral contract in which one party, the long position, is compensated if
the price or index or rate underlying the contract rises while the other party, the short position, is com-
pensated if it goes down. An options contract grants the right but not the obligation to purchase or sell a
commodity or financial instrument at a particular price in the future; the option holder derives a benefit
if the price moves in his or her favor. In a swaps contract, the two parties exchange streams of payments
based on different benchmarks.
30. Securities options are regulated by the SEC.
31. Commodity Futures Trading Commission, Exemption for Certain Swap Agreements, Final Rule,
Federal Registrar 58 (January 22, 1993): 5587.
32. Brooksley Born, chairperson, Commodity Futures Trading Commission, “Concerning the Over-
the-Counter Derivatives Market,” prepared testimony before the House Committee on Banking and Fi-
nancial Services, 105th Cong., 2nd sess., July 24, 1998.
33. GAO, “Financial Derivatives: Actions Needed to Protect the Financial System,” GGD-94-133 (Re-
port to Congressional Requesters), May 18, 1994.
34. Commodity Futures Trading Commission, “Division of Enforcement” (www.cftc.gov/anr/an-
renf98.htm).
35. “Joint Statement by Treasury Secretary Robert E. Rubin, Federal Reserve Board Chairman Alan
Greenspan, and Securities and Exchange Commission Chairman Arthur Levitt,” Treasury Department
press release, May 7, 1998.
36. Fed Chairman Alan Greenspan, “The Regulation of OTC Derivatives,” prepared testimony before
the House Committee on Banking and Financial Services, 105th Cong., 2nd sess., July 24, 1998.
37. GAO, “Long-Term Capital Management: Regulators Need to Focus Greater Attention on Systemic
Risk,” GAO/GGD-00-3 (Report to Congressional Requesters), October 1999, pp. 7, 18, 39–40. The no-
tional amount of OTC derivatives contracts is a standard measure used in reporting the outstanding vol-
ume of such contracts. Its calculation is based on the value of the underlying instrument, commodity,
index, or rate that the swap is based on. It therefore may be of limited use in measuring the potential ex-
posure of the parties to the contracts. For example, an interest rate swap based on changes in interest rate
on a $100 million loan would likely involve only a small percentage of the $100 million notional amount.
On the other hand, price changes on an oil swap based on $100 million worth of oil could be even more
than the notional amount, depending on the volatility in oil prices. For credit default swaps, which are
discussed in more detail later in this volume, the notional amount is usually a close measure of the poten-
tial financial exposure of the issuer or seller of the swap.
 Notes to Chapter 4 561

38. Fed Chairman Alan Greenspan, “Private-sector Refinancing of the Large Hedge Fund, Long-Term
Capital Management,” prepared testimony before the House Committee on Banking and Financial Serv-
ices, 105th Cong., 2nd sess., October 1, 1998.
39. Fed Chairman Alan Greenspan, “Financial Derivatives,” remarks before the Futures Industry As-
sociation, Boca Raton, Florida, March 19, 1999.
40. “Over-the-Counter Derivatives Markets and the Commodity Exchange Act,” report of the Presi-
dent’s Working Group on Financial Markets, November 1999.
41. Gross market value is the current price at which the outstanding swaps contract can be sold or re-
placed on the market. As such, that amount reflects the current amount owing on a contract but does not
reflect the possible future exposure on these generally long-term instruments.
42. Bank for International Settlements, data on semiannual OTC derivatives statistics.
43. Alan Greenspan, testimony before the FCIC, Hearing on Subprime Lending and Securitization
and Government-Sponsored Entities (GSEs), day 1, session 1: The Federal Reserve, April 1, 2010, tran-
script, pp. 88–89.
44. Robert Rubin, testimony before the FCIC, FCIC Hearing on Subprime Lending and Securitization
and Government-Sponsored Entities (GSEs), day 2, session 1: Citigroup Senior Management, April 8,
2010, transcript, pp. 108–10, 123–24.
45. Lawrence Summers, interview by FCIC, May 28, 2010.
46. Daniel K. Tarullo, Banking on Basel: The Future of International Financial Regulation (Washington,
DC: Peterson Institute for International Economics, 2008), p. 58.
47. Final Rule—Amendment to Regulations H and Y,” Federal Reserve Bulletin 75, no. 3 (March 1989),
164–66.
48. Tarullo, Banking on Basel, pp. 61–64.
49. For more on derivatives, see FCIC, “Preliminary Staff Report: Overview on Derivatives,” June 29,
2010.
50. Warren Buffett, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the In-
vestment Decisions Made Based on Those Ratings, and the Financial Crisis, session 2: Credit Ratings and
the Financial Crisis, June 2, 2010, transcript, pp. 312, 326, 325.
51. Eric R. Dinallo, former superintendant, New York State Insurance Department, written testimony
for the FCIC, Hearing on the Role of Derivatives in the Financial Crisis, session 2, Derivatives: Supervi-
sors and Regulators, July 1, 2010, p. 7; Rochelle Katz, State of New York Insurance Department, letter to
Bertil Lundqvist, Skadden, Arps, Slate, Meagher & Flom, LLP, June 16, 2000.
52. Data provided by AIG to the FCIC, CDS notional balances at year-end.
53. Bank for International Settlements, semiannual OTC derivatives statistics.
54. Dinallo testified that the market in CDS in September 2008 was estimated to be $62 trillion at a
time when there was about $16 trillion of private-sector debt (written testimony for the FDIC, July 1,
2010, p. 9).
55. “AIGFP also participates as a dealer in a wide variety of financial derivatives transactions” (AIG,
2007 Form 10-K, p. 83). AIG’s notional derivatives outstanding were $2.1 trillion at the end of 2007, in-
cluding $1.2 trillion of interest rate swaps, $0.6 trillion of credit derivatives, $0.2 trillion of currency
swaps, and $0.2 trillion of other derivatives (p. 163).
56. FCIC staff calculations using data from Office of the Comptroller of the Currency; call reports.
57. Data provided to the FCIC by Goldman Sachs.

Chapter 4
1. 103 Public Law 103-328, September 29, 1994. Before the 1994 legislation, some states had voluntar-
ily opened themselves up to out-of-state banks. FDIC, History of the Eighties: Lessons for the Future, vol. 1,
An Examination of the Banking Crises of the 1980s and Early 1990s (Washington, DC: FDIC, 1997),
p. 130.
2. These were the largest banks as of 2007. See FCIC, “Preliminary Staff Report: Too-Big-to-Fail Fi-
nancial Institutions,” August 31, 2010, p. 14.
3. Data from SNL Financial (www.snl.com/).
4. Public Law 104-208, sec. 2222, codified as 12 U.S.C. § 3311; law in effect as of January 3, 2007.
5. Arthur Levitt, interview by FCIC, October 1, 2010.
562 Notes to Chapter 4

6. John D. Hawke and John Dugan, testimony before the FCIC, Hearing on Subprime Lending and
Securitization and Government-Sponsored Enterprises (GSEs), day 2, session 2: Office of the Comptrol-
ler of the Currency, April 8, 2010, transcript, pp. 169, 175.
7. Fed Vice Chairman Roger W. Ferguson Jr., “The Future of Financial Services—Revisited,” remarks
at the Future of Financial Services Conference, University of Massachusetts, Boston, October 8, 2003.
8. Fed Chairman Alan Greenspan, “Government Regulation and Derivative Contracts,” speech at the
Financial Markets Conference of the Federal Reserve Bank of Atlanta, Coral Gables, Florida, February
21, 1997.
9. Richard Spillenkothen, “Notes on the performance of prudential supervision in the years preceding
the financial crisis by a former director of banking supervision and regulation at the Federal Reserve
Board (1991 to 2006),” May 31, 2010, p. 28.
10. See U.S. Department of the Treasury, Modernizing the Financial System (February 1991), pp. XIX-
5, XIX-6, 67–69: “the existence of fewer agencies would concentrate regulatory power in the remaining
ones, raising the danger of arbitrary or inflexible behavior. . . . Agency pluralism, on the other hand, may
be useful, since it can bring to bear on general bank supervision the different perspectives and experi-
ences of each regulator, and it subjects each one, where consultation and coordination are required, to the
checks and balances of the others’ opinion.”
11. Fed Chairman Alan Greenspan, statement before the Senate Committee on Banking, Housing,
and Urban Affairs, 103rd Cong., 2nd sess., March 2, 1994, reprinted in the Federal Reserve Bulletin, May
1, 1994, p. 382.
12. Securities Industry Association v. Board of Governors of the Federal Reserve System, 627 F.Supp.
695 (D.D.C. 1986); Kathleen Day, “Reinventing the Bank; With Depression-Era Law about to Be Rewrit-
ten, the Future Remains Unclear,” Washington Post, October 31, 1999.
13. Edward Yingling, quoted in “The Making of a Law,” ABA Banking Journal, December 1999.
14. The two-year exemption is contained in section 4(a)(2) of the Bank Holding Company Act. The
Fed could have granted up to three one-year extensions of that exemption.
15. FCIC staff computations based on data from the Center for Responsive Politics. “Financial sector”
here includes insurance companies, commercial banks, securities and investment firms, finance and
credit companies, accountants, savings and loan institutions, credit unions, and mortgage bankers and
brokers.
16. U.S. Department of the Treasury, Modernizing the Financial System (February 1991); Fed Chair-
man Alan Greenspan, “H.R. 10, the Financial Services Competitiveness Act of 1997,” testimony before
the House Committee on Banking and Financial Services, 105th Cong., 1st sess., May 22, 1997.
17. Katrina Brooker, “Citi’s Creator, Alone with His Regrets,” New York Times, January 2, 2010.
18. John Reed, interview by FCIC, March 24, 2010.
19. FDIC Institution Directory; SNL Financial.
20. Fed Governor Laurence H. Meyer, “The Implications of Financial Modernization Legislation for
Bank Supervision,” remarks at the Symposium on Financial Modernization Legislation, sponsored by
Women in Housing and Finance, Washington, D.C., December 15, 1999.
21. Ben S. Bernanke, written testimony before the FCIC, Hearing on Too Big to Fail: Expectations and
Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis,
day 1, session 1: The Federal Reserve, September 2, 2010, p. 14.
22. Patricia A. McCoy et al., “Systemic Risk through Securitization: The Result of Deregulation and
Regulatory Failure,” Connecticut Law Review 41 (2009): 1345–47, 1353–55.
23. Fed Chairman Alan Greenspan, “Lessons from the Global Crises,” remarks before the World Bank
Group and the International Monetary Fund, Program of Seminars, Washington, DC, September 27,
1999.
24. David A. Marshall, “The Crisis of 1998 and the Role of the Central Bank,” Federal Reserve Bank of
Chicago, Economic Perspectives (1Q 2001): 2.
25. Commercial and industrial loans at all commercial banks, monthly, seasonally adjusted, from the
Federal Reserve Board of Governors H.8 release; FCIC staff calculation of average change in loans out-
standing over any two consecutive months in 1997 and 1998.
26. Franklin R. Edwards, “Hedge Funds and the Collapse of Long-Term Capital Management,” Jour-
nal of Economic Perspectives 13 (1999): 198.
 Notes to Chapter 4 563

27. “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” Report of the Pres-
ident’s Working Group on Financial Markets, April 1999, p. 14.
28. Edwards, “Hedge Funds and the Collapse of Long-Term Capital Management,” pp. 200, 197; and
Bloomberg.
29. Ibid., pp. 197–205; Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital
Management (New York: Random House, 2000), pp. 36–54, 77–84, 94–105, 123–30.
30. “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” pp. 11–12.
31. William J. McDonough, president of the Federal Reserve Bank of New York, statement before the
House Committee on Banking and Financial Services, 105th Cong., 2nd sess., October 1, 1998.
32. GAO, “Long-Term Capital Management: Regulators Need to Focus Greater Attention on Systemic
Risk,” GAO/GGD-00-3 (Report to Congressional Requesters), October 1999, p. 39.
33. “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” pp. 13–14.
34. Lowenstein, When Genius Failed, pp. 205–18.
35. McDonough, statement before the House Committee on Banking and Financial Services, October
1, 1998.
36. Andrew F. Brimmer, “Distinguished Lecture on Economics in Government: Central Banking and
Systemic Risks in Capital Markets,” Journal of Economic Perspectives, no. 2 (Spring 1989) (lecture by a for-
mer Fed governor, analyzing the Fed’s market interventions in 1970, 1980 and 1987, and concluding that
the Fed had consciously assumed a “strategic role as the ultimate source of liquidity in the economy at
large”); Keith Garbade, “The Evolution of Repo Contracting Conventions in the 1980s,” Federal Reserve
Bank of New York Economic Policy Review (May 2006): 33.
37. Harvey Miller, interview by FCIC, August 5, 2010.
38. Stanley O’Neal, interview by FCIC, September 16, 2010.
39. Fed Chairman Alan Greenspan, “Do efficient financial markets mitigate financial crises?” remarks
before the 1999 Financial Markets Conference of the Federal Reserve Bank of Atlanta, October 19, 1999
(www.federalreserve.gov/boarddocs/speeches/1999/19991019.htm).
40. “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” p. 16.
41. Ibid.
42. Ibid.
43. Philip Goldstein, et al. v. SEC, Opinion, Case No. 04-1434 (D.C. Cir.  June 23, 2006).
44. Time, February 15, 1999; Bob Woodward, Maestro: Greenspan’s Fed and the American Boom (New
York: Simon & Schuster, 2000).
45. SIFMA (Securities Industry and Financial Markets Association), Fact Book 2008, pp. 9–10.
46. Board of Governors of the Federal Reserve System, Federal Reserve Statistical Release Z.1: Flow of
Funds Accounts of the United States, 4th Qtr. 1996, p. 88 (Table L.213, line 18); 4th Qtr. 2001, p. 90 (Table
L.213, line 20).
47. SEC Chairman William H. Donaldson, “Testimony Concerning Global Research Analyst Settle-
ment,” before the Senate Committee on Banking, Housing and Urban Affairs, 108th Cong., 1st sess., May
7, 2003.
48. SEC, “SEC Fact Sheet on Global Analyst Research Settlements,” April 30, 2003; Financial Industry
Regulatory Authority news release, “NASD Fines Piper Jaffray $2.4 Million for IPO Spinning,” July 12,
2004.
49. Arthur E. Wilmarth Jr., “Conflicts of Interest and Corporate Governance Failures at Universal
Banks During the Stock Market Boom of the 1990s: The Cases of Enron and WorldCom,” George Wash-
ington University Public Law and Legal Theory Working Paper 234 (2007).
50. Fed Chairman Alan Greenspan, “International Financial Risk Management,” remarks before the
Council on Foreign Relations, Washington, DC, November 19, 2002.
51. Ferguson, “The Future of Financial Services—Revisited.”
52. Spillenkothen, “Notes on the performance of prudential supervision in the years preceding the fi-
nancial crisis,” p. 28.
53. “First the Put; Then the Cut?” Economist, December 16, 2000, p. 81.
564 Notes to Chapter 4

54. Fed Chairman Alan Greenspan, “Risk and Uncertainty in Monetary Policy,” remarks at the Meet-
ings of the American Economic Association, San Diego, California, January 3, 2004. See also Fed Gover-
nor Ben S. Bernanke, “Asset-Price ‘Bubbles’ and Monetary Policy,” remarks before the N.Y. Chapter of the
National Association of Business Economics, New York, October 15, 2002.
55. Fed Chairman Alan Greenspan, “Reflections on Central Banking,” remarks at a symposium spon-
sored by the Federal Reserve Board of Kansas City, Jackson Hole, Wyoming, August 26, 2005.
56. Lawrence Lindsey, interview by FCIC, September 20, 2010.
57. The NYSE decided in 1970 to allow members to be publicly traded. See Andrew von Norden-
flycht, “The Demise of the Professional Partnership? The Emergence and Diffusion of Publicly-Traded
Professional Service Firms” (draft paper, Faculty of Business, Simon Fraser University, September 2006),
pp. 20–21.
58. Peter Solomon, written testimony for the FCIC, First Public Hearing of FCIC, day 1, panel 2: Fi-
nancial Market Participants, January 13, 2010, p. 2.
59. Brian R. Leach, interview by FCIC, March 4, 2010, p. 22.
60. Jian Cai, Kent Cherny, and Todd Milbourn, “Compensation and Risk Incentives in Banking and
Finance,” Federal Reserve Bank of Cleveland Economic Commentary (September 14, 2010).
61. Carola Frydman and Raven E. Saks, “Historical Trends in Executive Compensation, 1936–2005”
(2007), p.3.
62. Cai, Cherny, and Milbourn, “Compensation and Risk Incentives in Banking and Finance.”
63. Goldman Sachs, 2006 and 2009 10-K; Morgan Stanley, 2008 10-K; Merrill Lynch, 2005 and 2008
10-K.
64. “Gutfreund’s Pay Is Cut,” New York Times, December 23, 1987.
65. Merrill Lynch, “2007 Proxy Statement,” p. 38.
66. Goldman Sachs, “Proxy Statement for 2008 Annual Meeting of Shareholders,” March 7, 2008, p.
16: Blankfein received $600,000 base salary and a 2007 year-end bonus of $67.9 million.
67. Lehman Brothers, “Proxy Statement for Year-end 2007,” p. 28; JP Morgan Chase, “2007 Proxy
Statement,” p. 16.
68. New York State Office of the State Comptroller, “New York City Securities Industry Bonus Pool,”
February 23, 2010. The bonus pool is for securities industry (NAICS 523) employees who work in New
York City.
69. “Banks Set for Record Pay, Top Firms on Pace to Award $145 Billion for 2009, Up 18%, WSJ Study
Finds,” WSJ.com, January 14, 2010.
70. Sandy Weill, interview by FCIC, October 4, 2010.
71. Lord Adair Turner, interview by FCIC, November 30, 2010.
72. Ben S. Bernanke, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact
of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 2,
session 1: The Federal Reserve, September 2, 2010, transcript, p. 111.
73. Testimony of Armando Falcon Jr., former director Office of Federal Housing Enterprise Over-
sight, written testimony for the FCIC, Hearing on Subprime Lending and Securitization and Govern-
ment-Sponsored Enterprises (GSEs), day 3, session 2: Office of Federal Housing Enterprise Oversight,
April 9, 2010, pp. 8–10.
74. Sheila C. Bair, written testimony for the FCIC, First Public Hearing of the FCIC, day 2, panel 1:
Current Investigations into the Financial Crisis—Federal Officials, January 14, 2010, p. 22.
75. Mary L. Schapiro, written testimony for the FCIC, First Public Hearing of the FCIC, day 2, panel
1: Current Investigations into the Financial Crisis—Federal Officials, January 14, 2010, p.18.
76. Bloomberg LLC, Financial Analysis Function, Public Filings for JPM, Citigroup, Bank of America,
Goldman Sachs, and Lehman Brothers.
77. Fannie Mae, SEC filings 10-K and 10-Q; see the 2009 10-K, p. 70, Total Assets and Fannie Mae MBS
held by Third Parties; Federal Housing Finance Agency, Report to Congress, 2008 (2009), pp. 111, 128.
78. FCIC staff calculations.
79. SNL Financial Database and SEC public filings.
80. Calculated from proxy statements.
81. John Snow, interview by FCIC, October 7, 2010.
82. Ibid.
 Notes to Chapter 5 565

Chapter 5
1. Gail Burks, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—State of
Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Estate, September 8, 2010, p. 3.
2. Tom C. Putnam, president, Putnam Housing Finance Consulting, written testimony for the FCIC,
Hearing on the Impact of the Financial Crisis—Sacramento, session 2: Mortgage Origination, Mortgage
Fraud and Predatory Lending in the Sacramento Region, September 23, 2010, pp. 3–4.
3. Board of Governors of the Federal Reserve System, Federal Reserve Statistical Release Z.1: Flow of
Funds Accounts of the United States, release date, December 9, 2010, Table L.1: Credit Market Debt Out-
standing, and Table L.126: Issuers of Asset-Backed Securities (ABS)
4. Jim Callahan, interview by FCIC, October 18, 2010.
5. Lewis Ranieri, former vice chairman of Salomon Brothers, interview by FCIC, July 30, 2010.
6. Federal Deposit Insurance Corporation, “Managing the Crisis: The FDIC and RTC Experience”
(August 1998), pp. 29, 6–7, 407–8, 38.
7. Ibid., 417.
8. Ibid., pp. 9, 32, 36, 48
9. The figures throughout this discussion of CMLTI 2006-NC2 are FCIC staff calculations, based on
analysis of loan-level data from Blackbox Inc. and Standard & Poor’s; Moody’s PDS database; Moody’s
CDO EMS database; and Citigroup, Fannie Mae Term Sheet, CMLTI 2006-NC2, September 7, 2006, pp.
1, 3. See also Brad S. Karp, counsel for Citigroup, letter to FCIC, November 4, 2010, p. 1, pp. 2–3. All rat-
ings of its tranches are as given by Standard & Poor’s.
10. Technically, this deal had two unrated tranches below the equity tranche, also held by Citigroup
and the hedge fund.
11. Fed Chairman Ben S. Bernanke, “The Community Reinvestment Act: Its Evolution and New
Challenges,” speech at the Community Affairs Research Conference, Washington, D.C., March 30, 2007.
12. Ibid.
13. See Glenn Canner and Wayne Passmore, “The Community Reinvestment Act and the Profitability
of Mortgage-Oriented Banks,” Working Paper, Federal Reserve Board, March 3, 1997. Under the Com-
munity Reinvestment Act, low- and moderate-income borrowers have income that is at most 80% of area
median income.
14. Fed Chairman Alan Greenspan, “Economic Development in Low- and Moderate-Income Com-
munities,” speech at Community Forum on Community Reinvestment and Access to Credit: California’s
Challenge, in Los Angeles, January 12, 1998.
15. John Dugan, interview by FCIC, March 12, 2010.
16. Lawrence B. Lindsey, interview by FCIC, September 20, 2010.
17. Souphala Chomsisengphet and Anthony Pennington-Cross, “The Evolution of the Subprime
Mortgage Market,” Federal Reserve Bank of St. Louis Review 88, no. 1 (January/February 2006): 40
18. Southern Pacific Funding Corp, Form 8-K, September 14, 1998
19. The top 10 list is as of 1996, according to FCIC staff calculations using data from the following
sources: Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 1, The Primary Mar-
ket (Bethesda, Md.: Inside Mortgage Finance Publications, 2009), p. 214, “Top 25 B&C Lenders in 1996”;
Thomas E. Foley, “Alternative Financial Ratios for the Effects of Securitization: Tools for Analysis,”
Moody’s Investor Services, September 19, 1997, p. 5; and Moody’s Investor Service, “Subprime Home Eq-
uity Industry Outlook—The Party’s Over,” Moody’s Global Credit Research, October 1998.
20. “FDIC Announces Receivership of First National Bank of Keystone, Keystone, West Virginia,”
Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency joint press release,
September 1, 1999.
21. FCIC staff calculations using data from Inside MBS & ABS.
22. See Marc Savitt, interview by FCIC, November 17, 2010.
23. Henry Cisneros, interview by FCIC, October 13, 2010.
24. Glenn Loney, interview by FCIC, April 1, 2010.
25. Senate Committee on Banking, Housing, and Urban Affairs, The Community Development, Credit
Enhancement, and Regulatory Improvement Act of 1993, 103rd Cong., 1st sess., October 28, 1993, S. Rep.
103–169, p. 18.
26. Ibid., p. 19.
566 Notes to Chapter 6

27. 15 U.S.C. § 1639(h) 2006.

28. Loans were subject to HOEPA only if they hit the interest rate trigger or fee trigger: i.e., if the an-
nual percentage rate for the loan was more than 10 percentage points above the yield on Treasury securi-
ties having a comparable maturity or if the total charges paid by the borrower at or before closing
exceeded $400 or 8% of the loan amount, whichever was greater. See Senate Committee on Banking,
Housing, and Urban Affairs, S. Rep. 103–169, p. 54.
29. Ibid., p. 24.
30. Board of Governors of the Federal Reserve System and Department of Housing and Urban Devel-
opment, “Joint Report Concerning Reform to the Truth in Lending Act and the Real Estate Settlement
Procedures Act” (July 1998), p. 56.
31. Griffith L. Garwood, director, Division of Consumer and Community Affairs, Board of Gover-
nors of the Federal Reserve System, “To the Officers and Managers in Charge of Consumer Affairs Ex-
amination and Consumer Complaint Programs,” Consumer Affairs Letter CA 98–1, January 20, 1998
32. GAO, “Large Bank Mergers: Fair Lending Review Could Be Enhanced with Better Coordination,”
GAO/GGD-00–16 (Report to the Honorable Maxine Waters and the Honorable Bernard Sanders, House
of Representatives), November 1999, p. 20.
33. Fed and HUD, “Joint Report,” pp. I–XXVII.
34. Griffith L. Garwood, director, Division of Consumer and Community Affairs, Board of Gover-
nors of the Federal Reserve System, memorandum to the Committee on Consumer and Community Af-
fairs, “Memorandum concerning the Board’s Report to the Congress on the Truth in Lending and Real
Estate Settlement Procedures Acts,” April 8, 1998, p. 42.
35. Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office
of the Comptroller of the Currency, and Office of Thrift Supervision, “Interagency Guidance on Sub-
prime Lending” (March 1, 1999), p. 1
36. Ibid., pp. 1–7; quotation, p. 5.
37. U.S. Department of the Treasury and U.S. Department of Housing and Urban Development,
“Curbing Predatory Home Lending” (June 1, 2000), pp. 13–14, 1–2, 81 (quotations, 2, 1–2).
38. Gail Burks, president and chief executive officer, Nevada Fair Housing Center, Inc., testimony be-
fore the FCIC, Hearing on the Impact of the Financial Crisis—State of Nevada, session 3: The Impact of
the Financial Crisis on Nevada Real Estate, September 8, 2010, transcript, p. 242–43.See also Kevin Stein,
associate director, California Reinvestment Coalition, written testimony for the FCIC, Hearing on the
Impact of the Financial Crisis—Sacramento, session 2: Mortgage Origination, Mortgage Fraud and
Predatory Lending in the Sacramento Region, September 23, 2010, pp. 8–9. See also his testimony at the
same hearing, transcript, pp. 73–74. See Diane E. Thompson, of counsel, National Consumer Law Cen-
ter, Inc., and Margot F. Saunders, of counsel, National Consumer Law Center, Inc., interview by FCIC,
September 10, 2010.
39. Diane E. Thompson and Margot F. Saunders, both of counsel, National Consumer Law Center, in-
terview by FCIC, September 10, 2010.
40. Gary Gensler, interview by FCIC, May 14, 2010.
41. Sheila Bair, testimony before the FCIC, First Public Hearing of the FCIC, day 2, panel 1: Current
Investigations into the Financial Crisis—Federal Officials, January 14, 2010, transcript, p. 97.
42. Sheila Bair, interview by FCIC, March 29, 2010.
43. Sandra F. Braunstein, interview by FCIC, April 1, 2010, pp. 31–34.
44. Bair, interview.
45. Treasury and HUD, “Curbing Predatory Home Lending,” p. 31.

Chapter 6
1. Figures represented the compound average growth rate and FCIC staff calculations from CoreLogic
National Home Price Index, Single-Family Combined (SCF); CoreLogic Loan Performance HPI August
2010.
2. Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 1, The Primary Market
(Bethesda, Md.: Inside Mortgage Finance, 2009), p. 4, “Mortgage Originations by Product.”
3. Federal Reserve Board press release, May 27, 2004.
 Notes to Chapter 6 567

4. Fed Governor Ben S. Bernanke, “The Great Moderation,” remarks at the meetings of the Eastern
Economic Association, Washington, D.C., February 20, 2004. See also Olivier Blanchard and John Si-
mon, “The Long and Large Decline in U.S. Output Volatility,” Brookings Papers on Economic Activity, no.
1 (2001): 135–64.
5. Fed Governor Ben S. Bernanke, “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” remarks before
the National Economists Club, Washington, D.C., November 21, 2002.
6. FCIC staff calculations from Board of Governors of the Federal Reserve System, H.15 Selected In-
terest Rate release, 3-month AA Nonfinancial Commercial Paper Rate, WCPN3M (weekly, ending Fri-
day); U.S. Department of Treasury, Daily Treasury Yield Curve Rates, 1990 to Present.
7. This example assumes that the homeowner is able to come up with a larger down payment to cover
20% of the higher-priced home. Here, the difference would be about $13,000.
8. Federal Housing Finance Agency, “Data on the Risk Characteristics and Performance of Single-
Family Mortgages Originated from 2001 through 2008 and Financed in the Secondary Market” (Septem-
ber 13, 2010), Table 2a: Share of Single-Family Mortgages Originated from 2001 through 2008 and
Acquired by the Enterprises or Finances with Private-Label MBS by Loan-to-Value Ratio and Borrower
FICO Score at Origination, Adjustable-Rate Mortgages, p. 22. Prime borrowers are defined as those
whose mortgages are financed by the government-sponsored enterprises.
9. Yuliya Demyanyk and Otto Van Hemert, “Understanding the Subprime Mortgage Crisis” (Decem-
ber 5, 2008), table 1: Loan Characteristics at Origination for Different Vintages, p. 7.
10. FCIC staff calculations from CoreLogic/First American, Home Price Index for Single-Family
Combined State HPI data, last updated August 2010, and CoreLogic State Home Price Index, provided to
the FCIC by CoreLogic. Staff calculations of all annual growth rates are compound annual growth rates
from January to January.
11. U.S. Census Bureau, “Housing Vacancies and Homeownership, CPS/HVS,” Table 14: Homeowner-
ship Rates for the US 1965 to Present.
12. Brian K. Bucks, Arthur B. Kennickell, and Kevin B. Moore, “Recent Changes in US Family Fi-
nances: Evidence from the 2001 and 2004 Survey of Consumer Finances,” Federal Reserve Bulletin (2006):
Tables 8A and 8B, pp. A20–A23, A8.
13. Congressional Budget Office, “Housing Wealth and Consumer Spending,” Background Paper, Jan-
uary 2007, p. 15.
14. Mortgages may have been refinanced more than once in that year.
15. FCIC staff calculations with updated data provided by Alan Greenspan and James Kennedy,
whose data originally appeared in “Sources and Uses of Equity Extracted from Homes,” Finance and Eco-
nomics Discussion Series, Federal Reserve Board, 2007-20 (March 2007).
16. CBO, “Housing Wealth and Consumer Spending,” p. 2.
17. Fed Chairman Alan Greenspan, “The Economic Outlook,” prepared testimony before the Joint
Economic Committee, 107th Cong., 2nd sess., November 13, 2002.
18. Fed Chairman Alan Greenspan, “Federal Reserve Board’s Semiannual Monetary Policy Report to
the Congress,” prepared testimony before the House Committee on Financial Services, 108th Cong., 2nd
sess., February 12, 2004.
19. FCIC staff calculations from 2009 Mortgage Market Statistical Annual, 1:4, “Mortgage Origina-
tions by Product” (total subprime volume); 2:13, “Non-Agency MBS Issuance by Type” (subprime PLS).
20. Ibid., 1:3, “Mortgage Origination Indicators”; 220, 227, “Mortgage Originations by Product.”
21. Bart McDade, interview by FCIC, April 16, 2010.
22. Presentation to the Lehman Board of Directors, March 20, 2007. Lehman had also acquired three
international lenders during this time period.
23. New Century, 1999 10-K, March 30, 2000, p. 2.
24. Final Report of Michael J. Missal, Bankruptcy Court Examiner, in RE: New Century TRS Hold-
ings, Chapter 11, Case No. 07-10416 (KJC), (Bankr. D.Del.), February 29, 2008, p 42.
25. New Century, 2000 10-K, April 2, 2001, p. 15; New Century, 2003 10-K, March 15, 2004, p. 13.
Rankings from 2009 Mortgage Market Statistical Annual, 1:220, 223.
26. Aseem Mital and Angelo Mozilo, quoted in Erick Bergquist, “Under Scrutiny, Ameriquest Details
Procedures,” American Banker 170, no. 125 (June 30, 2005): 1. Volume and rankings from 2009 Mortgage
Market Statistical Annual, 1:220, 223.
568 Notes to Chapter 6

27. Lewis Ranieri, interview by FCIC, July 30, 2010.

28. James M. Lacko and Janis K. Pappalardo, “The Effect of Mortgage Broker Compensation Disclo-
sures on Consumers and Competition: A Controlled Experiment,” Federal Trade Commission Bureau of
Economics Staff Report (February 2004), p. 1.
29. Jay Jeffries, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—State of
Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Estate, September 8, 2010, tran-
script, p. 177.
30. Brian Bucks and Karen Pence, “Do Borrowers Know Their Mortgage Terms?” Journal of Urban
Economics 64 (2008): 223.
31. Michael Calhoun and Julia Gordon, interview by FCIC, September 16, 2010.
32. Annamaria Lusardi, “Americans’ Financial Capability,” report prepared for the FCIC, February 26,
2010, p. 3.
33. FCIC staff estimates based on analysis of Blackbox, S&P, and IP Recovery, provided by Antje
Berndt, Burton Hollifield, and Patrik Sandas, in their paper, “The Role of Mortgage Brokers in the Sub-
prime Crisis,” April 2010.
34. William C. Apgar and Allen J. Fishbein, “The Changing Industrial Organization of Housing Fi-
nance and the Changing Role of Community-Based Organizations,” working paper (Joint Center for
Housing Studies, Harvard University, May 2004), p. 9.
35. Herb Sandler, interview by FCIC, September 22, 2010.
36. Wholesale Access, “Mortgage Brokers 2006” (August 2007), pp. 35, 37.
37. Jamie Dimon, testimony before the FCIC, First Public Hearing of the FCIC, panel 1: Financial In-
stitution Representatives, January 13, 2010, transcript, p. 13.
38. October Research Corporation, executive summary of the 2007 National Appraisal Survey, p. 4.
39. Dennis J. Black, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—
Miami, session 2: Uncovering Mortgage Fraud in Miami, September 21, 2010, p. 8.
40. Karen J. Mann, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—
Sacramento, session 2: Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacramento
Region, September 23, 2010, p. 2.
41. Gary Crabtree, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—
Greater Bakersfield, session 4: Local Housing Market, September 7, 2010, transcript, p. 172.
42. Complaint, People of the State of New York v. First American Corporation and First American
eAppraiseIT (N.Y. Sup. Ct. November 1, 2007), pp. 3, 7, 8.
43. Martin Eakes, quoted in Richard A. Oppel Jr. and Patrick McGeehan, “Along with a Lender, Is
Citigroup Buying Trouble?” New York Times, October 22, 2000.
44. Pam Flaherty, quoted in Erick Bergquist, “Judging Citi, a Year Later: Subprime Reform ‘on Track’;
Critics Unsatisfied,” American Banker, September 10, 2001.
45. “Citigroup Settles FTC Charges against the Associates Record-Setting $215 Million for Subprime
Lending Victims,” Federal Trade Commission press release, September 19, 2002.
46. Mark Olson, interview by FCIC, October 4, 2010.
47. Timothy O’Brien, “Fed Assess Citigroup Unit $70 Million in Loan Abuse,” The New York Times,
May 28, 2004.
48. Federal Reserve Board internal staff document, “The Problem of Predatory Lending,” December
5, 2000, pp. 10–13.
49. Federal Reserve Board, Morning Session of Public Hearing on Home Equity Lending, July 27,
2000, opening remarks by Governor Gramlich, p. 9.
50. Scott Alvarez, interview by FCIC, March 23, 2010.
51. Alan Greenspan, written testimony for the FCIC, Hearing on Subprime Lending and Securitiza-
tion and Government-Sponsored Enterprises (GSEs), day one, session 1: The Federal Reserve, April 7,
2010, p. 13.
52. Alan Greenspan, quoted in David Faber, And Then the Roof Caved In: How Wall Street’s Greed and
Stupidity Brought Capitalism to Its Knees (Hoboken, N.J.: Wiley, 2009), pp. 53–54.
53. “Truth in Lending,” Federal Register 66, no. 245 (December 20, 2001): 65612 (quotation), 65608.
 Notes to Chapter 6 569

54. Robert B. Avery, Glenn B. Canner, and Robert E. Cook, “New Information Reported under
HMDA and Its Application in Fair Lending Enforcement,” Federal Reserve Bulletin 91 (Summer 2005):
372.
55. Alan Greenspan, interview by FCIC, March 31, 2010
56. Sheila Bair, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of
Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 2, ses-
sion 2: Federal Deposit Insurance Corporation, September 2, 2010, transcript, p. 191.
57. Dolores Smith and Glenn Loney, memorandum to Governor Edward Gramlich, “Compliance In-
spections of Nonbank Subsidiaries of Bank Holding Companies,” August 31, 2000.
58. GAO, “Consumer Protection: Federal and State Agencies Face Challenges in Combating Preda-
tory Lending,” GAO 04–280 (Report to the Chairman and Ranking Minority Member, Special Commit-
tee on Aging, U.S. Senate), January 2004, pp. 52–53.
59. Sandra Braunstein, interview by FCIC, April 1, 2010. Transcript pp. 32–33.
60. Greenspan, interview.
61. Ibid.
62. Edward M. Gramlich, “Booms and Busts: The Case of Subprime Mortgages,” Federal Reserve Bank
of Kansas City Economic Review (2007): 109.
63. Edward Gramlich, quoted in Greg Ip, “Did Greenspan Add to Subprime Woes? Gramlich Says Ex-
Colleague Blocked Crackdown On Predatory Lenders Despite Growing Concerns,” Wall Street Journal,
June 9, 2007. See also Edmund L. Andrews, “Fed Shrugged as Subprime Crisis Spread,” New York Times,
December 18, 2007.
64. Patricia McCoy and Margot Saunders, quoted in Binyamin Appelbaum, “Fed Held Back as Evi-
dence Mounted on Subprime Loan Abuses,” Washington Post, September 27, 2009.
65. GAO, “Large Bank Mergers: Fair Lending Review Could be Enhanced with Better Coordination,”
GAO/GDD-00-16 (Report to the Honorable Maxine Waters and Honorable  Bernard Sanders, House of
Representatives), November 1999; GAO, “Consumer Protection:  Federal and State Agencies Face Chal-
lenges in Combating Predatory Lending.”
66. “Federal and State Agencies Announce Pilot Project to Improve Supervision of Subprime Mort-
gage Lenders,” Joint press release (Fed Reserve Board, OTC, FTC, Conference of State Bank Supervisors,
American Association of Residential Mortgage Regulators), July 17, 2007.
67. “Truth in Lending,” pp. 44522–23. “Higher-priced mortgage loans” are defined in the 2008 regula-
tions to include mortgage loans whose annual percentage rate exceeds the “average prime offer rates for a
comparable transaction” (as published by the Fed) by at least 1.5% for first-lien loans or 3.5% for subordi-
nate-lien loans.
68. Alvarez, interview.
69. Raphael W. Bostic, Kathleen C. Engel, Patricia A. McCoy, Anthony Pennington-Cross, and Susan
M. Wachter, “State and Local Anti-Predatory Lending Laws: The Effect of Legal Enforcement Mecha-
nisms,” Journal of Economics and Business 60 (2008): 47–66.
70. “Lending and Investment,” Federal Register 61, no. 190 (September 30, 1996): 50965.
71. Joseph A. Smith, “Mortgage Market Turmoil: Causes and Consequences,” testimony before the
Senate Committee on Banking, Housing, and Urban Affairs, 110th Cong., 1st sess., March 22, 2007, p. 33
(Exhibit B), using data from the Mortgage Asset Research Institute.
72. Lisa Madigan, written testimony for the FCIC, First Public Hearing of the FCIC, day 2, panel 2:
Current Investigations into the Financial Crisis—State and Local Officials, January 14, 2010, p.12.
73. Commitments compiled at National Community Reinvestment Coalition, “CRA Commitments”
(2007).
74. Josh Silver, NCRC, interview by FCIC, June 16, 2010.
75. Data references based on Reginald Brown, counsel for Bank of America, letter to FCIC, June 16,
2010, p. 2; Jessica Carey, counsel for JPMorgan Chase, letter to FCIC, December 16, 2010; Brad Karp,
counsel for Citigroup, letter to FCIC, March 18, 2010, in response to FCIC request; Wells Fargo public
commitments 1990–2010, data provided by Wells Fargo to the FCIC.
76. Karp, letter to FCIC, March 18, 2010, in response to FCIC request.
77. Carey, letter to FCIC, December 16, 2010, p. 9; Brad Karp, counsel for JP Morgan, letter to FCIC,
May 26, 2010, p. 10.
570 Notes to Chapter 7

78. FCIC calculation based on Federal Housing Finance Agency, “Data on the Risk Characteristics
and Performance of Single-Family Mortgages Originated in 2001–2008 and Financed in the Secondary
Market” (August 2010), Table 1-C; this report covers all loans purchased or securitized by the GSEs or in
private-label securitizations. Delinquency data provided by Wells Fargo covered 81% of loans.
79. “Orders Issued Under the Bank Holding Company Act,” Federal Reserve Bulletin 75, no. 4 (April
1989): 304.
80. “Statement of the Federal Financial Supervisory Agencies Regarding the Community Reinvest-
ment Act,” Federal Register 54 (April 5, 1989): 13742. This remains the interagency policy. “Community
Reinvestment Act: Interagency Questions and Answers Regarding Community Reinvestment; Notice,”
Federal Register 75 (March 11, 2010): 11666.
81. Glenn Loney, interview by FCIC, April 1, 2010.
82. “Community Reinvestment Act Regulations and Home Mortgage Disclosure; Final Rules,” Federal
Register 60, no. 86 (May 4, 1995): 22155–223.
83. Division of Consumer and Community Affairs, memorandum to Board of Governors, August 10,
1998.
84. Federal Reserve Board press release, “Order Approving the Merger of Bank Holding Companies,”
August 17, 1998, pp. 63–64.
85. Lloyd Brown, interview by FCIC, February 5, 2010.
86. Andrew Plepler, interview by FCIC, July 14, 2010.
87. Assuming 75% AAA tranche ($1.20), 10% AA tranche ($0.20), 8% A tranche ($0.30), 5% BBB
tranche ($0.40), and 2% equity tranche ($2.00). See Goldman Sachs, “Effective Regulation: Part 1, Avoid-
ing Another Meltdown,” March 2009, p. 22.
88. David Jones, interview by FCIC, October 19, 2010. See David Jones, “Emerging Problems with the
Basel Capital Accord: Regulatory Capital Arbitrage and Related Issues,” Journal of Banking and Finance
24, nos. 1–2 (January 2000): 35–58.
89. Henry Paulson, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, ses-
sion 1: Perspective on the Shadow Banking System, May 6, 2010), transcript, p. 34.
90. Jones, interview.

Chapter 7
1. For example, an Alt-A loan may have no or limited documentation of the borrower’s income, may
have a high loan-to-value ratio (LTV), or may be for an investor-owned property.
2. Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 2, The Secondary Mar-
ket (Bethesda, MD: Inside Mortgage Finance, 2009), p. 9, “Mortgage & Asset Securities Issuance” (show-
ing Wall St. securitizing a third more than Fannie and Freddie); p. 13, “Non-Agency MBS Issuance by
Type.” FCIC staff calculations from 2004 to 2006 (for growth in private label MBS).
3. Charles O. Prince, interview by FCIC, March 17, 2010.
4. John Taylor, interview by FCIC, September 23, 2010.
5. William A. Fleckenstein and Frederick Sheeham, Greenspan’s Bubbles: The Age of Ignorance at the
Federal Reserve (New York: McGraw-Hill, 2008), p. 181.
6. Alan Greenspan, “The Fed Didn’t Cause the Housing Bubble,” Wall Street Journal, March 11, 2009.
See also Ben Bernanke, “Monetary Policy and the Housing Bubble,” speech at the Annual Meeting of the
American Economic Association, Atlanta, Georgia, January 3, 2010.
7. Alan Greenspan, testimony before the Senate Committee on Banking, Housing, and Urban Affairs,
109th Cong., 1st sess., February 16, 2005.
8. Fed Chairman Ben S. Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit,” re-
marks at the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, March 10,
2005.
9. Frederic Mishkin, interview by FCIC, October 1, 2010.
10. Pierre-Olivier Gourinchas, written testimony for the FCIC, Forum to Explore the Causes of the
Financial Crisis, day 1, session 2: Macroeconomic Factors and U.S. Monetary Policy, February 26, 2010,
pp. 25–26. .
11. Paul Krugman, interview by FCIC, October 6, 2010.
 Notes to Chapter 7 571

12. Ellen Schloemer, Wei Li, Keith Ernst, and Kathleen Keest, “Losing Ground: Foreclosures in the
Subprime Market and Their Cost to Homeowners,” Center for Responsible Lending, December 2006,
p. 22.
13. 2009 Mortgage Market Statistical Annual, vol. 1, The Primary Market, p. 4, “Mortgage Originations
by Product.”
14. Christopher Mayer, Karen Pence, and Shane M. Sherlund, “The Rise in Mortgage Defaults,” Jour-
nal of Economic Perspectives 23, no. 1 (Winter 2009): Table 2, Attributes for Mortgages in Subprime and
Alt-A Pools, p. 31.
15. 2009 Mortgage Market Statistical Annual, 2:13, “Non-Agency MBS Issuance by Type.”
16. 2009 Mortgage Market Statistical Annual, 1:6, “Alternative Mortgage Originations”; previous data
extrapolated in FCIC estimates from Golden West, Form 10-K for fiscal year 2005, and Federal Reserve,
“Residential Mortgage Lenders Peer Group Survey: Analysis and Implications for First Lien Guidance,”
November 30, 2005.
17. Inside Mortgage Finance.
18. Countrywide, 2005 Form 10-K, p. 39; 2007 Form 10-K, p. 47 (showing the growth in Country-
wide’s originations).
19. Angelo Mozilo, email to Sambol and Kurland re: Sub-prime Seconds. See also Angelo Mozilo,
email to Sambol, Bartlett, and Sieracki, re: “Reducing Risk, Reducing Cost,” May 18, 2006; Angelo
Mozilo, interview by FCIC. September 24, 2010.
20. David Sambol, interview by FCIC, September 27, 2010.
21. See Countrywide, Investor Conference Call, January 27, 2004, transcript, p. 5. See also Jody
Shenn, “Countrywide Adding Staff to Boost Purchase Share,” American Banker, January 28, 2004.
22. Patricia Lindsay, written testimony for the FCIC, hearing on Subprime Lending and Securitization
and Government-Sponsored Enterprises (GSEs), day 1, sess. 2: Subprime Origination and Securitization,
April 7, 2010, p. 3
23. Andrew Davidson, interview by FCIC, October 29, 2020.
24. Ibid.
25. David Berenbaum, testimony before Senate Committee on Banking, Subcommittee on Housing,
Transportation and Community Development, 110th Cong., 1st sess., June 26, 2007.
26. Email and data attachment from former Golden West employee to FCIC, subject: “re: Golden
West Estimated Volume of Adjustable Rate Mortgage Originations,” December 6, 2010.
27. Herbert Sandler, interview by FCIC, September 22, 2010.
28. Washington Mutual, “Option ARM Focus Groups—Phase II,” September 17, 2003; Washington
Mutual, “Option ARM Focus Groups—Phase I,” August 14, 2003, Exhibits 35 and 36 in Senate Perma-
nent Subcommittee on Investigations, exhibits, Wall Street and the Financial Crisis: The Role of High Risk
Home Loans, 111th Cong., 2nd sess., April 13, 2010 (hereafter cited as PSI Documents), PDF pp. 330–51,
available at http://hsgac.senate.gov/public/_files/Financial_Crisis/041310Exhibits.pdf.
29. PSI Documents, Exhibits 35 and 36 pp. 330–51.
30. Ibid., pp. 330–51, 334.
31. Ibid., p. 345.
32. Ibid., p. 346.
33. Washington Mutual, “Option ARM Credit Risk,” August 2006, PSI Document Exhibit 37, p. 366.
34. PSI Documents Exhibit 37, p. 366, showing average FICO score of 698; p. 356; comparing con-
forming and jumbo originations.
35. Ibid., p. 357.
36. Document listing Countrywide originations by quarter from 2003 to 2007, provided by Bank of
America.
37. Countrywide October 2003 Loan Program Guide (depicting a maximum CLTV of 80 and mini-
mum FICO of 680) and July 2004 Loan Program Guide (showing 90% 620 FICO).
38. Countrywide Loan Program Guide, dated March 7, 2005.
39. Federal Reserve, “Residential Mortgage Lenders Peer Group Survey: Analysis and Implications for
First Lien Guidance,” November 30, 2005, pp. 6, 8.
40. Angelo Mozilo, email to Carlos Garcia (cc: Stan Kurland), Subject: “Bank Assets,” August 1, 2005.
572 Notes to Chapter 7

41. Angelo Mozilo, email to Carlos Garcia (cc: Kurland), subject: “re: Fw: Bank Assets,” August 2,
2005.
42. Countrywide, 2005 Form 10-K, p. 57; 2007 Form 10-K, p. F-45.
43. See Washington Mutual, 2006 Form 10-K, p. 53.
44. John Stumpf, interview by FCIC, September 23, 2010.
45. Countrywide, 2007 Form 10-K, p. F-45; 2005 Form 10-K, p. 57
46. Washington Mutual, 2007 Form 10-K, p. 57; 2005 Form 10-K, p. 55
47. Kevin Stein, testimony before the FCIC, Sacramento Hearing on the Impact of the Financial
Crisis–San Francisco, day 1, session 2: Mortgage Origination, Mortgage Fraud and Predatory Lending in
the Sacramento Region, September 23, 2010, transcript, p. 72.
48. Mona Tawatao, in ibid., p. 228.
49. Real Estate Lending Standards, Federal Register 57 (December 31, 1992): 62890.
50. Ibid.
51. Office of the Comptroller of the Currency, Board of Governors of the Federal Deposit Insurance
Corporation, Office of Thrift Supervision, “Real Estate Lending Standards: Final Rule,” SR 93–1, January
11, 1993.
52. Office of the Comptroller of the Currency, Board of Governors of the Federal Deposit Insurance
Corporation, Office of Thrift Supervision, “Interagency Guidance on High LTV Residential Real Estate
Lending,” October 8, 1999.
53. Final Report of Michael J. Missal, Bankruptcy Court Examiner, In RE: New Century TRS Hold-
ings, Chapter 11, Case No. 07-10416 (KJC), (Bankr. D.Del.), February 29, 2008, pp. 128, 149, 128.
54. Yuliya Demyanyk and Otto Van Hemert, “Understanding the Subprime Mortgage Crisis,” Review
of Financial Studies, May 2009.
55. Sandler, interview.
56. CoreLogic loan performance data for subprime and Alt-A loans, and CoreLogic total outstanding
loans servicer data provided to the FCIC.
57. Christopher Mayer, Karen Pence, and Shane M. Sherlund, “The Rise in Mortgage Defaults,” Jour-
nal of Economic Perspectives 23, no. 1 (Winter 2009): 32.
58. William Black, testimony for the FCIC, Miami Hearing on the Impact of the Financial Crisis, day
1, session 1: Overview of Mortgage Fraud, September 21, 2010, p. 27.
59. Richard Bowen, interview by FCIC, February 27, 2010.
60. Jamie Dimon, testimony before the FCIC, January 13, 2010, p. 60.
61. This particular deal would be described as an excess-spread over-collateralized-based credit en-
hancement structure; see Gary Gorton, “The Panic of 2007,” paper presented at the Federal Reserve Bank
of Kansas City’s Jackson Hole Conference, August 2008, p. 23.
62. FCIC staff estimates based on analysis of data from BlackBox, S&P, and Bloomberg. The prospec-
tive loan pool for this deal originally contained 4,507 mortgages. Eight of these had been dropped from
the pool by the time the bonds were issued. Therefore, these estimates may differ slightly from those re-
ported in the deal prospectus because these estimates are based on a pool of 4,499 loans.
63. Ibid.
64. Federal Register 69 (January 7, 2004): 1904. The rules were issued in proposed form at Federal Reg-
ister 68 (August 5, 2003): 46119.
65. See OTS Opinion re California Minimum Payment Statute, October 1, 2002, p. 6.
66. Comptroller of the Currency John Hawke, remarks before Women in Housing and Finance,
Washington, D.C., February 12, 2002, attached to OCC News Release 2002-10, p. 2.
67. John Hawke, quoted in Jess Bravin and Paul Beckett, “Friendly Watchdog: Federal Regulator Of-
ten Helps Banks Fighting Consumers,” Wall Street Journal, January 28, 2002.
68. Oren Bar-Gill and Elizabeth Warren, “Making Credit Safer,” University of Pennsylvania Law Re-
view 157 (2008): 182-83, 192-94.
69. See Watters v. Wachovia Bank NA, 550 U.S. 1 (2007).
70. John Dugan, testimony before the FCIC, Public Hearing on Subprime Lending and Securitization
and Government-Sponsored Enterprises (GSEs), day 2, session 2: Office of the Comptroller of the Cur-
rency, April 8, 2010, transcript, p. 150.
71. Lisa Madigan, testimony before the FCIC, First Public Hearing of the FCIC, day 2, panel 2: Inves-
tigations into the Financial Crisis—State and Local Officials, January 14, 2010, transcript, p. 104.
 Notes to Chapter 7 573

72. John D. Hawke Jr., written testimony for the FCIC, Public Hearing on Subprime Lending and Se-
curitization and Government-Sponsored Enterprises (GSEs), day 2, session 2: Office of the Comptroller
of the Currency, April 8, 2010, p. 6.
73. Citigroup Warehouse Lines of Credit with Mortgage Originators, in Global Securitized Markets,
2000–2010 (revised), produced by Citigroup; staff calculations.
74. Charles O. Prince, interview by FCIC, March 17, 2010.
75. Moody’s Special Report, “The ABCP Market in the Third Quarter of 1998,” February 2, 1999.
76. Moody’s 2007 Review and 2008 Outlook: US Asset-backed Commercial Paper, February 27, 2008.
77. Moody’s ABCP Reviews of Park Granada and Park Sienna.
78. Moody’s ABCP Program Review: Park Granada, July 16, 2007.
79. Letters from the American Securitization Forum (November 17, 2003) and State St. Bank
(November 14, 2003) to the Office of Thrift Supervision.
80. Darryll Hendricks, interview by FCIC, August 6, 2010.
81. Citi August 29, 2006, Loan Sale.
82. Correspondence between Citi and New Century provided to FCIC. FCIC staff estimates from
prospectus and Citigroup production dated November 4, 2010. Citi August 29, 2006, Loan Sale.
83. Fannie Mae Term Sheet.
84. For the more than 20 institutional investors around the world, see Citigroup letter to the FCIC re
Senior Investors, October 14, 2010. The $582 million figure is based on FCIC staff estimates that, in turn,
were based on analysis of Moody’s PDS database.
85. See Brad S. Karp, counsel for Citigroup, letter to FCIC, about senior investors, October 14, 2010,
p. 2. See also Eric S. Goldstein, counsel for JPMorgan Chase & Co., letter to FCIC, November 16, 2010.
86. Citigroup letter to the FCIC, November 4, 2010.
87. See, e.g., Simon Kennedy, “BNP Suspends Funds Amid Credit-Market Turmoil,” August 9, 2007.
(www.marketwatch.com/story/bnp-suspends-fund-valuations-amid-credit-market-turmoil).
88. See Brad S. Karp, letter to FCIC, about mezzanine investors, November 4, 2010, p. 1. The equity
tranches were not offered for public sale but were retained by Citigroup.
89. FCIC staff estimates from prospectus and Citigroup production dated November 4, 2010.
90. Patricia Lindsay, interview by FCIC, March 24, 2010.
91. PSI Documents, Exhibit 59a: “Long Beach Mortgage Production, Incentive Plan 2004,” and Ex-
hibit 60a (quoting page 2 of WaMu Home Loans Product Strategy PowerPoint presentation).
92. John M. Quigley, “Compensation and Incentives in the Mortgage Business,” Economists’ Voices
(The Berkeley Electronic Press, October 2008), p. 2.
93. Barclays Capital, Bear Stearns, BNP Paribas, Citigroup, Deutsche Bank, Goldman Sachs, HSBC,
JPMorgan, Lehman Brothers, Morgan Stanley, and UBS.
94. Figures are average top-tier pay worldwide in mortgages and MBS sales and trading. See Options
Group, “2005 Global Financial Market Overview & Compensation Report” (October 2005), pp. 42, 52;
Options Group, “2006 Global Financial Market Overview & Compensation Report” (November 2006),
pp. 59, 69; and Options Group, “2007 Global Financial Market Overview & Compensation Report” (No-
vember 2007), pp. 73, 82.
95. See Merrill Lynch, 2007 Proxy Statement, p. 46.
96. See FCIC staff analysis of Moody’s Form 10-Ks for years 2005, 2006, and 2007.
97. See FCIC staff calculations based on Moody’s Form 10-Ks for years 2003–07.
98. “Moody’s Expands Moody’s Mortgage Metrics to Include Subprime Residential Mortgages,” Sep-
tember 6, 2006; FCIC staff estimate based on analysis of Moody’s SFDRS and PDS databases.
99. The ratings from the three agencies measure slightly different credit risk characteristics. S&P and
Fitch base their ratings on the probability that a borrower will default; Moody’s bases its ratings on the
expected loss to the investor. Despite such differences, investors and regulators tend to view the ratings as
roughly equivalent. Ratings are divided into two categories: investment grade securities are rated BBB- to
AAA, while securities rated below BBB- are considered speculative and are also referred to as junk (for
S&P; similar levels for Moody’s are Baa to triple-A).
100. Richard Cantor and Frank Packer, “The Credit Rating Industry,” FRBNY Quarterly Review (Sum-
mer–Fall 1994): 6.
574 Notes to Chapter 7

101. Andrew J. Donahue, director, Division of Investment Management, SEC, “Speech by SEC Staff:
Opening Remarks before the Commission Open Meeting,” Washington, DC, June 25, 2008. See also
Lawrence J. White, “Markets: The Credit Rating Agencies,” Journal of Economic Perspectives 24, no. 2
(Spring 2010): 214.
102. Lewis Ranieri, interview by FCIC, July 30, 2010.
103. Eric Kolchinsky, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the In-
vestment Decisions Made Based on Those Ratings, and the Financial Crisis, session 1: The Ratings
Process, June 2, 2010, transcript, pp. 19–20.
104. See 15 U.S.C. 78o-7(c)(2).
105. Jerome S. Fons, testimony before the House Committee on Oversight and Government Reform,
110th Cong., 2nd sess., October 22, 2008, p. 2.
106. Arnold Cattani, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—
Greater Bakersfield, session 2: Local Banking, transcript, p. 60.
107. Gary Witt, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the Invest-
ment Decisions Made Based on Those Ratings, and the Financial Crisis, session 1: The Ratings Process,
June 2, 2010, transcript, p. 41.
108. Moody’s Investors Service, “Introducing Moody’s Mortgage Metrics: Subprime Just Became
More Transparent,” September 7, 2009.
109. David Teicher, Moody’s Investors Service, interview by FCIC, May 4, 2010; “Moody’s Mortgage
Metrics: A Model Analysis of Residential Mortgage Pools,” April 1, 2003.
110. Jay Siegel, interview by FCIC, May 26, 2010.
111. Teicher, interview.
112. Jay Siegel, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the Invest-
ment Decisions Made Based on Those Ratings, and the Financial Crisis, session 1: The Ratings Process,
June 2, 2010, transcript, p. 29.
113. Roger Stein, interview by FCIC, May 26, 2010.
114. Moody’s Investors Service, “Introducing Moody’s Mortgage Metrics.”
115. Stein, interview.
116. Jerome Fons, interview by FCIC, April 22, 2010.
117. Moody’s Rating Committee Memorandum, August 29, 2006.
118. FCIC staff estimates based on analysis of Moody’s PDS database.
119. Invoice from Moody’s Investors Service to Susan Mills, Citigroup Global Markets Inc., October
12, 2006.
120. Standard & Poor’s, Global New Issue Billing Form, Citigroup Mortgage Loan Trust 2006-NC2,
September 28, 2006.
121. FCIC staff estimates based on analysis of Moody’s SFDRS data as of April 2010.
122. Chris Cox, SEC chairman, prepared testimony before the Senate Banking Committee, 109th
Cong., 2nd sess., June 15, 2006; “Freddie Mac, Four Former Executives Settle SEC Action Relating to
Multi-Billion Dollar Accounting Fraud,” SEC press release, September 27, 2007.
123. James Lockhart, director, FHFA, speech to American Securitization Forum in Las Vegas, New
Mexico, February 9, 2009 (p. 2, slide 4 of presentation shows the chart).
124. OFHEO Special Examination Report, December 2003.
125. In 2006, OFHEO issued its final Report of the Special Examination of Fannie Mae. OFHEO said
that management engaged in numerous acts of misconduct, involving well over a dozen different forms
of accounting manipulation and violations of generally accepted accounting principles. As in the case of
Freddie, OFHEO said Fannie’s management sought to hit ambitious earnings-per-share targets that were
linked to their own compensation.
126. Donald Bisenius, interview by FCIC, September 29, 2010.
127. Mortgage Market Statistical Annual 2009.
128. See Tables 5.1/5.2 in FHFA Conservatorship report for third-quarter 2010.
129. OFHEO Special Examination Report, September 2004, pp. 9–10.
130. Ibid., pp. 2, 10.
131. OFHEO, “2005 Report to Congress,” June 15, 2005, p. 15.
 Notes to Chapter 8 575

132. Alan Greenspan, testimony before the FCIC, Hearing on Subprime Lending and Securitization
and Government-Sponsored Enterprises (GSEs), day 1, session 1: The Federal Reserve, April 7, 2010,
transcript, p. 13.
133. FHFA, “Mortgage Market Note: Goals of Fannie Mae and Freddie Mac in the Context of the
Mortgage Market: 1996–2009,” February 2010, p. 22; “FCIC calculations.”
134. FHFA, Report to Congress, 2008 (2009), pp. 116, 125.
135. BlackRock Solutions, “Fannie Mae’s Strategy and Business Model, Supplementary Exhibits,”
December 2007.
136. Robert Levin, interview by FCIC, March 17, 2010.
137. Mark Winer, interview by FCIC, March 23, 2010.
138. John Weicher, former FHA commissioner, interview by FCIC, March 11, 2010.
139. Letter from Robert Levin to FCIC, June 17, 2010, p. 2.

Chapter 8
1. Joe Donovan, Credit Suisse, quoted in Michael Gregory, “The ‘What If ’s’ in ABS CDOs,” Asset Secu-
ritization Report, February 18, 2002.
2. FCIC staff calculations, using data from the U.S. Census, data in Moody’s CDO PDS database, and
data in Moody’s CDO Enhanced Monitoring Service database. The FCIC selected CDOs with at least
10% of their collateral invested in mortgage-backed securities or with other characteristics that identified
them as ABS CDOs.
3. Scott Eichel, quoted in Allison Pyburn, “CDO Machine? Managers, Mortgage Companies, Happy
to Keep Fuel Coming,” Asset Securitization Report, May 23, 2005.
4. Patrick Parkinson, interview by FCIC, March 30, 2010.
5. Jian Hu, “Assessing the Credit Risk of CDOs Backed by Structured Finance Securities: Rating Ana-
lysts’ Challenges and Solutions,” Journal of Structured Finance 13, no. 3 (2007): 46.
6. Wing Chau, interview by FCIC, November 11, 2010.
7. CDOs that bought relatively senior tranches of mortgage-backed securities were known as high-
grade; those that bought the BBB-rated and other junior tranches were known as mezzanine.
8. Joe Donovan, quoted in Gregory, “The ‘“What If ’s’ in ABS CDOs.”
9. Laurie Goodman et al., Subprime Mortgage Credit Derivatives (Hoboken, NJ: John Wiley, 2008),
p. 315.
10. Hu, “Assessing the Credit Risk of CDOs Backed by Structured Finance Securities,” p. 47, Exhibit 5.
11. Issuance dropped in 2007 to $194 billion and virtually disappeared in 2008. FCIC staff estimates
based on data provided by Moody’s CDO Enhanced Monitoring System (EMS).
12. FCIC staff estimates based on analysis of Moody’s CDO EMS database.
13. Nestor Dominguez, interview by FCIC, September 28, 2010.
14. Michael Lamont, interview by FCIC, September 21, 2010.
15. Chris Ricciardi, interview by FCIC, September 15, 2010.
16. Lamont, interview.
17. FCIC staff calculations using data in FCIC CDO manager and underwriter survey.
18. Mark Adelson, interview by FCIC, October 22, 2010.
19. FCIC staff calculations. Our estimate assumes an annual management fee of 0.10% of the total
value of the deal—that is, the lowest normally earned in the industry—applied to the mortgage-focused
multisector CDOs in the FCIC database. It does not include other income, such as interest on equity
tranches retained by the managers. CDO managers responding to the FCIC survey reported manage-
ment fees ranging from as low as 0.10% to as high as 0.40%.
20. “Summary of Key Fee Provisions for Cash CDOs as of January 2000–2010,” prepared by Moody’s
for the FCIC.
21. FCIC Hedge Fund Survey. See FCIC website for details.
22. FCIC staff estimates based on Moody’s CDO Enhanced Monitoring Service.
23. Bloomberg LLC, Financial Analyst Function; Bear Stearns Companies Inc., Form 10-K, for the fis-
cal year ended November 30, 2006, filed February 13, 2007, Exhibit 13.
24. The Options Group, “2005 Global Financial Market Overview & Compensation Report,” October
2005, p. 16.
576 Notes to Chapter 8

25. Moody’s, Kleros Real Estate CDO III, Ltd., CDO EMS Data, last updated May 27, 2008.The fol-
lowing discussion of CMLTI 2006-NC2 relies on FCIC staff estimates based on analysis of Moody’s CDO
EMS database.
26. Ricciardi, interview.
27. For example, Kleros III tranches were in Buckingham CDO, Buckingham CDO II, and Bucking-
ham CDO III, all deals underwritten by Barclays.
28. Adelson, interview.
29. Chau, interview.
30. James Grant, “Up the Capital Structure” (December 15, 2006), in Mr. Market Miscalculates: The
Bubble Years and Beyond (Mount Jackson, VA: Axios Press, 2008), 186.
31. UBS Global CDO Group, Presentation on Product Series (POPS), January 2007.
32. Dan Sparks, interview by FCIC, June 15, 2010.
33. Dominguez, interview.
34. The ratio of the book value of assets to equity ranged from 2.5 to 28.3 times for all SIVs; the aver-
age was 13.6 times. Moody’s Investors Service, “Moody’s Special Report: Moody’s Update on Structured
Investment Vehicles,” January 16, 2008, p. 13.
35. Mark Klipsch, quoted in Colleen Marie O’Connor, “Drought of CDO Collateral Tops Concerns,”
Asset Securitization Report, October 18, 2004.
36. Bear Stearns Asset Management, Collateral Manager Presentation; Ralph Cioffi, interview by
FCIC, October 19, 2010; Bear Stearns High-Grade Structured Credit Strategies Master Fund, Ltd., finan-
cial statements for the year ended December 31, 2006 (total assets were $8,573,315,025); Bear Stearns
High-Grade Structured Credit Strategies Enhanced Leverage Master Fund, Ltd., financial statements for
the year ended December 31, 2006 (total assets were $9,403,235,402).
37. James Cayne, written testimony for the FCIC, Hearing on the Shadow Banking System, day 1, ses-
sion 2: Investment Banks and the Shadow Banking System, May 5, 2010, p. 2; Warren Spector, interview
by FCIC, March 30, 2010.
38. Cioffi, interview.
39. AIMA’s Illustrative Questionnaire for Due Diligence of Bear Stearns High Grade Structured
Credit Strategies Fund; Bank of America presentation to Merrill Lynch’s Board of Directors, “Bear Steams
Asset Management: What Went Wrong.”
40. Bear Stearns High-Grade Structured Credit Strategies Master Fund, Ltd., financial statements for
the year ended December 31, 2006; Financial Statements, Bear Stearns High-Grade Structured Credit
Strategies Enhanced Leverage Master Fund, Ltd., financial statements for the year ended December 31,
2006; BSAM fund chart prepared by JP Morgan.
41. FCIC staff calculations using data from FCIC survey of hedge funds. The hedge funds responding
to the survey had a total of $1.2 trillion in investments.
42. IMF, Global Financial Stability Report, April 2008, Table 1.2, page 23, “Typical ‘Haircut’ or Initial
Margin.”
43. Alan Schwartz, interview by FCIC, April 23, 2010.
44. Cioffi, interview.
45. Ibid.
46. Ibid.
47. Bear Stearns High-Grade Structured Credit Strategies, investor presentation, stating that “the fund
is subject to conflicts of interest.” Bear Stearns High-Grade Structured Credit Strategies Enhanced Lever-
age Fund, L.P., Preliminary Confidential Private Placement Memorandum, August 2006. Everquest Fi-
nancial Ltd., Form S-1, p. 13.
48. Bear Stearns Asset Management Collateral Manager, presentation, stating that Klio I collateral in-
cludes 73% RMBS and ABS and 27% CDOs, Klio II collateral includes 74% RMBS and ABS and 26%
CDOs, and Klio III collateral includes 74% RMBS and ABS and 26% CDOs; Cioffi, interview.
49. Everquest Financial Ltd., Form S-1, pp. 9, 3.
50. Bear Stearns Asset Management, Collateral Manager Presentation.
51. Cioffi and Tannin Compensation Table, produced by Paul, Weiss, Rifkind, Wharton & Garrison,
LLP.
 Notes to Chapter 8 577

52. Matt Tannin, Bear Stearns, email to Bella Borg-Brenner, Stillwater Capital, March 16, 2007; Greg
Quental, Bear Stearns, email to Andrew Donnellan, Bear Stearns, et al., June 6, 2007.
53. Charles Prince, interview by FCIC, March 17, 2010.
54. Regulators in Japan and the United Kingdom also came down on the company in 2004 and 2005.
In September 2004, Japan’s Financial Services Agency suspended Citibank’s ability to operate branches in
Japan because of the bank’s participation in alleged illegal activity in that country, and in the following
year the United Kingdom’s Financial Services Authority fined Citigroup $25 million for engaging in a
bond trading scheme labeled “Dr. Evil” by Citigroup bond traders. Financial Services Agency, Govern-
ment of Japan, “Administrative Actions on Citibank, N.A. Japan Branch,” September 17, 2004; Financial
Services Authority, “Final Notice” to Citigroup Global Markets Limited, June 28, 2005
(www.fsa.gov.uk/pubs/final/cgml_28jun05.pdf); David Reilly, “Moving the Market: Citigroup to Take
$25 Million Hit in ‘Dr. Evil’ Case,” Wall Street Journal, June 29, 2005.
55. Prince, interview.
56. Robert Rubin, interview by FCIC, March 11, 2010.
57. Dominguez, interview by FCIC, March 2, 2010. The CDO desk earned revenues of $367 million in
2005. Paul, Weiss, Citigroup’s counsel, letter to FCIC, March 31, 2010, in re the FCIC’s second and third
supplemental requests, “Response to Interrogatory No. 21.”
58. Janice Warne, interview by FCIC, February 2, 2010; Paul, Weiss, Citigroup’s counsel, letter to
FCIC, March 1, 2010, “Response to Interrogatory No. 18.”
59. Paul, Weiss, Citigroup’s counsel, letter to FCIC, March 1, 2010, “Response to Interrogatory No.
18.”
60. Moody’s Investors Service, “CDOs with Short-Term Tranches: Moody’s Approach to Rating
Prime-1 CDO Notes,” February 3, 2006, p. 11.
61. Citigroup Inc., Form 10-K, for the fiscal year ended December 31, 2007, filed February 22, 2008,
p. 91.
62. Everquest Financial Ltd., Form S-1, May 9, 2007, p. 93.
63. Dominguez, interview, March 2, 2010.
64. Ibid.; Warne, interview.
65. Dominguez, interview, March 2, 2010.
66. Warne, interview.
67. GCIB Capital Markets Approval Committee, Coventree Capital, “Liquidity Put Option,” draft as of
December 13, 2002, p. 4.
68. Ron Frake, interview by FCIC, March 11, 2010.
69. “Formal Agreement” between the Comptroller of the Currency and Citibank, July 22, 2003.
70. Moody’s Investors Service, “CDOs with Short-Term Tranches.”
71. Ibid.; Bank of America Corporation, Form 10-Q for the quarterly period ended September 30,
2007, p. 19; Floyd Norris, “As Bank Profits Grew, Warning Signs Went Unheeded,” New York Times, No-
vember 16, 2007.
72. Dominguez, interview, March 2, 2010.
73. Paul, Weiss, Citigroup’s counsel, letter to FCIC, June 23, 2010, “Responses of Nestor Dominguez,”
p. 6.
74. OCC, “Subprime CDO Valuation and Oversight Review—Conclusion Memorandum,” Memoran-
dum from Michael Sullivan, RAD, and Ron Frake, NBE, to John Lyons, Examiner-in-Charge, Citibank,
NA, January 17, 2008, p. 6,
75. Ibid.
76. Tobias Brushammar et al., memorandum to Nestor Dominguez et al., “Re: Liquidity Put Valua-
tion,” October 19, 2006, pp. 1, 3–4; “Liquidity Put Discussion,” pt. 1, produced by Citi.
77. “Liquidity Put Discussion,” produced by Citi.
78. Data provided by Moody’s to the FCIC.
79. Gary Gorton, interview by FCIC, May 11, 2010.
80. AIG, 2008 10-K, p. 133. Assets are assigned a “risk weighting” or percentage that is then multiplied
by 8% capital requirement to determine the amount of risk-based capital.
81. AIG, CDS notional balances at year-end 2000 through 2010 Q1, provided to the FCIC.
82. The total would reach $78 billion by 2007 (ibid.).
578 Notes to Chapter 8

83. Gene Park, interview by FCIC, May 18, 2010.

84. Craig Broderick, testimony before the FCIC, Hearing on the Role of Derivatives in the Financial
Crisis, day 1, session 3: Goldman Sachs Group, Inc. and Derivatives, June 30, 2010, transcript, pp. 289–
90.
85. Moody’s, “CDOs with Short-Term Tranches”; AIG, “Information Pertaining to the Multi-sector
CDS Portfolio,” provided to the FCIC.
86. Park, interview.
87. AIG, CDS notional balances at year-end, 2000 through 2010 Q1.
88. Alan Frost, interview by FCIC, May 11, 2010.
89. AIG Financial Products Corp. Deferred Compensation Plan, March 18, 2005, p. 2.
90. Joseph Cassano, email to All Users, re: 2007 Special Compensation Plan, December 17, 2007.
91. Joseph Cassano compensation history, provided by AIG to the FCIC.
92. AIG, Form 8-K, filed May 1, 2005.
93. “Fact Sheet on AIGFP,” provided by Hank Greenberg, p. 4.
94. AIG, CDS notional balances at year-end.
95. Gene Park, email to Joseph Cassano, re: “CDO of ABS Approach Going Forward—Message to the
Dealer Community,” February 28, 2006.
96. Henry M. Paulson Jr., testimony before the FCIC, Hearing on the Shadow Banking System, day 2,
session 1: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 22.
97. Henry M. Paulson Jr., written testimony for the FCIC, Hearing on the Shadow Banking System,
day 2, session 1: Perspective on the Shadow Banking System, May 6, 2010, p. 2.
98. Goldman Sachs, 2005 and 2006 10-K (appendix 5a to Goldman’s March 8, 2010, letter to the
FCIC).
99. Appendix 5c to Goldman’s March 8, 2010, letter to the FCIC.
100. Goldman’s March 8, 2010, letter to the FCIC, p. 28 (subprime securities).
101. “Protection Bought by GS,” spreadsheet provided by Goldman Sachs to the FCIC. Specifically,
IKB purchased $30 million of Class A notes, $40 million of Class B notes, and $30 million of Class C
notes on June 9, 2004. TCW purchased $50 million of Class A notes in January 2005, and Wachovia pur-
chased $45 million of Class A notes in March 2005. See ibid., Exhibit 1.
102. FCIC staff calculations based on data provided by Goldman Sachs.
103. “Protection Bought by GS,” spreadsheet.
104. FCIC calculations based on data provided by Goldman Sachs.
105. FCIC staff analysis based on data provided by Goldman Sachs.
106. Sparks, interview.
107. Of course, in theory the net impact on the financial system is not greater, because there is a win-
ner for every loser in the derivatives market.
108. Sparks, interview.
109. From Goldman Sachs data provided to the FCIC in a handout titled “Amplification” and quoted
at the FCIC’s Hearing on the Role of Derivatives in the Financial Crisis, day 1, session 3: Goldman Sachs
Group, Inc. and Derivatives, June 30, 2010.
110. FCIC staff analysis based on data provided by Goldman Sachs.
111. Lloyd Blankfein, chairman of the board and chief executive officer, Goldman Sachs Group, inter-
view by FCIC, June 16, 2010; Sparks, interview.
112. Gary Cohn, testimony before the FCIC, Hearing on the Role of Derivatives in the Financial Cri-
sis, day 1, session 3: Goldman Sachs Group, Inc. and Derivatives, June 30, 2010, transcript, p. 351.
113. Parkinson, interview.
114. Michael Greenberger, before the FCIC, Hearing on the Role of Derivatives in the Financial Cri-
sis, day 1, session 1: Overview of Derivatives, June 30, 2010; oral testimony, transcript, p. 109; written tes-
timony, p. 16.
115. Moody’s Investors Service, “Summary of Key Provisions for Cash CDOs as of January 2000–
2010.”
116. Gary Witt, written testimony for the FCIC, Hearing on Credibility of Credit Ratings, the Invest-
ment Decisions Made Based on Those Ratings, and the Financial Crisis, day 1, session 1: The Ratings
Process, June 2, 2010, pp. 12, 15.
 Notes to Chapter 8 579

117. Ibid., 12.

118. Gary Witt, testimony before the FCIC, Hearing on Credibility of Credit Ratings, the Investment
Decisions Made Based on those Ratings, and the Financial Crisis, day 1, session 1: The Ratings Process,
June 2, 2010, transcript, pp. 168, 436.
119. Moody’s Investors Service, “Moody’s Approach to Rating Multisector CDOs,” September 15,
2000, p. 5.
120. Gary Witt, interview by FCIC, April 21, 2010.
121. Witt, written testimony for the FCIC, June 2, 2010, p. 17.
122. Gary Witt, follow-up interview by FCIC, May 13, 2010.
123. Witt, interview, April 21, 2010.
124. For example, Moody’s assumed that borrowers with different credit ratings would not default at
the same time. The agency split the securities into three subcategories based on the average FICO score
of the underlying mortgages: prime (FICO greater than 700), midprime (FICO between 700 and 625),
and subprime (FICO under 625). Creating three FICO-based subcategories rather than the traditional
two (prime and subprime) resulted in lower correlation assumptions, because mortgage-backed securi-
ties in different subcategories were assumed to be less correlated. “Moody’s Revisits Its Assumptions Re-
garding Structured Finance Default (and Asset) Correlations for CDOs,” June 27, 2005, pp. 15, 5, 7, 9, 4;
Gary Witt, interview by FCIC, May 6, 2010.
125. Hedi Katz, “U.S. Subprime RMBS in CDOs,” Fitch Special Report, April 15, 2005, p. 3; Sten
Bergman, “CDO Evaluator Applies Correlation and Monte Carlo Simulation to Determine Portfolio
Quality,” Standard & Poor’s Global Credit Portal RatingsDirect, November 13, 2001, p. 8.
126. Ingo Fender and Janet Mitchell, “Structured Finance: Complexity, Risk and the Use of Ratings,”
BIS Quarterly Review (June 2005): 68 (www.bis.org/publ/qtrpdf/r_qt0506.pdf).
127. Based on an FCIC survey of 40 CDO managers and 11 underwriters about the process of creat-
ing and marketing CDOs.
128. Moody’s Investors Service, “Structured Finance Rating Transitions: 1983–2006,” January 2007,
pp. 7, 64. Of structured finance securities originally rated triple-A between 1984 and 2006, 56% retained
their original rating 5 years later, 5% were downgraded, and 39% were withdrawn.
129. Kyle Bass, testimony to the House Financial Services Committee, Subcommittee on Capital Mar-
kets, Insurance, and Government Sponsored Enterprises, Hearing on the Role of Credit Rating Agencies in
the Structured Finance Market, 110th Cong., 1st sess., September 27, 2007, p. 11.
130. “Structured Finance Rating Transitions: 1983–2008,” Moody’s Credit Policy Special Comment,
March 2009, p. 2.
131. Moody’s Investors Service, “Announcement: Moody’s Updates Its Key Assumptions for Rating
Structured Finance CDOs,” December 11, 2008.
132. Ben Bernanke, closed-door session with FCIC, November 17, 2009.
133. Ann Rutledge, email to FCIC, November 16, 2010. Ann Rutledge is a principal in R&R Consult-
ing, a coauthor of Elements of Structured Finance (Oxford: Oxford University Press, 2010), and a former
employee of Moody’s Investor Service. She and co-principal Sylvain Raines first spoke to the FCIC on
April 12, 2010.
134. From Moody’s “Structured Finance: Special Report,” the following page 1 headlines: “2004 U.S.
CDO Review / 2005 Preview: Record Activity Levels Driven by Resecuritization CDOs and CLOs,” Feb-
ruary 1, 2005; “2005 U.S. CDO Review: Looking Ahead to 2006: Record Year Follows Record Year,” Feb-
ruary 6, 2006; “2008 U.S. CDO Outlook and 2007 Review: Issuance Down in 2007 Triggered by
Subprime Mortgages Meltdown; Lower Overall Issuance Expected in 2008,” March 3, 2008.
135. Moody’s annual gross revenues for ABS CDO ratings was $11,730,234 in 2003, $22,210,695 in
2004, $40,332,909 in 2005, $91,285,905 in 2006, and $94,666,014 in 2007. Information provided by
Moody’s, May 3, 2010. See also Moody’s Corporation 2006 10-K, p. 66 and Moody’s Corporation, 2007
10-K.
136. Witt, testimony before the FCIC, June 2, 2010, transcript, p. 46.
137. Witt, written testimony for the FCIC, June 2, 2010, p. 11; Witt, interview, April 21, 2010.
138. Eric Kolchinsky, interview by FCIC, April 27, 2010.
139. Witt, interview, April 21, 2010.
140. FCIC staff estimates based on analysis of Moody’s CDO EMS database.
580 Notes to Chapter 9

141. Yuri Yoshizawa, interview by FCIC, May 17, 2010. The chart was labeled “Derivatives (Amer-
ica).”
142. Brian Clarkson, interview by FCIC, May 20, 2010.
143. Harvey Goldschmid, interview by FCIC, March 24, 2010; Annette Nazareth, interview by FCIC,
April 1, 2010.
144. Office of Thrift Supervision, letter to the SEC, February 11, 2004.
145. Lehman Brothers, Inc., letter to the SEC, March 8, 2004; J.P. Morgan Chase & Co., letter to the
SEC, February 12, 2004; Deutsche Bank A.G. and Deutsche Bank Secs., letter to the SEC, February 18,
2004.
146. Harvey Goldschmid, interview by FCIC, April 8, 2010.
147. Closed meeting of the Securities and Exchange Commission, April 28, 2004.
148. In 2005, the Division of Market Regulation became the Division of Trading and Markets. For the
sake of simplicity, throughout this report it is referred to as the Division of Market Regulation.
149. Erik Sirri, interview by FCIC, April 1, 2010. Although there are more than 1,000 SEC examiners,
collectively they regulate more than 5,000 broker-dealers (with more than 750,000 registered representa-
tives) as well as other market participants.
150. Michael Macchiaroli, interview by FCIC, March 18, 2010.
151. The monitors met with senior business and risk managers at each CSE firm every month about
general concerns and risks the firms were seeing. Written reports of these meetings were given to the di-
rector of market regulation every month. In addition, the CSE monitors met quarterly with the treasury
and financial control functions of each CSE firm to discuss liquidity and funding issues.
152. Erik Sirri, written testimony for the FCIC, Hearing on the Shadow Banking System, day 1, ses-
sion 3: SEC Regulation of Investment Banks, May 5, 2010.
153. Internal SEC memorandum, Re: “CSE Examination of Bear Stearns & Co. Inc.,” November 4,
2005.
154. Securities and Exchange Commission, Office of Inspector General, “SEC’s Oversight of Bear
Stearns and Related Entities: The Consolidated Supervised Entity Program,” Report No. 446-A, Septem-
ber 25, 2008, pp. 17–18.
155. Michael Macchiaroli, interview by FCIC, April 13, 2010.
156. Robert Seabolt, email to James Giles, Steven Spurry, and Matthew Eichner, October 1, 2007.
157. Matt Eichner, interview by FCIC, April 14, 2010; SEC, OIG, “SEC’s Oversight of Bear Stearns and
Related Entities: The Consolidated Supervised Entity Program,” p. 109.
158. Goldschmid, interview.
159. GAO, “Financial Markets Regulation: Financial Crisis Highlights Need to Improve Oversight of
Leverage at Financial Institutions,” GAO-09-739 (Report to Congressional Committees), July 2009, pp.
38–42.
160. Erik Sirri, “Securities Markets and Regulatory Reform,” remarks at the National Economists
Club, Washington, D.C., April 9, 2009.
161. Harvey Goldschmid, interview, April 8, 2010.
162. “Chairman Cox Announces End of Consolidated Supervised Entities Program,” SEC press re-
lease, September 26, 2008.
163. Mary Schapiro, testimony before the FCIC, First Public Hearing of the Financial Crisis Inquiry
Commission, day 2, panel 1: Current Investigations into the Financial Crisis—Federal Officials, January
14, 2010, transcript, p. 39.
164. The Fed remained the supervisor of JP Morgan at the holding company level.
165. Mark Olson, interview by FCIC, October 4, 2010.
166. Federal Reserve System, “Financial Holding Company Project,” January 25, 2008, p. 3.

Chapter 9
1. Warren Peterson, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—
Greater Bakersfield, session 3: Residential and Community Real Estate, September 7, 2010, pp. 1, 3.
2. Gary Crabtree, principal owner, Affiliated Appraisers, written testimony for the FCIC, Hearing on
the Impact of the Financial Crisis—Greater Bakersfield, session 4: Local Housing Market, September 7,
2010, p. 2.
 Notes to Chapter 9 581

3. Lloyd Plank, Lloyd E. Plank Real Estate Consultants, written testimony for the FCIC, Hearing on
the Impact of the Financial Crisis—Greater Bakersfield, session 4: Local Housing Market, September 7,
2010, p. 2.
4. CoreLogic Single Family Combined (SFC) Home Price Index, data accessed August 2010. FCIC
calculation of change from January 1997 to April 2006, peak.
5. Professor Robert Shiller, Historical Housing data..
6. Final Report of Michael J. Missal, Bankruptcy Court Examiner, In RE: New Century TRS Holdings,
Chapter 11, Case No. 07-10416 (KJC), (Bankr. D.Del), February 29, 2008, pp. 145, 138, 139–40 (hereafter
Missal).
7. Ibid., p. 3.
8. Nomura Fixed Income Research, “Notes from Boca Raton: Coverage from Selected Sessions of ABS
East 2005,” September 20, 2005, pp. 5–7.
9. Alan Greenspan, “The Economic Outlook,” testimony before the Joint Economic Committee, 109th
Cong., 1st sess., June 9, 2005.
10. Christopher Mayer, written testimony for the FCIC, Forum to Explore the Causes of the Financial
Crisis, day 2, session 5: Mortgage Lending Practices and Securitization, February 27, 2010, pp. 5–6.
11. Antonio Fatás, Prakash Kannan, Pau Rabanal, and Alasdair Scott, “Lessons for Monetary Policy
from Asset Price Fluctuations Leaving the Board,” International Monetary Fund, World Economic Out-
look (Fall 2009), chapter 3.
12. James MacGee, “Why Didn’t Canada’s Housing Market Go Bust?” Federal Reserve Bank of Cleve-
land. Economic Comment (December 2, 2009).
13. Morris A. Davis, Andreas Lehnert, and Robert F. Martin, “The Rent-Price Ratio for the Aggregate
Stock of Owner-Occupied Housing,” Federal Reserve Board Working Paper, May 2005, p. 2.
14. Price data from CoreLogic CSBA Home Price Index, Single-Family Combined. Rent data is Bu-
reau of Labor Statistics, metro-level Consumer Price Index (CPI-U), Owners’ Equivalent Rent for Pri-
mary Residence; all index figures are adjusted so that Jan. 1997=1. Methods follow from Federal Reserve
Bank of San Francisco Economic Letter, “House Prices and Fundamental Value,” Number 2004–27, Oc-
tober 1, 2004.
15. National Association of Realtors Housing Affordability Index, accessed from Bloomberg as com-
posite Index (HOMECOMP). The index began in 1986.
16. The index also assumes that the qualifying ratio of 25%, so that the monthly principal & interest
payment could not exceed 25% of the median family monthly income. More about the methodology can
be found at National Association of Realtors, Methodology for the Housing Affordability Index.
17. Ben Bernanke, letter to FCIC Chairman Phil Angelides, December 21, 2010, p. 2.
18. Kristopher S. Gerardi, Christopher L. Foote, and Paul S. Willen, “Reasonable People Did Disagree:
Optimism and Pessimism about the U.S. Housing Market Before the Crash,” Federal Reserve Bank of
Boston Public Policy Discussion Paper No. 10-5, August 12, 2010.
19. Donald L. Kohn, “Monetary Policy and Asset Prices,” speech delivered at “Monetary Policy: A
Journey from Theory to Practice,” a European Central Bank Colloquium held in honor of Otmar Issing,
Frankfurt, Germany, March 16, 2006.
20. Richard A. Brown, “Rising Risks in Housing Markets,” memorandum to the National Risk Com-
mittee of the Federal Deposit Insurance Corporation, March 21, 2005, pp. 1–2.
21. Board of Governors, memorandum from Josh Gallin and Andreas Lehnert to Vice Chairman
[Roger] Ferguson, “Talking Points on House Prices,” May 5, 2005, p. 3.
22. Missal, p. 40.
23. William Black, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—Miami,
Florida, session 1: Overview of Mortgage Fraud, September 21, 2010, transcript, p. 78; and email from
William Black to FCIC, December 12, 2010.
24. Reply of Attorney General Lisa Madigan (Illinois) to the FCIC, April 27, 2010, p. 7.
25. Chris Swecker, Assistant Director Criminal Investigative Division Federal Bureau of Investigation,
statement before the House Financial Services Subcommittee on Housing and Community Opportunity,
108th Cong., 2nd sess., October 7, 2004.
26. Florida Department of Law Enforcement, “Mortgage Fraud Assessment,” November 2005.
582 Notes to Chapter 9

27. Wilfredo Ferrer, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—
Miami, Florida, session 3: The Regulation, Oversight, and Prosecution of Mortgage Fraud in Miami, Sep-
tember 21, 2010, transcript, pp. 186–87.
28. Ann Fulmer, supplemental written testimony for the FCIC, Hearing on the Impact of the Finan-
cial Crisis—Miami, Florida, session 1: Overview of Mortgage Fraud, September 21, 2010, p. 2; Fulmer,
testimony, transcript, pp. 80–81.
29. Ed Parker, interview by FCIC, May 26, 2010.
30. David Gussmann, interview by FCIC, March 30, 2010.
31. William H. Brewster, interview by FCIC, October 29, 2010.
32. Henry Pontell, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—
Miami, Florida, session 1: Overview of Mortgage Fraud, September 21, 2010, p. 1.
33. Department of Justice, Office of the Inspector General, “The Internal Effects of the FBI’s Reprior-
itization, September 2004,” p. 1.
34. Chris Swecker, interview by FCIC, March 8, 2010.
35. Patrick Crowley, MortgageDaily.com, November 24, 2003.
36. Swecker, statement to the House Financial Services Subcommittee on Housing and Community
Opportunity, October 7, 2004.
37. William Black, written testimony for the FCIC, September 21, 2010, p. 17.
38. Francisco San Pedro, interview by FCIC, September 20, 2010.
39. FinCEN report to the FCIC on Countrywide SAR activity, 1999–2009.
40. OCC, letter to Bank of America, June 5, 2007.
41. Darcy Parmer, interview by FCIC, June 4, 2010.
42. FinCEN, “Mortgage Loan Fraud: An Industry Assessment Based on SAR Analysis,” November
2006, pp. 2, 6.
43. Swecker, statement before the House Financial Services Subcommittee on Housing and Commu-
nity Opportunity, October 7, 2004.
44. Swecker, interview.
45. FinCEN, “Mortgage Loan Fraud Update: Suspicious Activity Report Filings from April–June 30,
2010,” p. 21.
46. DOJ, letter from Assistant Attorney General Ronald Welch to the FCIC, April 28, 2010, pp. 1, 3,
October 21, 2010, p. 2.
47. Robert Mueller, interview by FCIC, December 14, 2010.
48. Alberto Gonzales, interview by FCIC, November 1, 2010.
49. OFHEO, “2007 Performance and Accountability Report,” pp. 13, 17.
50. Richard Spillenkothen, interview by FCIC, March 19, 2010.
51. Michael J. Mukasey, interview by FCIC, October 20, 2010.
52. DOJ response to FCIC request, April 16, 2010; see also DOJ response to FCIC request, April 28,
2010.
53. William Black, testimony before the FCIC, September 21, 2010, transcript, p. 38.
54. Swecker, interview.
55. Ellen Wilcox, special agent, Florida Department of Law Enforcement, testimony before the FCIC,
Hearing on the Impact of the Financial Crisis—Miami, session 2: Uncovering Mortgage Fraud in Miami,
September 21, 2010, transcript, p. 80; “Participant in $13 Million Mortgage Fraud Scheme Convicted by
Polk County Jury,” Office of Florida Attorney General Bill McCollum press release, August 28, 2008.
56. Tenth Judicial Circuit in and for Polk County, Florida, State of Florida vs. Scott Almeida, et al.,
OSWP No. 2005-0256-TPA; July 23, 2007, see paragraphs 2, 17, 18, 19, 28, and 32.
57. Wilcox, testimony before the FCIC, September 21, 2010, transcript, pp. 98–99.
58. Gary Gorton, “The Panic of 2007,” paper presented at the Federal Reserve Bank of Kansas City,
Jackson Hole Conference, “Maintaining Stability in a Changing Financial System,” August 2008.
59. Adam B. Ashcraft and Til Schuermann, “Understanding the Securitization of Subprime Mortgage
Credit,” Federal Reserve Bank of New York Staff Report No. 318, March 2008, pp. 5–11.
60. Raymond McDaniel, quoted in the transcript of Moody’s Managing Director’s Town Hall Meeting,
September 11, 2007.
 Notes to Chapter 9 583

61. Keith Johnson, former president and chief operating officer of Clayton Holdings, Inc., interview
by FCIC, September 2, 2010.
62. Frank Filipps, interview by FCIC, August 9, 2010.
63. Vicki Beal, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—Sacra-
mento, session 3: The Mortgage Securitization Chain: From Sacramento to Wall Street, September 23,
2010, transcript, pp. 155, 155–56.
64. Beal, testimony before the FCIC, September 23, 2010, transcript, pp. 169, 157; see also Martha
Coakley, Massachusetts Attorney General, comment letter to the Securities and Exchange Commission
regarding proposed rule regarding asset-backed securities, Release No. 33-9117; 34-61858; File No. S7-
08-10, August 2, 2010, p. 6.
65. Beal, testimony before the FCIC, September 23, 2010, transcript, pp. 169–70.
66. D. Keith Johnson, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—
Sacramento, session 3: The Mortgage Securitization Chain: From Sacramento to Wall Street, September
23, 2010, transcript, pp. 183–84.
67. Ibid., p. 211.
68. Beal, testimony before the FCIC, September 23, 2010, transcript, p. 172.
69. John J. Goggins, senior vice president and general counsel, Moody’s, letter to FCIC regarding
“September 27, 2010 Article Published in The New York Times Misconstruing Commission Testimony,”
September 30, 2010.
70. Johnson, testimony before the FCIC, September 23, 2010, transcript, p. 174.
71. Missal, p. 67.
72. Roger Ehrnman, interview by FCIC, September 2, 2010; Johnson, testimony before the FCIC, Sep-
tember 23, 2010, transcript, p. 178.
73. Tony Peterson, interview by FCIC, October 14, 2010.
74. Joseph Schwartz, vice president in charge of mortgage acquisition due diligence, Deutsche Bank,
interview by FCIC, July 21, 2010; William Collins Buell VI, head of mortgage acquisition, JP Morgan, in-
terview by FCIC, September 15, 2010.
75. Richard M. Bowen, written testimony for the FCIC, Hearing on Subprime Lending and Securiti-
zation and Government-Sponsored Enterprises (GSEs), day 1, session 2: Subprime Origination and Se-
curitization, April 7, 2010, p. 2.
76. Richard M. Bowen, interview by FCIC, February 27, 2010; FCIC correspondence with Richard
M. Bowen.
77. Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 2, The Secondary
Market (Bethesda, MD: Inside Mortgage Finance, 2009), p. 156; FCIC staff estimate based on analysis of
Moody’s CDO EMS database.
78. See, for example, James C. Treadway Jr., “An Overview of Rule 415 and Some Thoughts About the
Future,” remarks to the thirteenth annual meeting of the Securities Industry Association, Hot Springs,
Virginia, October 8, 1983.
79. Shelley Parratt and Paula Dubberly, interview by the FCIC, October 1, 2010.
80. 17 C.F.R. Part 229.1111(a)(3), “Pool Assets,” revised as of April 1, 2005.
81. See Part V of complaint filed by Cambridge Place Investment Management Inc., dated July 9,
2010, in Suffolk County (Massachusetts) Superior Court, Cambridge Place Investment Management,
Inc., v. Morgan Stanley & Co., Inc., Case No. 10-27841, p. 71 (hereafter Cambridge Complaint), and Part
V of complaint filed by Federal Home Loan Bank of Chicago, dated October 15, 2010, in Circuit Court of
Cook County, Illinois (Chancery Division), Federal Home Loan Bank of Chicago v. Banc of America
Funding Corp. et al., Case No. 10CH450B3, p. 173.
82. Cambridge Complaint, pp. 32–33, 61–63, 70–71, 75–76.
83. Bowen, interview.
84. D. Keith Johnson, former president and chief operating officer, Clayton Holdings, Inc., interview
by FCIC, June 8, 2010.
85. A QIB was defined under Rule 144A to include “entities, acting for its own account or the ac-
counts of other qualified institutional buyers, that in the aggregate owns and invests on a discretionary
basis at least $100 million in securities of issuers that are not affiliated with the entity.” See 17 C.F.R.
230.144A, “Private Resale of Securities to Institutions.”
584 Notes to Chapter 9

86. Dennis Voigt Crawford, testimony before the FCIC, First Public Hearing of the FCIC, day 2, ses-
sion 2: Current Investigation into the Financial Crisis—State and Local Officials, January 14, 2010,
p. 112.
87. Richard Breeden, interview by FCIC, October 14, 2010. See Public Law 104–290 (Oct. 11, 1996);
Rule 144A contained provisions that ensured it did not expand to the securities markets in which retail
investors did participate.
88. Federal Reserve Board, SR 9724, “Risk-Focused Framework for Supervision of Large Complex In-
stitutions,” October 27, 1997.
89. Alan Greenspan, “The Evolution of Bank Supervision,” speech before the American Bankers As-
sociation, Phoenix, Arizona, October 11, 1999.
90. Eugene Ludwig, interview by FCIC, September 2, 2010.
91. Federal Reserve Bank of New York, “Report on Systemic Risk and Supervision,” Draft of August 5,
2009, p. 2.
92. Rich Spillenkothen, “Notes on the performance of prudential supervision in the years preceding
the financial crisis by a former director of banking supervision and regulation at the Federal Reserve
Board (1991 to 2006),” May 31, 2010, 12.
93. Susan Bies, interview by FCIC, October 11, 2010.
94. Bernanke, letter to the FCIC, December 21, 2010.
95. John Snow, interview by FCIC, October 7, 2010.
96. Office of the Comptroller of the Currency, Board of Governors of the Federal Deposit Insurance
Corporation, Office of Thrift Supervision, and National Credit Union Administration, “Credit Risk
Management Guidance for Home Equity Lending,” May 16, 2005.
97. 2009 Mortgage Market Statistical Annual, 1:3; “Residential Mortgage Lenders Peer Group Survey:
Analysis and Implications for Guidance,” PowerPoint presentation, November 30, 2005, pp. 13, 3.
98. Sabeth Siddique, interview by the FCIC, September 9, 2010.
99. “Residential Mortgage Lenders Peer Group Survey: Analysis and Implications for Guidance,”
PowerPoint, November 30, 2005.
100. Bies, interview.
101. Office of the Comptroller of the Currency, Board of Governors of the Federal Deposit Insurance
Corporation, Office of Thrift Supervision, and National Credit Union Administration, “Interagency
Guidance on Nontraditional Mortgage Products,” Federal Register 70 (December 29, 2005): 77,249,
72,252, 72,253.
102. Paul Smith, American Bankers Association, letter to the Federal Deposit Insurance Corporation,
Board of Governors of the Federal Reserve System, Office of Thrift Supervision, and Office of the Comp-
troller of the Currency, March 29, 2006, p. 2.
103. Letter from American Financial Services Association to federal regulators 8, available at
http://www.ots.treas.gov/_files/comments/d1e85ce1–07ab-4acf-8db5–8d1747afba0a.pdf.
104. Letters to the Office of Thrift Supervision from the American Bankers Association (March 29,
2006), p. 2; the American Financial Services Association (March 28, 2006), p. 8; and Indymac Bank
(March 29, 2006), p. 4.
105. The Housing Policy Council of the Financial Services Roundtable, letter to the Office of Thrift
Supervision, March 29, 2006, p. 6.
106. Siddique, interview.
107. Binyamin Appelbaum and Ellen Nakashima, “Banking Regulator Played Advocate Over En-
forcer: Agency Let Lenders Grow Out of Control, Then Fail,” Washington Post, November 23, 2008.
108. Bies, interview.
109. See, e.g. “Countrywide Seeks to Become Savings Bank; The Mortgage Lender Says It Is Planning
to Apply to Convert Its Charter So It Will Be Regulated by One Federal Agency instead of Two,” Los An-
geles Times, November 11, 2006, based on Bloomberg, Reuters.
110. Kim Sherer, interview by FCIC, August 3 2003.
111. Countrywide, “Briefing Paper: Meeting with Office of Thrift Supervision, Thursday July 13,
2006.”
 Notes to Chapter 9 585

112. Angelo Mozilo, email to John McMurray (cc Dave Sambol, Carlos Garcia), re: Pay Options, Au-
gust 12, 2006; John McMurray, email to Angelo Mozilo (cc Kevin Bartlett, Carlos Garcia, Dave Sambol,
re: Pay Options, August 13, 2006.
113. The cost of borrowing is reflected by credit spreads, the portion of interest rates that compensate
investors for credit risk. Credit spreads are the interest rates that investors require above the so-called
risk-free interest rate, usually measured in terms of Treasuries or interest rate swaps with similar charac-
teristics.
114. Congressional Oversight Panel, “Commercial Real Estate Losses and the Risk to Financial Stabil-
ity,” February 10, 2010, pp. 58–60.
115. Loan Syndication Trading Association, “The US Loan Market Today,” presentation.
116. Loan Syndication Trading Association, “Financial Reform and the Leveraged Loan Market,”
presentation.
117. Ibid., Loan Syndication Trading Association, “Challenges Facing CLOs … and the Loan Market,”
presentation.
118. Ibid., p. 14. SEC, “Risk Management Reviews at Consolidated Supervised Entities,” memoran-
dum, April 26, 2007.
119. Michael Flaherty and Dena Aubin, “For Private Equity Market, All Eyes on First Data,” Reuters,
September 4, 2007.
120. SEC, “Risk Management Reviews of Consoldated Supervised Entities,” memorandum, July 5,
2007.
121. Charles Prince, quoted in “Citigroup chief stays bullish on buyouts,” Financial Times, July 9,
2007; testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-
Sponsored Enterprises (GSEs), day 2, session 1: Citigroup Senior Management, April 8, 2010, transcript,
pp. 49–50.
122. Roben Farzad, Matthew Goldstein, David Henry, and Christopher Palmeri, “Not So Smart,” Busi-
nessWeek, September 3, 2007.
123. Joseph Gyourko, “Understanding Commercial Real Estate: Just How Different from Housing Is
It?” NBER Working Paper 14708, National Bureau of Economic Research, February 2009, pp. 23, 38.
124. CRE Finance Council, Compendium of Statistics, November 5, 2010, Exhibits 3, 2.
125. Joe Keohane, “Heartbreak Hotels,” Portfolio, November 11, 2008.
126. “Hilton Debt Clogs Lenders’ Balance Sheets,” Commercial Mortgage Alert, February 20, 2009.
127. Tom Marano, interview by FCIC, April 19, 2010.
128. Jeff Mayer and Tom Marano, “Fixed Income Overview,” Bear Stearns, March 29, 2007, p. 18.
129. Gyourko, “Understanding Commercial Real Estate: Just How Different from Housing Is It?” p. 1.
130. New York Federal Reserve Bank, “Maiden Lane LLC Holdings as of 9/30/2008.”
131. Anton R. Valukas, Report of Examiner, In re Lehman Brothers Holdings Inc., et al., Chapter 11
Case No. 08-13555 (JMP), (Bankr. S.D.N.Y.), March 11, 2010, 2:356 (hereafter cited as Valukas).
132. Ibid., 2:356–58.
133. Madelyn Antoncic, “Lehman Brothers Risk Management,” August 7, 2007, p. 5; and Antoncic, in-
terview by FCIC, July 14, 2010.
134. Valukas, 1:43, 4; Antoncic, interview.
135. Valukas, 1:45–62, 79–80.
136. Jody Shenn, “Lehman Said to Return to Mortgage Market through Aurora Unit (Update 1),”
Bloomberg, October 21, 2009.
137. SEC, “Risk Management Reviews of Consolidated Supervised Entities,” memoranda, October 6,
2006; December 6, 2007; February 2, 2007; March 30, 2007; May 31, 2007; July 5, 2007; August 3, 2007;
September 5, 2007; October 5, 2007.
138. Erik Sirri, interview by FCIC, April 1, 2010.
139. Valukas, 1:7; 18 nn. 63, 64; 3: 742, 815–22.
140. Valukas, 1:8, 20–21.
141. The People of the State of New York v. Ernst & Young LLP (N.Y. Sup. Ct. filed Dec. 21, 2010).
142. Ronald Marcus, interview by FCIC, July 23, 2010.
143. See Ronald S. Marcus, OTS, “Report of Examination Lehman Brothers Holdings Inc.,” July 7,
2008, pp. 1–2.
586 Notes to Chapter 9

144. David Sambol, interview by FCIC, September 27, 2010.

145. See Countrywide Financial Corporation, Form 10-K, February 29, 2007, p. 47. See also Fannie
Mae, “Single-Family Conventional Acquisition Characteristics: Overall” (2007); Fannie Mae, “Single
Family Conventional Acquisition Characteristics: Countrywide Financial Corporation” (2007); Country-
wide, “Response to June 23 Request: 11 and 12: Summary.”
146. “Single Family Guarantee Business: Facing Strategic Crossroads,” June 27, 2005.
147. Ibid.
148. Daniel Mudd, interview by FCIC, March 26, 2010.
149. “Single Family Guarantee Business: Facing Strategic Crossroads.”
150. “Single Family Guaranty Business Strategic Review Summary,” PowerPoint presentation, July 19,
2005.
151. Citigroup, “Project Phineas: Presentation to the Board of Directors,” executive summary, July 18
and 19, 2005.
152. “Single Family Conventional Acquisition Characteristics Overall,” produced by Fannie Mae.
153. Tom Lund, interview by FCIC, March 4, 2010.
154. Christopher Dickerson to James B. Lockhart III, “Proposed Appointment of the Federal Housing
Finance Agency as Conservator for the Federal National Mortgage Association,” memorandum, Septem-
ber 6, 2008, p. 14
155. Fannie Mae, 3Q 2008 Form 10-Q, p. at 115; Fannie Mae, 2007 Form 10K, pp. 126–30.
156. By December 31, 2005, Freddie reported capital of $36.4 billion; $173 billion in loans to borrow-
ers with FICO scores below 660; $80 billion in high LTV; and $93 billion in loans for non-owner-occu-
pied homes.  Federal Home Loan Mortgage Corporation, “Information Statement and Annual Report to
Stockholders: For the fiscal year ended December 31, 2007,” February 28, 2008, p. 74.
157. Richard Syron, interview by FCIC, August 31, 2010.
158. Anurag Saksena, interview by FCIC, June 22, 2010.
159. Donald Bisenius, interview by FCIC, September 29, 2010.
160. Saksena, interview.
161. “OFHEO, SEC Reach Settlement with Fannie Mae; Penalty Imposed,” Office of Federal Housing
Enterprise Oversight press release, May 23, 2006.
162. “Freddie Mac Voluntarily Adopts Temporary Limited Growth for Retained Portfolio,” Federal
Home Loan Mortgage Corporation press release, August 1, 2006.
163. OFHEO, Report of the Special Examination of Fannie Mae, May 2006.
164. OFHEO Report: “Fannie Mae Façade; Fannie Mae Criticized for Earnings Manipulation,” Office
of Federal Housing Enterprise Oversight press release, May 23, 2006.
165. James Lockhart, written testimony for the FCIC, Hearing on Subprime Lending and Securitiza-
tion and Government-Sponsored Enterprises (GSEs), day 3, session 2: Office of Federal Housing Enter-
prise Oversight, April 9, 2010, p. 2.
166. Ibid., p. 1.
167. Robert J. Levin, Board of Director Presentation, PowerPoint presentation, January 2006.
168. Minutes of the February 21, 2006, meeting of the Board of Directors of Fannie Mae (approved on
April 25, 2006).
169. Stephen B. Ashley, Chairman Fannie Mae, remarks prepared for delivery at the Senior Manage-
ment Meeting, Cambridge, Maryland, June 27, 2006.
170. Fannie Mae, “Notes to Single Family Conventional Acquisition Report,” August 3, 2007; See also
Federal National Mortgage Association, Form 10-K, for the fiscal year ended December 31, 2006, filed
August 16, 2007.
171. FCIC staff estimates based on data provided by Fannie Mae.
172. Federal National Mortgage Association, “Form DEF 14A,” November 2, 2007, p. 42; Federal Na-
tional Mortgage Association, Form 10-K, May 2, 2007, p. 202.
173. OFHEO, Report of the Special Examination for Fannie Mae, May 2006, p. 8.
174. Federal Home Loan Mortgage Corporation, Form 10-K, for the fiscal year ended December 31,
2005, filed June 28, 2006, pp. 3, 19. Federal Home Loan Mortgage Corporation, Form 10-K, for the fiscal
year ended December 31, 2006, filed March 23, 2007, pp. 3, 22.
 Notes to Chapter 9 587

175. Federal Home Loan Mortgage Corporation, Proxy Statement and Notice of Annual Meeting of
Stockholders (May 7, 2007), Summary Compensation Table, p. 52 (for 2006 figures). Federal Home Loan
Mortgage Corporation, Proxy Statement and Notice of Annual Meeting of Stockholders (July 12, 2006),
Summary Compensation Table, p. 37 (for 2005 figures).
176. Ibid.
177. OFHEO, Report of the Special Examination for Fannie Mae, May 2006, pp. 3, 9–10, 15.
178. Ibid., p 2.
179. Ibid.
180. Ibid., pp. 7–8.
181. Ibid.
182. Mark Winer, interview by FCIC, March 23, 2010.
183. Todd Hempstead, interview by FCIC, March 23, 2010.
184. Daniel Mudd, interview by FCIC, March 26, 2010.
185. Dickerson to Lockhart, Fannie Mae conservatorship memo, September 6, 2008, p. 14.
186. Minutes of a Meeting of the Fannie Mae Board of Directors, April 21, 2007.
187. Minutes of a Meeting of the Fannie Mae Board of Directors, May 21, 2007.
188. Federal National Mortgage Association, Form 10-K, for the fiscal year ended December 31, 2007,
p. 24.
189. FCIC staff estimate based on data provided by Fannie Mae.
190. “Deepen Segments—Develop Breadth,” Fannie Mae Strategic Plan, 2007–2011.
191. Enrico Dallavecchia, email to Daniel Mudd, “Budget 2008 and strategic investments,” July 16,
2007.
192. Enrico Dallavecchia, email to Michael Williams, “RE:,” July 16, 2007.
193. Daniel Mudd, email to Enrico Dallavecchia, “RE: Budget 2008 and strategic investments,” July 17,
2007.
194. Enrico Dallavecchia, interview by FCIC, March 16, 2010.
195. Freddie Mac, “Freddie Mac’s Business Strategy, Board of Directors Meeting,” March 2–3, 2007,
pp. 3–4.
196. Freddie Mac, “Freddie Mac’s Business Strategy, Board of Directors Meeting,” March 2–3, 2007,
pp. 3–4, 70, 73.
197. OFHEO, 2006 Report of Examination for the Federal Home Loan Mortgage Corporation, pp. 8–
9, 10–11.
198. Federal Housing Finance Agency, “Mortgage Market Note 10–2: The Housing Goals of Fannie
Mae and Freddie Mac in the Context of the Mortgage,” February 1, 2010.
199. “HUD Announces New Regulations to Provide $2.4 Trillion in Mortgages for Affordable Hous-
ing for 28.1 Million Families,” Department of Housing and Urban Development, press release, October
31, 2000.
200. Mudd, interview.
201. Robert Levin, interview by FCIC, March 17, 2010.
202. “HUD Finalizes Rule on New Housing Goals for Fannie Mae and Freddie Mac,” Department of
Housing and Urban Development press release, November 1, 2004.
203. Mudd, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Gov-
ernment-Sponsored Enterprises (GSEs), day 3, session: 1 Fannie Mae, April 9, 2010, transcript, pp. 63–
64.
204. See FHFA, “Annual Report to Congress 2009,” pp. 131, 148. The numbers are for mortgage assets
+ outstanding MBS guaranteed. Total assets + MBS are slightly greater.
205. OFHEO, “2008 Report to Congress,” April 15, 2008.
206. Robert Levin, interview by FCIC, March 17, 2010; Robert Levin, testimony before the FCIC,
Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day
3, session 1: Fannie Mae, April 9, 2010, transcript, pp. 68–72.
207. Tom Lund, interview by FCIC, March 4, 2010.
208. Dallavecchia, interview.
209. Todd Hempstead, interview by FCIC, March 23, 2010.
210. Kenneth Bacon, interview by FCIC, March 5, 2010.
588 Notes to Chapter 10

211. Stephen Ashley, interview by FCIC, March 31, 2010.

212. Levin, interview.
213. Mike Quinn, interview by FCIC, March 10, 2010.
214. Ashley, interview.
215. Armando Falcon, testimony before the FCIC, Hearing on Subprime Lending and Securitization
and Government-Sponsored Enterprises (GSEs), day 3, session 2: Office of Federal Housing Enterprise
Oversight, April 9, 2010, transcript, pp. 155–56, 192; .written testimony, p. 10.
216. Lockhart, written testimony for the FCIC, April 9, 2010, p. 6;; Lockhart, testimony before the
FCIC, April 9, 2010, transcript, pp. 156–61.
217. James Lockhart, interview by FCIC, March 19, 2010.
218. Edward DeMarco, interview by FCIC, March 18, 2010; Maria Fernandez (with Alfred Pollard,
Chris Dickerson, Jeffrey Spohn, and Jamie Newell), interview by FCIC, March 5, 2010.
219. Mike Price (with Janice Kuhl, Paul Manchester, Charlotte Reid, Alfred Pollard, and Kevin Shee-
han), interview by FCIC, February 19, 2010.
220. Department of Housing and Urban Development, “HUD’s Housing Goals for the Federal Na-
tional Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie
Mac) for the Years 2005–2008 and Amendments to HUD’s Regulation of Fannie Mae and Freddie Mac,”
Federal Register 69, no. 211 (2 Nov. 2004): 63629.
221. FHFA, “The Housing Goals of Fannie Mae and Freddie Mac in the Context of the Mortgage
Market.”
222. Daniel Mudd, letter to Brian Montgomery re affordable housing goals, December 21, 2007.
223. “Deepen Segments—Develop Breadth,” Fannie Mae Strategic Plan.
224. Brian D. Montgomery, Federal Housing Commissioner, to Daniel Mudd, Fannie Mae, typed let-
ter, April 24, 2008; Brian D. Montgomery, Federal Housing Commissioner, to Richard F. Syron, Fannie
Mae, typed letter, April 24, 2008.
225. “Cost of Freddie Mac’s Affordable Housing Mission,” PowerPoint presentation, June 4, 2009, pp.
7–8, 10–11.
226. Freddie’s net income was $4.8 billion in 2003, $2.6 billion in 2004, $2.1 billion in 2005, $2.3 bil-
lion in 2006, net loss of $3.1 billion in 2007, and net loss of $50.1 billion in 2008. Federal Home Loan
Mortgage Corporation, Form 10-K, for the fiscal year ended December 31, 2009, filed February 24, 2010,
Item 6, Selected Financial Data, p. 57 (for 2008 figure). Federal Home Loan Mortgage Corporation, “In-
formation Statement and Annual Report to Stockholders: For the fiscal year ended December 31, 2007,”
February 28, 2008, Selected Financial Data and Other Operating Measures, p. 28 (for 2003–07 figures).
227. “Cost and Benefits of Mission Activities: Project Phineas,” presentation, June 14, 2005.
228. March 13, 2007, Business Review Briefing; information confirmed by counsel to Fannie Mae on
January 4, 2011.
229. “Fannie Mae’s Housing Goals,” Audit Team briefing, May 8, 2007.
230. “Fannie Mae Board of Directors Management Report,” PowerPoint presentation, July 17, 2007.
231. “Cost of Freddie Mac’s Affordable Housing Mission,” PowerPoint presentation, June 4, 2009, pp.
7–8, 10–11.

Chapter 10
1. Gary Gorton, interview by FCIC, May 11, 2010.
2. Lewis Ranieri, interview by FCIC, July 30, 2010.
3. Complaint, SEC v. Goldman Sachs & Co. and Fabrice Tourre (S.D.N.Y. April 16, 2010).
4. Office of the Comptroller of the Currency, Treasury; Office of Thrift Supervision, Treasury; Board
of Governors of the Federal Reserve System; Federal Deposit Insurance Corporation; and Securities and
Exchange Commission, “Interagency Statement on Sound Practices Concerning Elevated Risk Complex
Structured Finance Activities” (Notice of final interagency statement), January 5, 2007.
5. Wing Chau, interview by FDIC, November 11, 2010.
6. FCIC, Survey of 40 CDO Managers, Schedule A and B (1st production served on 28 managers, 2nd
production served on 12 managers).
7. Vertical Capital, email response to FCIC survey, October 29, 2010.
 Notes to Chapter 10 589

8. As two market observers would later write, “Starting in 2004, CDOs and CDO investors became the
dominant class of agents pricing credit risk on sub-prime mortgage loans. . . . In the absence of restraints,
lenders started originating unreasonably risky loans in late 2005 and continued to do so into 2007.” Mark
Adelson and David Jacob, “The Sub-prime Problem: Causes and Lessons,” January 8, 2008, p. 1.
9. Scott Simon, quoted in Allison Pyburn, “CDO Investors Debate Morality of Spread Environment,”
Asset Securitization Report, May 9, 2005, p. 1.
10. Armand Pastine, quoted in ibid. According to the FCIC database, PIMCO did manage one more
new CDO, Costa Bella CDO, which was issued in December 2006.
11. Source on downgrades: Bloomberg. Source on events on default: Moody’s Investors Service,
“Moody’s downgrades ratings of Notes issued by Maxim High Grade CDO I, Ltd.,” April 18, 2008, and
“Moody’s downgrades ratings of Notes issued by Maxim High Grade CDO II, Ltd.,” April 18, 2008.
12. ACA Capital, 2006 10-K, p. 12.
13. “ISDA Publishes Template for Credit Default Swaps on Asset-Backed Securities with Pay As You
Go Settlement,” International Swaps and Derivatives Association press release, June 21, 2005
(www.isda.org/press/press062105.html). Under the terms of the pay-as-you-go swap, if the referenced
mortgage-backed security does not receive the full interest and principal payments, the pay-as-you-go
protection seller is required to pay the buyer the amount of the shortfall. For long investors—the protec-
tion provider under the swap—the advantage was the leverage embedded in the trade: they did not have
to come up with the cash up front for the principal amount of the bond; they simply agreed to receive
quarterly swap fees in return for accepting the risk of loss if the securities experienced a shortfall.
14. Laura Schwartz, interview by FCIC, May 10, 2010.
15. Laurie S. Goodman, Shumin Li, Douglas J. Lucas, Thomas A. Zimmerman, and Frank J. Fabozzi,
Subprime Mortgage Credit Derivatives (Frank J. Fabozzi Series) (Hoboken, NJ: John Wiley, 2008), p. 176.
16. Greg Lippmann, interview by FCIC, May 20, 2010.
17. FCIC staff estimates based on analysis of Moody’s CDO EMS database.
18. FCIC Hedge Fund Survey. From July through December 2006, several hedge funds with average
assets under management of $4–$8 billion accumulated positions totaling more than $1.4 billion in
mortgage-related CDO equity tranches and almost $3 billion of short positions in mortgage-related
CDO mezzanine tranches. FCIC staff used a Moody’s proprietary CDO database to estimate the total
mortgage-related CDO equity tranche issuance. Please see FCIC website for more information about the
hedge fund survey. Note: the FCIC did not survey hedge funds that fully liquidated or closed. These
funds may have purchased substantial “long only” positions in mortgage-related securities.
19. FCIC Hedge Fund Survey. See FCIC website for details.
20. Rabobank’s counsel, letter to Judge Fried of the Supreme Court of NY, May 11, 2010.
21. Norma Flow of Funds, information provided by Merrill Lynch.
22. Steven Ross, email to FCIC, December 21, 2010.
23. See letter from Rabobank’s counsel, letter to Judge Fried, May 11, 2010; the letter was never filed
with the court because the case was settled.
24. Document of Magnetar Investments in Norma, Attachment G-13 (showing Magnetar purchases
of equity tranche in Norma); provided by Merrill Lynch.
25. Information provided by Merrill Lynch, December 22, 2010.
26. Complaint, SEC v. Goldman Sachs & Co. and Fabrice Tourre.
27. Ira Wagner, interview by FCIC, April 20, 2010.
28. Alan Roseman, interview by FCIC, May 17, 2010.
29. Schwartz, interview.
30. John Paulson, interview by FCIC, October 28, 2010.
31. “Goldman Sachs to Pay Record $550 Million to Settle SEC Charges Related to Subprime Mortgage
CDO,” SEC press release, July 15, 2010.
32. Jamie Mai and Ben Hockett, interview by FCIC, April 22, 2010.
33. Sihan Shu, interview by FCIC, September 27, 2010.
34. Steven Eisman, interview by FCIC, April 22, 2010.
35. James Grant, “Inside the Mortgage Machine,” in Mr. Market Miscalculates: The Bubble Years and
Beyond (Mount Jackson, VA: Axios, 2008), pp. 180–81, 182–83.
36. Eisman, interview.
590 Notes to Chapter 10

37. Michael Burry, interview by FCIC, May 18, 2010.

38. Paulson, interview.
39. Burry, interview.
40. FCIC Hedge Fund Survey. See FCIC website for details.
41. John Geanakoplos, written testimony for the FCIC, Forum to Explore the Causes of the Financial
Crisis, day 1, session 3: Risk Taking and Leverage, February 26, 2010, p. 16.
42. OCC, “Subprime CDO Valuation and Oversight Review—Conclusion Memorandum,” memoran-
dum from Michael Sullivan, RAD, and Ron Frake, NBE, to John Lyons, Examiner-in-Charge, Citibank,
NA, January 17, 2008, p. 6; Paul, Weiss, Citigroup’s counsel, letter to FCIC, June 23, 2010, “Responses of
Nestor Dominguez.”
43. Richard Bookstaber, interview by FCIC, May 11, 2010.
44. “RMBS and Citi-RMBS as a Percentage of Citi-CDO Portfolio Notionals,” produced by Citi for the
FCIC.
45. Federal Reserve Bank of New York, Federal Reserve Board, Office of the Comptroller of the Cur-
rency, Securities and Exchange Commission, U.K. Financial Services Authority, and Japan Financial
Services Authority, “Notes on Senior Supervisors’ Meetings with Firms,” November 19, 2007, p. 3.
46. FCIC staff estimates, based on analysis of Moody’s CDO EMS database.
47. Paul, Weiss, Citigroup’s counsel, letter to FCIC, March 1, 2010, in re the FCIC’s second supple-
mental request, “Response to Interrogatory no. 7”; Paul, Weiss, letter to FCIC, March 31, 2010, updated
response to interrogatory no. 7, p. 5.
48. Nestor Dominguez, interview by FCIC, March 2, 2010; Paul, Weiss, letter of March 31, 2010, pp.
3–6.
49. Board Analyst Profile for Citigroup Inc., April 16, 2007.
50. SEC staff (Sam Forstein, Tim McGarey, Mary Ann Gadziala, Kim Mavis, Bob Sollazo, Suzanne
McGovern, and Chris Easter), interview by FCIC, February 9, 2010.
51. Comptroller of the Currency, memorandum, Examination of Citigroup Risk Management
(CRM), January 13, 2005, p. 3.
52. Ronald Frake, Comptroller of the Currency, letter to Geoffrey Coley, Citibank, N.A., December
22, 2005.
53. Federal Reserve, “New York Operations Review, May 17–25, 2005,” p. 4.
54. Federal Reserve Bank of New York Bank Supervision Group, “Operations Review Report,” De-
cember 2009.
55. Federal Reserve Bank of New York, “Summary of Supervisory Activity and Findings, Citigroup
Inc., January 1, 2005–December 31, 2005,” April 10, 2006; Federal Reserve Bank of New York, “Summary
of Supervisory Activity and Findings,” Citigroup Inc., January 1, 2004–December 31, 2004,” April 5,
2005.
56. Citigroup Inc., Form 8-K, April 3, 2006, Exhibit 99.1.
57. Federal Reserve Board, memo to Governor Susan Bies, February 17, 2006.
58. The board reversed a 15% reduction that had been implemented when the issues began and then
added a 5% raise. Citigroup, 2006 Proxy Statement, p. 37.
59. Comptroller of the Currency, letter to Citigroup CEO Vikram Pandit (Supervisory Letter 2008-
05), February 14, 2008; quotation, p. 2.
60. Federal Reserve Bank of New York, letter to Vikram Pandit and the Board of the Directors of Citi-
group, April 15, 2008, pp. 6–7.
61. Timothy Geithner, testimony before the FCIC, Hearing on the Shadow Banking System, day 2,
session 1: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 128.
62. Gene Park, interview by FCIC, May 18, 2010.
63. Andrew Forster, email to Gary Gorton, Alan Frost, et al., July 21, 2005.
64. Park, interview.
65. Gorton, interview.
66. Park, interview.
67. Gene Park, email to Joseph Cassano, February 28, 2006.
68. Park, interview.
 Notes to Chapter 10 591

69. Data supplied by AIG. The CDO—RFC CDO III Ltd.—was 93% subprime and 7% RMBS Home
Equity, according to the AIG credit committee. A review by FCIC staff showed that the remaining 7%
designated as RMBS Home Equity included subprime collateral.
70. AIG, “Residential Mortgage Presentation (Financial Figures are as of June 30, 2007),” August 9,
2007, p. 28.
71. Park, interview.
72. Joseph Cassano, interview by FCIC, June 25, 2010.
73. Park, interview.
74. Dow Kim, interview by FCIC, September 9, 2010.
75. Stanley O’Neal, interview by FCIC, September 16, 2010.
76. Kim, interview.
77. FCIC staff estimates based on analysis of Moody’s CDO EMS database.
78. Complaint, Coöperatieve Centrale Raiffeisen=Boerenleenbank v. Merrill Lynch, No. 601832/09
(N.Y.S. June 12, 2009), paragraph 147.
79. Kim, interview.
80. FCIC analysis based on Moody’s CDO EMS database.
81. Presentation to Merrill Lynch and Co. Board of Directors, “Leveraged Finance and
Mortgage/CDO Review,” October 21, 2007, p. 35.
82. Chau, interview.
83. FCIC staff analysis of Moody’s CDO EMS database.
84. FCIC staff estimates based on Moody’s CDO EMS database. Data supplied by Merrill Lynch. Rele-
vant information not provided for Robeco High Grade CDO I.
85. FCIC staff analysis of Moody’s CDO EMS database.
86. Data supplied by Merrill Lynch.
87. FCIC staff analysis of Moody’s CDO EMS database. The total value of Baa tranches issued by
CDOs in the FCIC database was $684 million in 2003 and $3.9 billion in 2007; Aa tranches, $1.4 billion
in 2003 and $8.3 billion in 2007; A tranches, $522 million in 2003 and $4.3 billion in 2007.
88. FCIC staff telephone discussion with SEC staff, September 1, 2010.
89. FCIC staff analysis of Moody’s CDO EMS database.
90. Chau, interview; for number of the CDOs he managed, FCIC staff analysis of Moody’s Enhanced
CDO Monitoring Database.
91. Super Senior Credit Transactions Principal Collateral Provisions, December 7, 2007, produced by
AIG.
92. Presentation to the Merrill Lynch Board, “Leveraged Finance and Mortgage/CDO Review,” p. 23;
Jeff Kronthal, former head of Merrill Lynch’s Global Credit, Real Estate and Structured Products, inter-
view by FCIC, September 14, 2010.
93. Al Yoon, “Merrill’s Own Subprime Warnings Unheeded,” Reuters, October 30, 2007.
94. SEC, “Risk Management Reviews of Consolidated Supervised Entities,” internal memo to Erik Si-
rri and others, February 2, 2007, p. 3.
95. Ibid., p. 1.
96. Yoon, “Merrill’s Own Subprime Warnings Unheeded.”
97. Kim, interview.
98. Senate Permanent Subcommittee on Investigations, Fishtail, Bacchus, Sundance, and Slapshot:
Four Enron Transactions Funded and Facilitated by U.S. Financial Institutions, 107th Cong., 2nd sess., Jan-
uary 2, 2003, S-Prt 107–82, pp. 36, 37.
99. “Interagency Statement on Sound Practices” (Notice of final interagency statement), January 5,
2007 (see n. 4, above).
100. Office of the Comptroller of the Currency, Treasury; Office of Thrift Supervision, Treasury;
Board of Governors of the Federal Reserve System; Federal Deposit Insurance Corporation; and Securi-
ties and Exchange Commission, “Interagency Statement on Sound Practices Concerning Complex Struc-
tured Finance Activities” (Notice of interagency statement with request for public comments),May 13,
2004.
101. Ibid., pp. 7–8.
592 Notes to Chapter 10

102. John C. Dugan, Comptroller of the Currency, written testimony for the FCIC, Hearing on Sub-
prime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 2, session 2: Of-
fice of the Comptroller of the Currency, April 8, 2010, Appendix E: OCC Supervision of Citibank, N.A.,
p. 10.
103. “Interagency Statement on Sound Practices” (Notice of final interagency statement), January 5,
2007, p. 6.
104. Basel Committee on Banking Supervision: Joint Forum, “Credit Risk Transfer,” Bank for Interna-
tional Settlements, March 2005, pp. 3–4, 6–7, 5–10.
105. Ibid., p. 4.
106. Ibid.
107. Ibid., pp. 3–4.
108. SEC, Office of Compliance Inspections and Examinations, “Examination Report to Moody’s In-
vestor Services, Inc.,” p. 4 (examination begun August 31, 2007).
109. Warren Buffett, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the In-
vestment Decisions Made Based on Those Ratings, and the Financial Crisis, session 2: Credit Ratings and
the Financial Crisis, June 2, 2010, transcript, p. 301.
110. Warren Buffett, interview by FCIC, May 26, 2010; Buffett, testimony before the FCIC, June 2,
2010, transcript, p. 302.
111. Eric Kolchinsky, written testimony for the FCIC, Hearing on the Credibility of Credit Ratings,
the Investment Decisions Made Based on Those Ratings, and the Financial Crisis, session 1: The Ratings
Process, June 2, 2010, p. 2.
112. Brian Clarkson, interview by FCIC, May 20, 2010.
113. Gary Witt, interview by FCIC, April 21, 2010. John Rutherford was the president and CEO of
Moody’s Corporation from the time of its spin-off from Dun & Bradstreet in 2000 until he retired from
the firm in 2005.
114. Jerome Fons, interview by FCIC, April 22, 2010.
115. Raymond McDaniel, interview by FCIC, May 21, 2010.
116. Clarkson, interview.
117. Ibid.
118. McDaniel, interview.
119. Raymond McDaniel, testimony before the FCIC, Hearing on the Credibility of Credit Ratings,
the Investment Decisions Made Based on Those Ratings, and the Financial Crisis, session 2: Credit Rat-
ings and the Financial Crisis, June 2, 2010, transcript, pp. 203–4.
120. Scott McCleskey, interview by FCIC, April 16, 2010.
121. Clarkson, interview.
122. Witt, interview.
123. Mark Froeba, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the In-
vestment Decisions Made Based on Those Ratings, and the Financial Crisis, session 3: The Credit Rating
Agency Business Model, June 2, 2010, transcript, p. 347.
124. Clarkson, interview; McDaniel, interview.
125. Witt, interview; Gary Witt, testimony before the FCIC, Hearing on the Credibility of Credit Rat-
ings, the Investment Decisions Made Based on those Ratings, and the Financial Crisis, Session 3: The
Credit Rating Agency Business Model, June 2, 2010, transcript, p. 394.
126. Brian Clarkson, email to Ed Bankole, Pramila Gupta, Michael Kanef, Andrew Kriegler, Sam Pil-
cer, Andrew Silver, and Linda Stesney, subject: “June YTD AFG by analyst.xls,” July 5, 2001.
127. William May, email to Gus Harris, subject: “RE: BES and PEs,” January 12, 2006.
128. Yuri Yoshizawa, email to direct report managing directors, subject: “3Q Market Coverage-CDO,”
October 5, 2007.
129. Clarkson, interview.
130. McDaniel, interview.
131. Witt, testimony before the FCIC, June 2, 2010, transcript, pp. 456–57.
132. Moody’s Investors Service: Managing Director’s Town Hall Meeting, September 11, 2007, tran-
script, pp. 42, 51–52.
133. Witt, interview.
 Notes to Chapter 11 593

134. Andrew Kimball, internal email, October 21, 2007, attaching memorandum, “Credit policy is-
sues at Moody’s suggested by the subprime/liquidity crisis.” The susceptibility of a ratings committee to
external pressures was shown in the constant proportion debt obligation (CPDO) scandal in Europe.
135. Ibid., p. 3.
136. David Teicher, project manager at Moody’s, interview by FCIC, May 4, 2010; Standard & Poor’s,
“Credit FAQ: The Basics of Credit Enhancement in Securitizations,” RatingsDirect, June 24, 2008.
137. Richard Michalek, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the
Investment Decisions Made Based on Those Ratings, and the Financial Crisis, session 3: The Credit Rat-
ing Agency Business Model, June 2, 2010, transcript, p. 361.
138. Witt, interview.
139. Clarkson, interview.
140. Fons, interview.
141. Kimball, memorandum, “Credit policy issues at Moody’s,” p. 1.
142. Eric Kolchinsky, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the In-
vestment Decisions Made Based on Those Ratings, and the Financial Crisis, session 1: The Ratings
Process, June 2, 2010, transcript, pp. 68–69.
143. E Kolchinsky, email to Y Fu and Y Yoshizawa, May 30, 2005.
144. Kolchinsky, testimony before the FCIC, June 2, 2010, transcript, pp. 68–69.
145. Eric Kolchinsky, interview by FCIC, April 14, 2010.
146. FCIC staff estimates, based on analysis of Moody’s SFDRS database.
147. Riachra O’Driscoll, email to Yuri Yoshizawa, subject: “Magnolia 2006–5 Class Ds,” April 27, 2006.
148. Kimball, memorandum, “Credit policy issues at Moody’s,” p. 2.
149. SEC, Office of Compliance Inspections and Examinations, “Examination Report for Moody’s In-
vestors Services, Inc.,” p. 2.

Chapter 11
1. William Dudley, interview by FCIC, October 15, 2010.
2. Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 2, The Secondary Mar-
ket (Bethesda, Md.: Inside Mortgage Finance, 2009), p. 13, “Non-Agency MBS Issuance by Type.”
3. FCIC staff estimates based on Moody’s CDO Enhanced Monitoring System (EMS) database.
4. 2009 Mortgage Market Statistical Annual, 2:373, “Commercial MBS Issuance.”
5. Ben S. Bernanke, chairman of the Federal Reserve, letter to Phil Angelides, chairman of the FCIC,
December 21, 2010.
6. Mark Zandi, Celia Chen, and Brian Carey, “Housing at the Tipping Point,” Moody’s Economy.com,
October 2006, pp. 6–7.
7. CoreLogic Home Price Index, Single-Family Combined (available at www.corelogic.com/
Products/CoreLogic-HPI.aspx), FCIC staff calculations, January to January.
8. CoreLogic Census Bureau Statistical Area (CBSA) Home Price Index, FCIC staff calculations.
9. Data provided by Mark Fleming, chief economist for CoreLogic, in his written testimony for the
FCIC, Hearing on the Impact of the Financial Crisis—Sacramento, session 1: Overview of the Sacra-
mento Housing and Mortgage Markets and the Impact of the Financial Crisis on the Region, September
9, 2010, figures 4, 5.
10. Mark Fleming, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—Sacra-
mento, session 1: Overview of the Sacramento Housing and Mortgage Markets and the Impact of the Fi-
nancial Crisis on the Region, September 9, 2010, transcript, p. 14.
11. Mortgage Bankers Association, National Delinquency Survey, data provided to the FCIC.
12. Ibid., with FCIC staff calculations.
13. FCIC staff analysis, “Analysis of housing data,” July 7, 2010. The underlying data come from Core-
Logic and Loan Processing Svcs. Tabulations were provided to the FCIC by staff at the Federal Reserve.
14. Subprime and Alt-A mortgages are defined as those included in subprime or Alt-A securitiza-
tions, respectively. GSE mortgages included mortgages purchased or guaranteed by Fannie Mae or Fred-
die Mac. FHA mortgages included mortgages insured by the FHA or VA.
15. FCIC staff analysis.
594 Notes to Chapter 11

16. A recent analysis published by FHFA comes to very similar conclusions. See “Data on the Risk
Characteristics and Performance of Single-Family Mortgages Originated from 2001 through 2008 and
Financed in the Secondary Market,” September 13, 2010.
17. FCIC staff analysis, “Analysis of housing data and comparison with Ed Pinto’s analysis,” August 9,
2010. In the sample data provided by the Federal Reserve, Fannie Mae and Freddie Mac mortgages with a
FICO score below 660 had an average rate of serious delinquency of 6.2% in 2008. In public reports, the
GSEs stated that the average serious delinquency rates for loans with FICO scores less than 660 in their
guarantee books was 6.3%. Fannie Mae 2008 Credit Supplement, p. 5; Freddie Mac Fourth Quarter 2008
Financial Results Supplement, March 11, 2009, p. 15.
18. In the sample data provided by the Federal Reserve, Fannie Mae and Freddie Mac mortgages with
LTVs above 90% had an average rate of serious delinquency of 5.7% in 2008. In public reports, the GSEs
stated that the average serious delinquency rates for loans with LTVs above 90% in their guarantee books
was 5.8%. Fannie Mae 2008 Credit Supplement, p. 5;
Freddie Mac Fourth Quarter 2008 Financial Results Supplement, March 11, 2009, p. 15.
19. Edward Pinto, “Memorandum: Sizing Total Federal Government and Federal Agency Contribu-
tions to Subprime and Alt-A Loans in U.S. First Mortgage Market as of 6.30.08,” Exhibit 2 with correc-
tions through October 11, 2010 (www.aei.org/docLib/PintoFCICTriggersMemo.pdf). The 26.7 million
loans include 6.7 million loans in subprime securitizations and another 2.1 million loans in Alt-A securi-
tizations, for a total of 8.8 million mortgages in subprime or Alt-A pools, which Pinto calls “self-denomi-
nated” subprime and Alt-A, respectively. To these, he adds another 8.8 million loans with FICO scores
below 660, which he labels “subprime by characteristic.” He also adds 6.3 million loans at the GSEs that
are either interest-only loans, negative amortization loans, or loans with an LTV—including any second
mortgage—greater than 90%, which he collectively refers to as “Alt-A by characteristic.” The last addi-
tions include an estimated 1.4 million loans insured by the FHA and VA with an LTV greater than 90%—
out of a total of roughly 5.5 million FHA and VA loans—and 1.3 million loans in bank portfolios that are
inferred to have his defined “Alt-A characteristics.”
20. Fannie Mae 2008 Credit Supplement, p. 5; Freddie Mac Fourth Quarter 2008 Financial Results
Supplement, March 11, 2009.
21. Edward Pinto, “Yes, the CRA Is Toxic,” City Journal, Autumn 2009.
22. Neil Bhutta and Glenn Canner, “Did the CRA Cause the Mortgage Market Meltdown?” Federal
Reserve Board of Governors, March 2009. The authors use the Home Mortgage Disclosure Act data,
which cover roughly 80% of the mortgage market in the United States—see Robert B. Avery, Kenneth P.
Brevoort, and Glenn B. Canner, “Opportunities and Issues in Using HMDA Data,” Journal of Real Estate
Research 29, no. 4 (October 2007): 351–79.
23. Elizabeth Laderman and Carolina Reid, “Lending in low and moderate income neighborhoods in
California: The Performance of CRA Lending During the Subprime Meltdown,” November 26, 2008,
working paper to be presented at the Federal Reserve System Conference on Housing and Mortgage Mar-
kets, Washington, DC, December 4, 2008.
24. FCIC, “Preliminary Staff Report: The Mortgage Crisis,” April 7, 2010.
25. Bank of America response letter to FCIC, August 20, 2010.
26. John Reed, interview by FCIC, March 4, 2010.
27. Lewis Ranieri, interview by FCIC, July 30, 2010.
28. Nicolas Weill, interview by FCIC, May 11, 2010.
29. Ibid.
30. Nicolas Weill, email to Raymond McDaniel and Brian Clarkson, July 4, 2007.
31. Moody’s Investors Service, “Early Defaults Rise in Mortgage Securitizations,” Structured Finance:
Special Report, January 18, 2007, pp. 1, 3.
32. Moody’s Investors Service, “Moody’s Downgrades Subprime First-lien RMBS-Global Credit Re-
search Announcement,” July 10, 2007.
33. Weill, interview.
34. FCIC staff estimates, based on analysis of Blackbox data.
35. Data on Bear Stearns provided by JP Morgan to the FCIC.
 Notes to Chapter 11 595

36. Moody’s Investors Service, “Moody’s Downgrades $33.4 billion of 2006 Subprime First-Lien
RMBS and Affirms $280 billion Aaa’s and Aa’s,” October 11, 2007; “October 11 Rating Actions Related to
2006 Subprime First-Lien RMBS,” Structured Finance: Special Report, October 17, 2007, pp. 1–2.
37. FCIC staff estimates, based on analysis of Blackbox data.
38. FCIC staff estimates, based on analysis of Moody’s SFDRS data as of April 2010.
39. Moody’s Investors Service, “The Impact of Subprime Residential Mortgage-Backed Securities on
Moody’s-Rated Structured Finance CDOs: A Preliminary Review,” Structured Finance: Special Com-
ment, March 23, 2007, p. 2.
40. Yuri Yoshizawa, email to Noel Kirnon and Raymond McDaniel, cc Eric Kolchinsky, subject:
“CSFB Pipeline information,” March 28, 2007.
41. Moody’s Investors Service, “First Quarter 2007 U.S. CDO Review: Climbing the Wall of Subprime
Worry,” Structured Finance: Special Report, May 31, 2007, p. 2.
42. Richard Michalek, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the
Investment Decisions Made Based on Those Ratings, and the Financial Crisis, session 3: The Credit Rat-
ing Agency Business Model, June 2, 2010, transcript, pp. 448–49.
43. “2007 MCO Strategic Plan Overview,” presentation by Ray McDaniel, July 2007.
44. Eric Kolchinsky—retaliation complaint, Chronology Prepared by Eric Kolchinsky.
45. FCIC staff estimates based on analysis of Moody’s SFDRS; FCIC, “Preliminary Staff Report: Credit
Ratings and the Financial Crisis,” June 2, 2010.
46. Eric Kolchinsky, interview by FCIC, April 27, 2010. 4838–2303–6167 (checked–BLK ); Kolchinsky—
retaliation complaint.
47. Eric Kolchinsky—retaliation complaint.
48. FCIC, “PSR: Credit Ratings and the Financial Crisis,” pp. 30–33.
49. Bingham McCutchen, Fannie Mae counsel, letter to FCIC, September 21, 2010 (hereafter “Bing-
ham Letter”); O’Melveny & Meyers LLP, Freddie Mac counsel, letter to FCIC, September 21, 2010 (here-
after “O’Melveny Letter”).
50. Federal Housing Finance Agency, “Conservator’s Report on the Enterprises’ Financial Perform-
ance: Third Quarter 2010,” tables 3.1 and 4.1.
51. Raymond Romano, interview by FCIC, September 14, 2010; Bingham Letter.
52. Bingham Letter.
53. Bingham Letter, Tab 3; Tab 1, “Repurchase Collections by Top Ten Sellers/Servicers.”
54. O’Melveny letter.
55. “Bank of America announces fourth-quarter actions with respect to its home loans and insurance
business,” Bank of America press release, January 3, 2011.
56. Mortgage Insurance Companies of America, 2009–2010 Fact Book and Member Directory, Exhibit
3: Primary Insurance Activity (Insurance in Force) p 17.
57. Documents produced for the FCIC by United Guaranty Residential Insurance, MGIC, Genworth,
RMIC, Triad, PMI, and Radian.
58. FCIC staff calculations based on productions from Fannie and Freddie. Figures are for Alt-A,
option ARM Alt-A, and subprime loans.
59. FHFA, “Conservator’s Report: Third Quarter 2010.” Accounting changes for impairments have re-
sulted in offsetting gains of $8 billion.
60. “FHFA Issue Subpoenas for PLS Documents,” Federal Housing Finance Agency news release, July
12, 2010.
61. Covington & Burling LLP, Freddie Mac counsel, letter to FCIC, October 19, 2010; see O’Melveny
& Meyers LLP, letter to FCIC, dated October 19, 2010.
62. NERA Economic Consulting, “Credit Crisis Litigation Revisited: Litigating the Alphabet of Struc-
tured Products,” Part VII of a NERA Insights Series, June 4, 2010, p. 1.
63. Defendants Wells Fargo Asset Securities Corp. and Wells Fargo Bank, N.A.’s Notice of Removal,
Charles Schwab Corp. v. BNP Paribas Securities Corp, et al., No. cv-10-4030 (N.D. Cal. September 8,
2010).
596 Notes to Chapter 12

64. Attorney General of Massachusetts, “Attorney General Martha Coakley and Goldman Sachs
Reach Settlement Regarding Subprime Lending Issues,” May 11, 2009; “Morgan Stanley to Pay $102 Mil-
lion for Role in Massachusetts Subprime Mortgage Meltdown under Settlement with AG Coakley’s Of-
fice,” June 24, 2010.
65. Complaint, Cambridge Place v. Morgan Stanley et al., No. 10-2741 (Mass. Super. Ct. filed July 9,
2010), p. 28.
66. Sarah Johnson, “How Far Can Fair Value Go?” CFO.com, May 6, 2008.
67. Vikas Shilpiekandula and Olga Gorodetsky, “Who Owns Residential Credit Risk?” Lehman Broth-
ers Fixed Income, U.S. Securitized Products Research, September 7, 2007.
68. Moody’s Investor Service, “Default & Loss Rates of Structured Finance Securities: 1993–2009,”
Special Comment, September 23, 2010.
69. Ben Bernanke, closed-door session with the FCIC, November 17, 2009.
70. Vikas Shilpiekandula and Olga Gorodetsky, “Who Owns Residential Credit Risk?,” September 7,
2007, p. 1. The Lehman analysts pegged ultimate subprime and Alt-A losses at $200 billion. Those fore-
casts were based, the analysts said, on a scenario in which house prices fell an average of 30% across the
country. For the securitization figures, see Inside Mortgage Finance, The 2009 Mortgage Market Statisti-
cal Annual, vol. 2, The Secondary Market.
71. IMF, “Financial Stress and Deleveraging: Macro-Financial Implications and Policy,” Global Finan-
cial Stability Report, October 2008, p. 78; IMF, “Containing Systemic Risks and Restoring Financial
Soundness,” Global Financial Stability Report, April 2008.
72. FCIC staff estimates, based on Moody’s Investor Service, “Default & Loss Rates of Structured Fi-
nance Securities: 1993–2009,” Special Comment, September 23, 2010, and analysis of Moody’s Structured
Finance Default Risk Service.
73. Ben Bernanke, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of
Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 2, ses-
sion 1: The Federal Reserve, September 2, 2010, transcript, p. 54.

Chapter 12
1. FCIC staff calculations using data in worksheets Markit ABX.HE. 06-1 prices and ABX.HE. 06-2
prices, produced by Markit; Nomura Fixed Income Research, CDO/CDS Update 12/18/06. The figures re-
fer to the BBB- index of the ABX.HE. 06-2.
2. Nomura Fixed Income Research, CDO/CDS Update 12/18/06, p. 2.
3. SEC, “Risk Management Reviews of Consolidated Supervised Entities,” internal memo to Erik Sirri
and others, January 4, 2007.
4. Jim Chanos, interview by FCIC, October 5, 2010.
5. SEC, “Risk Management Reviews of Consolidated Supervised Entities,” memo, January 4, 2007.
6. Fed Chairman Ben S. Bernanke, “The Economic Outlook,” testimony before the Joint Economic
Committee, U.S. Congress, 110th Cong., 1st sess., March 28, 2007.
7. Henry Paulson, quoted in Julie Haviv, “Bernanke Allays Subprime Fears as Beazer Faces Probe,”
Reuters, March 28, 2007.
8. David Viniar, written testimony, Wall Street and the Financial Crisis: The Role of Investment Banks,
Senate Permanent Subcommittee on Investigation, 111th Cong., 2nd sess., April 27, 2010, pp. 3–4.
9. Michael Dinias, email to David Viniar and Craig Broderick, December 13, 2006, Senate Permanent
Subcommittee on Investigations, Exhibit 2.
10. Viniar, written testimony, Permanent Subcommittee on Investigation, pp. 3–4; Daniel Sparks,
email to Tom Montag and Richard Ruzika, December 14, 2006, Senate Permanent Subcommittee on In-
vestigations, Exhibit 3.
11. Kevin Gasvoda, email to Genevieve Nestor and others, December 14, 2006, Senate Permanent
Subcommittee on Investigations, Exhibit 72.
12. David Viniar, email to Tom Montag, December 15, 2006, Senate Permanent Subcommittee on In-
vestigations, Exhibit 3.
13. Stacy Bash-Polley, email to Michael Swenson and others, December 20, 2006, Senate Permanent
Subcommittee on Investigations, Exhibit 151.
 Notes to Chapter 12 597

14. Tetsuya Ishikawa, email to Darryl Herrick, October 11, 2006, Senate Permanent Subcommittee on
Investigations, Exhibit 170c; Geoffrey Williams, email to Ficc-Mtgcorr-desk, October 24, 2006, Senate
Permanent Subcommittee on Investigations, Exhibit 170d.
15. Fabrice Tourre, email to Jonathan Egol and others, December 28, 2006, Senate Permanent Sub-
committee on Investigations, Exhibit 61.
16. Daniel Sparks, email to Tom Montag, January 31, 2007, Senate Permanent Subcommittee on
Investigations, Exhibit 91.
17. Fabrice Tourre, email to Marine Serres, January 23, 2007, Senate Permanent Subcommittee on
Investigations, Exhibit 62.
18. Lloyd Blankfein, email to Tom Montag, February 11, 2007, Senate Permanent Subcommittee on
Investigations, Exhibit 130.
19. FCIC calculations using data from “2004–2007 GS Synthetic CDOs,” produced by Goldman
Sachs.
20. Gretchen Morgenson and Louise Story, “Banks Bundled Bad Debt, Bet Against It and Won,” New
York Times, December 24, 2009.
21. Lloyd Blankfein, testimony before the FCIC, First Public Hearing of the FCIC, first day, panel 1:
Financial Institution Representatives, January 13, 2010, transcript, pp. 26–27.
22. “Goldman Sachs Clarifies Various Media Reports of Aspect of FCIC Hearing,” Goldman Sachs
press release, January 14, 2010.
23. Gary Cohn, testimony before the FCIC, Hearing on the Role of Derivatives in the Financial Crisis,
day 1, session 3: Goldman Sachs Group, Inc. and Derivatives, June 30, 2010, transcript, p. 267.
24. Michael Swenson, opening statement, Hearing on Wall Street and the Financial Crisis: The Role of
Investment Banks, Senate Permanent Subcommittee on Investigations, pp. 2–3.
25. Complaint, Basis Yield Alpha Fund v. Goldman Sachs Group, Inc., et al. (S.D.N.Y. June 9, 2010),
p. 29.
26. Blankfein, testimony before the FCIC, January 13, 2010, transcript, p. 140.
27. Craig Broderick, written testimony for the FCIC, Hearing on the Role of Derivatives in the Finan-
cial Crisis, day 1, session 3: Goldman Sachs Group, Inc. and Derivatives, June 30, 2010, p. 1.
28. Craig Broderick, email to Alan Rapfogel and others, May 11, 2007, Senate Permanent Subcommit-
tee on Investigations, Exhibit 84.
29. High Grade Risk Analysis, April 27, 2007, p. 4; High Grade—Enhanced Leverage Q&/A, June 13,
2007, stating “the percentage of underlying collateral in our investment grade structures collateralized by
“sub-prime” mortgages is approximately 60. On the March 12, 2007, investor call, Matthew Tannin told
investors that “most of the CDOs that we purchased are backed in some form by subprime” (Conference
Call transcript, pp. 21–22).
30. Email from matt.tannin@gmail.com to matt.tannin@gmail.com, November 23, 2006.
31. Matthew Tannin, Bear Stearns, email to Chavanne Klaus, MEAG New York, March 7, 2007.
32. BSAM Conference Call, April 25, 2007, transcript, p. 5.
33. Matt Tannin, Bear Stearns, email to Klaus Chavanne, MEAG New York, March 7, 2007; Matthew
Tannin, email to Steven Van Solkema, March 30, 2007; Complaint, SEC v. Cioffi, No. 08 Civ. 2457
(E.D.N.Y. June 19, 2008), p. 32.
34. Jim Crystal, Bear Stearns, email to Ralph Cioffi (and others), March 22, 2007; Ralph Cioffi, Bear
Stearns, email to Ken Mak, Bear Stearns, March 23, 2007.
35. Warren Spector, testimony before the FCIC, Hearing on the Shadow Banking System, day 1, ses-
sion 1: Investment Banks and the Shadow Banking System, May 5, 2010, transcript, pp. 83–84.
36. Information provided to FCIC by legal counsel to Bank of America, September 28, 2010.
37. Ibid.
38. Alan Schwartz, interview by FCIC, April 23, 2010. Notably, as one of only two tri-party repo clear-
ing banks, JP Morgan had more information about BSAM’s lending obligations than did most other mar-
ket participants or regulators. As discussed in greater detail later in this chapter, this superior market
knowledge later put JP Morgan in a position to step in and purchase Bear Stearns virtually overnight.
39. Email from Goldman to Bear, April 2, 2007.
40. Steven Van Solkema, Bear Stearns, internal email, Summary of CDO Analysis Using Credit
Model, April 19, 2007.
598 Notes to Chapter 12

41. Matt Tannin, Bear Stearns, email from Gmail account to Ralph Cioffi, Bear Stearns, at his Hotmail
account, April 22, 2007.
42. BSAM Conference Call, April 25, 2007, transcript.
43. Iris Semic, email to Matthew Tannin et al., May 1, 2007.
44. Robert Ervin, email to Ralph Cioffi et al., May 1, 2007; email from Goldman (ficc-ops-cdopricing)
to rervin@bear.com, May 1, 2007.
45. BSAM Pricing Committee minutes, June 5, 2007; Robert Ervin, email to Greg Quental et al., May
10, 2007, showing that losses for the High Grade fund would be 7.02% if BSAM used the prices Lehman’s
repo desk was using, rather than 11.45%—the loss without Lehman’s marks.
46. Email from “BSAM Hedge Fund Product Management (Generic),” May 16, 2007, produced by
JP Morgan.
47. BSAMFCIC-e0000013. An untitled chart produced by JPMorgan shows losses would have been
over $50 million less; NAV estimate reconciliation chart, produced by JPMorgan, shows losses would
have been almost $25 million less.
48. BSAM Pricing Committee minutes, June 4, 2007.
49. Ralph Cioffi, interview by FCIC, October 19, 2010.
50. Ralph Cioffi, email to John Geissinger, June 6, 2007.
51. Schwartz, interview.
52. Ibid.
53. Ibid.; CSE Program Memorandum to Erik Sirri and others through Matthew Eichner, July 5, 2007.
54. CSE Program Memorandum, July 5, 2007.
55. CSE Program Memorandum, July 5, 2007; Merrill Lynch analysis, “Bear Stearns Asset Mgm’t:
What Went Wrong”; Paul Friedman, interview by FCIC, April 28, 2010. While most of the Bear Stearns
executives interviewed by FCIC staff did not recall the percentage discount at which the collateral seized
by Merrill Lynch was auctioned, they did believe that it was significant (e.g., Robert Upton, interview by
FCIC, April 13, 2010).
56. “While the High Grade fund was not in default/had not missed any margin calls, creditors were
cutting off its liquidity by increasing haircuts or not rolling repo facilities.” Bear Stearns Packet dated
May 30, meeting held on June 20, produced by the Securities and Exchange Commission, p. 3; Upton,
interview.
57. Warren Spector, email to Mary Kay Scucci, April 26, 2007.
58. Friedman, interview; Warren Spector, interview by FCIC, March 30, 2010; Sam Molinaro, inter-
view by FCIC, April 9, 2010.
59. Thomas Marano, interview by FCIC, April 19, 2010; Spector, interview (on Marano’s being sent to
Marin).
60. Fed Chairman Ben S. Bernanke, letter to FCIC Chairman Phil Angelides, December 21, 2010.
61. James Cayne, interview by FCIC, April 21, 2010.
62. SEC, “Risk Management Reviews of Consolidated Supervised Entities,” memo to Erik Sirri and
others, August 3, 2007, p. 2; SEC, “Risk Management Reviews of Consolidated Supervised Entities,”
memo to Erik Sirri and others, July 5, 2007, p. 3, both produced by SEC.
63. Marano, interview.
64. Bill Jamison, internal email, June 21, 2007, produced by Federated.
65. JPMorgan, Directors Risk Policy Committee, “Worldwide Securities Services Risk Review,” Sep-
tember 18, 2007; Michael Alix, interview by FCIC, April 8, 2010.
66. For the downgrades, see Moody’s Investor Service, “Announcement: Moody’s Downgrades Sub-
prime First-Lien RMBS,” July 10, 2007; Standard & Poor’s, “S&PCorrect: 612 U.S. Subprime RMBS
Classes Put on Watch Neg; Methodology Revisions Announced,” July 11, 2007; Standard & Poor’s, “Vari-
ous U.S. First-Lien Subprime RMBS Classes Downgraded,” July 12, 2007, p. 2; Glenn Costello, “U.S. Sub-
prime Rating Surveillance Update,” Fitch Ratings, July 2007.
67. FCIC, “Preliminary Staff Report: Credit Ratings and the Financial Crisis,” June 2, 2010, p. 29.
68. Steven Eisman and Tom Warrack, Standard & Poor’s Structured Finance, July 10, 2007, teleconfer-
ence, transcript, p. 16.
69. Andrew Forster, telephone conversation, July 11, 2007, transcript, pp. 3–5.
 Notes to Chapter 13 599

70. Martin Sullivan, interview by FCIC, June 17, 2010; Steve Bensinger, interview by FCIC, June 16,
2010; Robert Lewis, interview by FCIC, June 15, 2010; Kevin McGinn, interview by FCIC, June 10, 2010;
Andrew Forster, Elias Habayeb, and Steve Bensinger, testimony before the FCIC, Hearing on the Role of
Derivatives in the Financial Crisis, day 2, session 1: American International Group, Inc. and Goldman
Sachs Group, Inc., July 1, 2010, transcript, pp. 11, 61–62.
71. Clarence K. Lee, former managing director for Complex and International Organizations, Office
of Thrift Supervision, testimony before the FCIC, Hearing on the Role of Derivatives in the Financial
Crisis, day 2, session 2: Derivatives: Supervisors and Regulators, July 1, 2010, transcript, pp. 232–35.
72. Alan Frost, interview by FCIC, May 11, 2010.
73. Joseph Cassano, interview by FCIC, June 25, 2010.
74. “Information Pertaining to the Multi-Sector CDS Portfolio,” produced by AIG, with FCIC staff
calculations.
75. Andrew Davilman, email to Alan Frost, subject: “Sorry to bother you on”; Frost, email to Davil-
man, subject: “Re: Sorry to bother you on”; Davilman, email to Frost, subject: “Re: Sorry to bother you
on”—all July 26, 2007.
76. Goldman Sachs International, Collateral Invoice to AIG Financial Products Corp., July 27, 2007,
produced by Goldman Sachs.
77. AIG hedges, January 2006–December 2008, produced by Goldman Sachs.
78. Andrew Forster, interview by FCIC, June 23, 2010.
79. Daniel Sparks, interview by FCIC, May 11, 2010.
80. “Valuation & Pricing Related to Initial Collateral Calls on Transactions with AIG,” produced by
Goldman Sachs.
81. Jon Liebergall and Andrew Forster, telephone conversation, July 30, 2007, transcript, pp. 402–4.
82. David Viniar, written testimony for the FCIC, Hearing on the Role of Derivatives in the Financial
Crisis, day 2, session 1: American International Group, Inc. and Goldman Sachs Group, Inc., July 1, 2010,
p. 2.
83. Liebergall and Forster, telephone conversation, July 30, 2007, transcript, p. 407.
84. Tom Athan, email to Andrew Forster, August 1, 2007.

Chapter 13
1. Henry Paulson, quoted in Kevin Carmichael and Peter Cook, “Paulson Says Subprime Rout Doesn’t
Threaten Economy,” Bloomberg, July 26, 2007.
2. Moody’s Investors Service, “Moody’s ABCP Program Index: CP Outstanding as of 06/30/2007.”
3. Moody’s Investors Service, “Moody’s Performance Overview: Rhineland Funding Capital Corpora-
tion,” June 30, 2007.
4. As noted, in the United States, there was a minimal capital charge for liquidity puts equal to 10% of
the base 8%, or 0.8%. Staff of Bundesanstalt fur Finanzdienstleistungsaufsicht (the Federal Financial
Services Supervisory Authority, Germany’s bank regulators), interview by FCIC, September 8, 2010. See
also Office of the Comptroller of the Currency, “Interagency Guidance on the Eligibility of Asset-Backed
Commercial Paper Liquidity Facilities and the Resulting Risk-Based Capital Treatment,” August 4, 2005.
For example, Citigroup would have held $200 million in capital against potential losses on the $25 billion
in liquidity put exposure that it had accumulated on CDOs it had issued.
5. IKB, 2006/2007 Annual Report, June 28, 2007, p. 78.
6. Securities Fraud Complaint, Securities and Exchange Commission v. Goldman Sachs & Co. and
Fabrice Tourre, no. 10-CV-3229 (S.D.N.Y. April 15, 2010), p. 6.
7. IKB staff, interview by FCIC, August 27, 2010; Securities and Exchange Commission (plaintiff)
v. Goldman Sachs & Co. and Fabrice Tourre (defendants), Securities Fraud Complaint, 10-CV-3229,
United States District Court, Southern District of New York, April 15, 2010, at 17, paragraph 58.
8. “Preliminary results for the first quarter (1 April-30 June 2007),” IKB press release, July 20, 2007.
9. IKB staff, interview; IKB, clarification of interview by FCIC, November 15, 2010; IKB, restated
2006/2007 Annual Report, p. 5.
10. Steven Meier, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session
3: Institutions Participating in the Shadow Banking System, May 6, 2010, transcript, p. 307.
600 Notes to Chapter 13

11. Angelo Mozilo, testimony taken by the SEC in the matter of Countrywide Financial Corp., File
No. LA-03370-A, November 9, 2007, pp. 150, 36–37.
12. Angelo Mozilo, email to Lyle Gramley, member of Board of Countrywide Financial Corporation
(cc Michael Perry, chief executive officer, IndyMac Bank), August 1, 2007.
13. Eric Sieracki, quoted in Mark DeCambre, “Countrywide Defends Liquidity,” TheStreet.com, Au-
gust 2, 2007.
14. “Minutes of a Special Telephonic Meeting of the Board of Directors of Countrywide Financial
Corporation,” August 6, 2007, pp. 1, 2, 1.
15. Fed Chairman Ben Bernanke, letter to FCIC Chairman Phil Angelides, December 21, 2010.
16. Federal Reserve Staff, memo to Board of Governors of the Federal Reserve System, “Background
on Countrywide Financial Corporation,” August 14, 2007, pp. 1–2.
17. Ibid., pp. 12–13.
18. Countrywide Financial Corporation, Form 8-K, Exhibit 99.1, filed August 6, 2007. See also “Min-
utes of a Special Telephonic Meeting of the Boards of Directors of Countrywide Financial Corporation
and Countrywide Bank, FSB,” August 15, 2007.
19. Angelo Mozilo, interview by FCIC, September 24, 2010.
20. Kenneth Bruce, “Liquidity Is the Achilles Heel,” Merrill Lynch Analyst Report, August 15, 2007, p.
4; Kenneth Bruce, “Attractive Upside, but Not without Risk,” Merrill Lynch Analyst Report, August 13,
2007, p. 4.
21. Mozilo, interview; the article, by E. Scott Reckard and Annette Haddad, was titled “Credit Crunch
Imperils Lender: Worries Grow about Countrywide’s Ability to Borrow—and Even a Possible Bank-
ruptcy.”
22. Angelo Mozilo, quoted in “One on One with Angelo Mozilo, Chairman and CEO of Countrywide
Financial,” Nightly Business Report, PBS, August 23, 2007, transcript; and in “CEO Exclusive: Country-
wide CEO, Pt. 1,” The Call, CNBC, interview by Maria Bartiromo, August 23, 2007, transcript, p. 1.
23. Sebastian Boyd, “BNP Paribas Freezes Funds as Loan Losses Roil Markets,” Bloomberg, August 9,
2007.
24. “BNP Paribas Investment Partners Temporally [sic] Suspends the Calculation of the Net Asset
Value of the following funds: Parvest Dynamic ABS, BNP Paribas ABS EURIBOR and BNP Paribas ABS
EONIA,” BNP Paribas press release, August 9, 2007.
25. Paul A. McCulley, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, ses-
sion 3: Institutions Participating in the Shadow Banking System, May 6, 2010, pp. 237, 309.
26. Daniel M. Covitz, Nellie Liang, and Gustavo A. Suarez, “The Evolution of a Financial Crisis: Panic
in the Asset-Backed Commercial Paper Market,” August 24, 2009, p. 39.
27. Ibid., figure 1, panel B, p. 33.
28. “The Federal Reserve Is Providing Liquidity to Facilitate the Orderly Functioning of Financial
Markets,” Federal Reserve Board press release, August 10, 2007.
29. Federal Reserve Board, press release, August 17, 2007.
30. Henry Tabe, Moody’s Investors Service, “SIVs: An Oasis of Calm in the Sub-prime Maelstrom:
Structured Investment Vehicles,” International Structured Finance: Special Report, July 20, 2007, p. 1.
31. Ibid.
32. Henry Tabe, interview by FCIC, October 4, 2010.
33. Moody’s Investors Service, “From Illiquidity to Liquidity: The Path Toward Credit Market Nor-
malization,” Moody’s International Policy Perspectives, September 5, 2007, p. 1.
34. Tabe, interview.
35. Moody’s Investors Service, “Moody’s Update on Structured Investment Vehicles,” Moody’s Special
Report, January 16, 2008, p. 12.
36. Information provided to the FCIC by Deloitte LLP’s counsel, August 2, 2010.
37. Moody’s Rating Action, “Sigma Finance,” September 30, 2008; Henry Tabe, The Unravelling of
Structured Investment Vehicles: How Liquidity Leaked through SIVs: Lessons in Risk Management and Reg-
ulatory Oversight ([Chatham, Kent]: Thoth Capital, 2010), p. 60.
38. The SEC indicated it is aware of at least 44 money market funds that were supported by affiliates
because of SIV investments. See Securities and Exchange Commission, “Money Fund Reform” (Proposed
rule), June 20, 2009, p. 14 n. 38.
 Notes to Chapter 14 601

39. Christopher Condon and Rachel Layne, “GE Bond Fund Investors Cash Out After Losses from
Subprime,” Bloomberg, November 15, 2007.
40. The identity of the investor has never been publicly disclosed. See Shannon D. Harrington and
Sree Vidya Bhaktavatsalam, “Bank of America to Liquidate $12 Billion Cash Fund,” Bloomberg, Decem-
ber 10, 2007. See also Michael M. Grynbaum, “Mortgage Crisis Forces the Closing of a Fund,” New York
Times, December 11, 2007.
41. Rich Rokus, portfolio manager at Marshall Money Market Funds, interview by Crane Data, Money
Fund Intelligence, June 2009; Crane Data, Money Fund Intelligence, January 2008.
42. Credit Suisse Institutional Money Market Fund, Inc., Notes to Financial Statements, December 31,
2008, Note 3, p. 30.
43. Florida Legislature, Office of Program Policy Analysis and Government Accountability, “The SBA
[State Board of Administration] Is Correcting Problems Relating to Its Oversight of the Local Govern-
ment Investment Pool,” Research Memorandum, March 31, 2009, p. 2.
44. SBA report, “Update on Sub-Prime Mortgage Meltdown and State Board of Administration In-
vestments,” November 9, 2007, pp. 721–22.

Chapter 14
1. Bloomberg Professional, Write downs and Credit Losses vs. Capital Raised (WDCI) function, data
reported for second half of 2007. Write-downs are for losses to holdings in structured finance and mort-
gages.
2. Roy C. Smith, Paper Fortune$: Modern Wall Street: Where It’s Been and Where It’s Going (New York:
St. Martin’s 2009), p. 341.
3. Bloomberg Historical Prices Index December 31, 2007; CGS1U5; CBSC1U5; and CLEH1U5. Fig-
ures refer to credit default swaps on five-year senior debt.
4. Presentation to Merrill Lynch & Co. Board of Directors, “Leveraged Finance and Mortgage/CDO
Review,” October 21, 2007, p. 23.
5. Presentation to Merrill board, October 21, 2007, p. 23.
6. Dow Kim, interview by FCIC, September 10, 2010.
7. Presentation to Merrill Board of Directors, October 21, 2007, p. 23.
8. Ibid., pp. 23–24.
9. Presentation to Merrill Lynch Risk Oversight Committee, “Market Risk Management Update,” Sep-
tember 26, 2007, p. 7.
10. Merrill Lynch, 1Q 2007 Earnings Call transcript, April 19, 2007, p. 3.
11. Merrill Lynch, 2Q 2007 Earnings Release, July 17, 2007, p. 1.
12. Merrill Lynch, 2Q 2007 Earnings Call transcript, July 17, 2007, pp. 8, 20.
13. Merrill Lynch Finance Committee Summary, July 22, 2007, p. 7.
14. Ibid.
15. Kim, interview.
16. Stanley O’Neal, interview by FCIC, September 16, 2010.
17. “ABS CDO Update” by Dale Lattanzio, July 2007, p. 10.
18. O’Neal, interview.
19. Merrill Lynch, 3Q 2007 Earnings Call transcript, October 24, 2007, pp. 7, 10.
20. SEC narrative chronology, Merrill Lynch specific, p. 1.
21. Nancy Moran and Rodney Yap, “O’Neal Ranks No. 5 on Payout List, Group Says: Table (Up-
date1),” Bloomberg, November 2, 2007.
22. Kim interview; Merrill Lynch, 2007 Proxy Statement, April 27, 2007, p. 47.
23. Charles Prince, interview by FCIC, March 17, 2010; Robert Rubin, interview by FCIC, March 11,
2010.
24. Prince, interview.
25. Moody’s Investors Service, “Structured Finance Rating Transitions: 1983–2006,” Special Com-
ment, January 2007.
26. Charles Prince, testimony before the FCIC, Hearing on Subprime Lending and Securitization and
Government-Sponsored Enterprises (GSEs), day 2, session 1: Citigroup Senior Management, April 8,
2010, transcript, p. 11.
602 Notes to Chapter 14

27. Prince, interview.

28. Tobias Brushammar, James Hua, Graham Jackson, and Subra Viswanathan, Citigroup memoran-
dum to Nestor Dominguez, Janice Warne, Michael Raynes, and Jo-Anne Williams, subject: Liquidity Put
Valuation, October 19, 2006.
29. Susan Mills, interview by FCIC, February 3, 2010; James Xanthos, interview by Financial Industry
Regulatory Authority (FINRA), March 24, 2009.
30. Susan Mills, testimony before the FCIC, hearing on Subprime Lending and Securitization and
Government-Sponsored Enterprises (GSEs), day 1, session 2: Subprime Origination and Securitization,
April 7, 2010, transcript, pp. 186–87.
31. Mills, interview.
32. Murray Barnes, former managing director of Independent Risk, interview by FCIC, March 2,
2010.
33. Notes on Senior Supervisors’ Meeting with Firms, meeting between Citigroup and Federal Re-
serve Bank of New York, Federal Reserve Board, Office of the Comptroller of the Currency, Securities
and Exchange Commission, U.K. Financial Services Authority, and Japan FSA, November 19, 2007, p. 17.
34. Janice Warne, interview by FCIC, February 2, 2010; Nestor Dominguez, interview by FCIC,
March 2, 2010.
35. Dominguez, interview.
36. Nestor Dominguez, testimony before the FCIC, Hearing on Subprime Lending and Securitization
and Government-Sponsored Enterprises (GSEs), day 1, session 3: Citigroup Subprime-Related Struc-
tured Products and Risk Management, April 7, 2010, transcript, pp. 282–83.
37. Barnes, interview.
38. Ibid.
39. Notes on Senior Supervisors’ Meeting with Firms, meeting with Citigroup, November 19, 2007,
p. 6.
40. FCIC staff calculations.
41. Prince, testimony before the FCIC, April 8, 2010, transcript, p. 118; David Bushnell, interview by
FCIC, April 1, 2010.
42. Bushnell, interview.
43. Ellen “Bebe” Duke, Citigroup Independent Risk, interview by FCIC, March 18, 2010.
44. Barnes, interview.
45. James Xanthos, interview by Financial Industry Regulatory Authority (FINRA), March 24, 2009.
46. Barnes, interview.
47. Prince, interview.
48. Robert Rubin, former chairman of the Executive Committee and adviser, interview by FCIC,
March 11, 2010.
49. Thomas Maheras, former co-CEO of Citi Markets & Banking, interview by FCIC, March 10, 2010.
50. Prince, interview.
51. Citigroup, Presentation to the Securities and Exchange Commission Regarding Overall CDO
Business and Subprime Exposure, June 2007, p. 11.
52. Paul, Weiss, Citigroup’s counsel, response to FCIC Interrogatory #18, March 1, 2010.
53. Citigroup, 2Q 2007 Earnings Call Q&A transcript, July 20, 2007.
54. Complaint, Securities and Exchange Commission v. Citigroup Inc., 1:10-cv-01277 (D.D.C), July
29, 2010.
55. Federal Reserve Board of New York, letter to Vikram Pandit and the Board of the Directors of
Citigroup, April 15, 2008, p. 11.
56. Dominguez, testimony before the FCIC, April 7, 2010, transcript, p. 281.
57. Maheras, interview, and testimony before the FCIC, Hearing on Subprime Lending and Securiti-
zation and Government-Sponsored Enterprises (GSEs), day 1, session 3: Citigroup Subprime-Related
Structured Products and Risk Management, April 7, 2010, transcript, p. 269.
58. Bushnell, interview.
59. Prince, interview.
60. Complaint, Securities and Exchange Commission v. Citigroup Inc., p. 13.
61. Maheras, interview.
 Notes to Chapter 14 603

62. Prince, interview; Charles Prince, email to Robert Rubin, re, September 9, 2007, 9:43 A.M. (on
Thomas Maheras and super seniors).
63. Robert Rubin, email to Charles Prince, September 9, 2007, 5:30 P.M.; Charles Prince, email to
Robert Rubin, September 9, 2007, 5: 51 P.M.
64. Robert Rubin, interview by FCIC, March 11, 2010.
65. Prince, interview.
66. Ibid.
67. Citigroup, “Risk Management Review: An Update to the Corporate Audit and Risk Management
Committee,” October 15, 2007, p. 4.
68. Citigroup, Q3 2007 Earnings Call transcript, October 15, 2007.
69. Prince, interview.
70. Paul, Weiss, Citigroup’s counsel, letter to FCIC in re the FCIC’s second and third supplemental re-
quests, March 31, 2010; Citigroup, 2008 Proxy Statement for fiscal year 2007, March 13, 2008, p. 74.
71. Federal Reserve Board of New York, letter to Vikram Pandit and the Board of Directors of Citi-
group, April 15, 2008, p. 8.
72. FCIC staff calculations from Citigroup proxy statements (information for 2000–06) and informa-
tion on 2007–09 provided by Paul, Weiss (on behalf of Citigroup), letter to FCIC, March 31, 2010, “Re-
sponse to Interrogatory No. 7,” pp. 3–6.
73. Robert Rubin, testimony before the FCIC, Hearing on Subprime Lending and Securitization and
Government-Sponsored Enterprises (GSEs), day 2, session 1: Citigroup Senior Management, April 8,
2010, transcript, pp. 15–16.
74. John Reed, interview by FCIC, March 24, 2010.
75. AIG, Earnings Call credit supplement, August 9, 2007.
76. Joseph St. Denis, letter to House Committee on Oversight and Government Reform, U.S. House of
Representatives, October 4, 2008, p. 4.
77. Joseph St. Denis, interview by FCIC, April 23, 2010.
78. Gene Park, interview by FCIC, May 18, 2010.
79. Jake Sun, interview by FCIC, June 21, 2010.
80. Alan Frost, interview by FCIC, May 11, 2010.
81. Pierre Micottis, interview by FCIC, June 24, 2010.
82. Park, interview.
83. PricewaterhouseCooper audit team, memo re 3Q07 review of AIG’s super-senior CDS portfolio,
November 7, 2007, p. 2.
84. Joseph Cassano, interview by FCIC, June 25, 2010.
85. Park, interview.
86. Goldman’s submissions to the FCIC on its valuation and pricing related to collateral calls made to
AIG are available on Goldman Sachs’s website (http://www2.goldmansachs.com/our-firm/on-the
-issues/responses-fcic.print.html).
87. Andrew Forster, telephone call to Jon Liebergall, July 30, 2007, transcript.
88. PricewaterhouseCooper, memo to AIGFP 2007 2Q review files, August 8, 2007.
89. Andrew Forster, email to Joseph Cassano and Pierre Micottis, November 9, 2007, enclosing marks
from Merrill Lynch,
90. AIG, Earnings Call credit supplement, August 9, 2007, pp. 28, 14, 21, 22.
91. These estimates are based on Federal Reserve Bank of New York, “Maiden Lane III Quarterly
Holdings Report,” January 2010. This probably isn’t a complete list of their positions, because not all
CDO tranches are part of the Maiden Lane III portfolio. Of the 335 securities listed in that document,
FCIC staff found data on 327 in Moody’s CDO EMS database and Bloomberg. For those 327 securities,
313 suffered a downgrade and 206 became materially impaired (i.e., were downgraded to Ca/C). Of the
139 initially rated Aaa, 134 suffered downgrades and 55 became materially impaired.
92. Alan Frost, email to Andrew Forster, August 16, 2007.
93. Cassano, interview.
94. Frost, email to Forster, August 16, 2007.
95. Tom Athan, email to Andrew Forster, cc Adam Budnick, September 11, 2007.
96. Joseph Cassano, email to Elias Habayeb, November 11, 2007.
604 Notes to Chapter 14

97. Minutes of the meeting of the AIG Audit Committee, November 6, 2007, p. 5.
98. Andrew Forster, email to Joseph Cassano, subject: GS Prices vs Others, November 18, 2007.
99. Goldman, submission to the FCIC, “Valuation & Pricing Related to Initial Collateral Calls on
Transactions with AIG,” pp. 2–3.
100. Based on staff analysis of data provided to the FCIC by the Depository Trust & Clearing Corpo-
ration and Markit.  ABX includes all tranches of the ABX.HE 06-2.  TABX is constructed based on the
reference obligations for the 06-2 and 07-1 BBB and BBB- tranches of the ABX.
101. Cassano, interview.
102. Andrew Forster, email to Alan Frost, August 16, 2007.
103. Tim Ryan, PricewaterhouseCooper, interview by FCIC, June 1, 2010.
104. SEC staff briefing of FCIC staff, June 4, 2010.
105. Joseph Cassano, email to Andrew Forster, Pierre Micottis, James Bridgwater, and Peter Robin-
son, subject: Fw: SS CDS Valuation, October 8, 2007.
106. PricewaterhouseCooper, minutes of meeting at AIGFP, October 11, 2007. See also PwC audit
team, memo re 3Q07 review of AIG’s super-senior CDS portfolio, November 7, 2007, pp. 230–31.
107. AIG, 3Q 2007 Earnings Call transcript, November 7, 2007, pp. 5, 17.
108. PwC audit team memo, p. 6.
109. Goldman Sachs International, to AIG Financial Products Corp., “Amended Side Letter Agree-
ment,” November 23, 2007.
110. Joe Cassano, email to Bill Dooley, November 27, 2007, attaching memo from Andrew Forster,
“Collateral Call Status.”
111. Andrew Forster, “Collateral Call Status,” memo prepared for Joe Cassano.
112. Joe Cassano, email to Bill Dooley, subject: Collateral Calls, November 27, 2007.
113. Joe Cassano, email to Bill Dooley, subject: GS call back, November 30, 2007.
114. Goldman Sachs International, Collateral Invoice to AIG Financial Products Corp., margin call,
November 23, 2007.
115. PwC audit team, memo, November 7, 2007, p. 5.
116. PricewaterhouseCooper, notes of a meeting to discuss super-senior valuations and collateral dis-
putes, November 29, 2007, p. 2, produced by PwC.
117. Andrew Forster, interview by FCIC, June 21, 2010.
118. Martin Sullivan, interview by FDIC, June 17, 2010.
119. PwC, notes of meeting of November 29, 2007, p. 2.
120. Ibid., p. 3.
121. Kevin McGinn, email to Paul Narayanan, November 20, 2007.
122. Sullivan, interview.
123. AIG Investor Conference Call, December 5, 2007, transcript, pp. 4–6, 25.
124. Joseph Cassano, email to Michael Sherwood and David Viniar, subject: CDO Valuations, January
16, 2008.
125. Andrew Davilman, interview by FCIC, June 18, 2010; David Lehman, interview by FCIC, June
23, 2010.
126. “AIG/Goldman Sachs Collateral Call Timeline,” available on FCIC website at http://fcic.gov/
hearings/pdfs/2010–0701-AIG-Goldman-supporting-docs.pdf.
127. PricewaterhouseCooper, memo to AIG workpaper files, February 24, 2008, pp. 2–3, 10.
128. PricewaterhouseCooper, notes on a February 6, 2008, meeting with AIG, February 13, 2008, p. 2.
129. Martin Sullivan, testimony before the FCIC, Hearing on the Role of Derivatives in the Financial
Crisis, day 1, session 2: American International Group, Inc. and Derivatives, June 30, 2010, transcript, p.
233.
130. PricewaterhouseCooper, notes on the AIG Audit Committee meeting, February 7, 2008, p. 2.
131. Joseph Cassano, testimony before the FCIC, Hearing on the Role of Derivatives in the Financial
Crisis. day 1, session 2: American International Group, Inc. and Derivatives, June 30, 2010, p. 233; Cas-
sano, interview.
132. Office of Thrift Supervision, letter to AIG General Counsel and Board, March 7, 2008.
133. William Dudley, interview by FCIC, October 15, 2010.
 Notes to Chapter 15 605

134. Adam B. Ashcraft, Morten L. Bech, and W. Scott Frame, “The Federal Home Loan Bank System:
The Lender of Next to Last Resort?” Federal Reserve Bank of New York Staff Reports, no. 357 (November
2008), p. 4.
135. Federal Reserve Board, “October 2007 Senior Loan Officer Opinion Survey on Bank Lending
Practices,” October 2007.
136. Frederic Mishkin, interview by FCIC, October 1, 2010.
137. Dudley, interview.
138. Ibid.
139. Ibid.
140. Standard & Poor’s, “Detailed Results of Subprime Stress Test of Financial Guarantors,” Ratings-
Direct, February 25, 2008.
141. Alan Roseman, interview by FCIC, May 17, 2010.
142. SEC, “Risk Management Reviews of Consolidated Supervised Entities,” internal memo to Erik
Sirri and others, November 6, 2007, p. 3.
143. Roseman, interview, May 17, 2010.
144. SEC, “Risk Management of Consolidated Supervised Entities,” internal memo to Erik Sirri and
others, January 2, 2008, p. 2.
145. Bill Lockyer, State of California 2008 Debt Affordability Report: Making the Municipal Bond Mar-
ket Work for Taxpayers in Turbulent Times (October 1, 2008), p. 4.
146. John J. McConnell and Alessio Saretto, “Auction Failures and the Market for Auction Rate Secu-
rities” (The Krannert School of Management, Purdue University, April 2009), p. 10.
147. Erik R. Sirri, director of Trading and Markets, U.S. Securities and Exchange Commission,
“Municipal Bound Turmoil: Impact on Cities, Towns and States,” testimony before the House Financial
Services Committee, 110th Cong., 2nd sess., March 12, 2008.
148. Georgetown University, “Annual Financial Report, 2008–2009,” p. 5.
149. Jacqueline Doherty, “The Sad Story of Auction-Rate Securities, Barrons, May 26, 2008.
150. “SEC Finalizes ARS Settlements with Bank of America, RBC, and Deutsche Bank,” SEC press re-
lease, June 3, 2009.

Chapter 15
1. “Prime Asset,” 2007 Upper HedgeWorld Prime Brokerage League Table, accessible at Gregory
Zuckerman, “Hedge Funds, Once a Windfall, Contribute to Bear’s Downfall,” Wall Street Journal, March
17, 2008.
2. Jeff Mayer and Thomas Marano, “Fixed Income Overview,” March 29, 2007, p. 8, produced by
JP Morgan.
3. Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 2, The Secondary Mar-
ket (Bethesda, MD: Inside Mortgage Finance, 2009), pp. 18–25.
4. FCIC staff estimates, based on Moody’s CDO EMS database. Different numbers are provided in Jeff
Mayer and Thomas Marano, “Fixed Income Overview,” March 29, 2007, p. 16.
5. Samuel Molinaro, interview by FCIC, April 9, 2010; Michael Alix, interview by FCIC, April 8, 2010.
6. SEC, “Risk Management Reviews of Consolidated Supervised Entities,” memorandum to Robert
Colby and others, May 8, 2006.
7. Robert Upton, interview by FCIC, April 13, 2010.
8. SEC, “Risk Management Reviews of Consolidated Supervised Entities,” memorandum to Erik Sirri
and others, March 1, 2007.
9. Ibid.
10. Bear Stearns, “Fitch Presentation,” PowerPoint slides, August 2007.
11. Upton, interview.
12. Bear Stearns, Form 10-K for the year ended November 30, 2007, filed January 29, 2008, pp. 52, 22.
13. Upton, interview.
14. Ibid.
15. Standard & Poor’s, Global Credit Portal RatingsDirect, “Research Update: Bear Stearns Cos. Inc.
Outlook Revised to Negative; ‘A+/A-1’ Rating Affirmed,” August 3, 2007.
16. Jimmy Cayne, interview by FCIC, April 21, 2010.
606 Notes to Chapter 15

17. Matthew Eichner, interview by FCIC, April 14, 2010.

18. Wendy de Monchaux, interview by FCIC, April 27, 2010; Steven Meyer, interview by FCIC, April
22, 2010.
19. Mike Alix, interview by FCIC, April 8, 2010.
20. Eichner, interview.
21. Timeline Regarding Bear Stearns Companies Inc., April 3, 2008, produced by SEC.
22. SEC Office of Inspector General, Office of Audits, “SEC’s Oversight of Bear Stearns and Related
Entities: The Consolidated Supervised Entity Program,” Report No. 446-A, September 25, 2008, pp. ix–x.
23. Michael Halloran, interview by FCIC.
24. Cayne, interview.
25. Samuel Molinaro, testimony before the FCIC, Hearing on the Shadow Banking System, day 1,
session 1: Investment Banks and the Shadow Banking System, May 5, 2010, transcript, p. 43; Cayne,
interview.
26. “Changes in Approved Commercial Paper List—10/01/2007–12/31/2007” and “Changes in Ap-
proved Commercial Paper List—1/01/2008–3/31/2008,” produced by Federated Advised Funds.
27. Federal Reserve Bank of New York, “Tri-Party Repo Infrastructure Reform,” white paper, May 17,
2010, p. 7.
28. Seth Carpenter, interview by FCIC, September 20, 2010.
29. Information provided by Federated to the FCIC.
30. Scott Goebel, Kevin Gaffney, and Norm Lind (Fidelity employees), interview by FCIC, February
25, 2010.
31. Steve Meier, executive vice president State Street Global Advisors, interview by FCIC, March 15,
2010.
32. Timeline Regarding the Bear Stearns Companies Inc., April 3, 2008, pp. 1–2, provided to the
FCIC.
33. Alan Schwartz, interview by FCIC, April 23, 2010.
34. Lucian A. Bebchuk et al., “The Wages of Failure: Executive Compensation at Bear Stearns and
Lehman 2000–2008,” November 22, 2009, Table 2, p. 15; SNL Financial.
35. Thomas Marano, interview by FCIC, April 19, 2010.
36. Paul Friedman, quoted in William Cohan, House of Cards: A Tale of Hubris and Wretched Excess
on Wall Street (New York: Doubleday, 2009), p. 71. Although Friedman acknowledged to the FCIC mak-
ing the cited statements, and many others as well, he attributes them to anger and frustration over Bear
Stearns’s failure. Currently, Friedman is employed at Guggenheim Securities, Inc., where he works for
Alan Schwartz, the former president of Bear Stearns. Paul Friedman, interview by FCIC, April 28, 2010.
37. The Corporate Library, “The Bear Stearns Companies Inc.: Governance Profile,” June 20, 2008,
p. 4.
38. Cayne, interview.
39. Molinaro, interview.
40. Cayne, interview; Schwartz (interview by FCIC) stated that bonuses for individual executives were
discussed by the Compensation Committee, and the final recommendation for bonuses came from the
CEO.
41. Alix, interview.
42. Bear Stearns, 2007 Performance Compensation Plan, p. I-1 (provided to the FCIC); Alix, inter-
view. The salary cap had been raised from $200,000 to $250,000 in 2006 (Alix, interview; Cayne, inter-
view).
43. Bebchuk et al., “The Wages of Failure,” Table 1, p. 12; Table 2, p. 15; Table 4, p. 20. The budget au-
thority for the SEC in 2008 was $906 million; in 2010, it was $1.026 billion.
44. In 2006, Alix received $3 million in total compensation, Cayne received more than $38.3 million
in salary and bonus, and Schwartz received more than $35.7 million in salary and bonus. SNL Financial;
interviews with Spector and Alix.
45. Marano, interview.
46. Tom Marano, email to Alan Schwartz and Richie Metrick, February 12, 2008.
47. Matthew Eichner, email to James Giles et al., January 30, 2008.
48. Lou Lebedin, interview by FCIC, April 23, 2010.
 Notes to Chapter 15 607

49. Timeline Regarding Bear Stearns Companies Inc., April 3, 2008, produced by SEC.
50. Upton, interview.
51. Minutes of Special Meeting of Bear Stearns Board of Directors, March 13, 2008.
52. Pat Lewis, Bear Stearns, email to Matthew Eichner, Steven Spurry, James Giles, and Kevin Silva,
March 10, 2008.
53. Matthew Eichner, email to Brian Peters, March 11, 2008.
54. David Fettig, “The History of a Powerful Paragraph,” Federal Reserve Bank of Minneapolis, June
2008.
55. James Embersit, email to Deborah Bailey, March 3, 2008.
56. In response to the FCIC’s interrogatories, JP Morgan produced a list of all payments Bear Stearns
made to or received from OTC derivatives counterparties from March 10, 2008, through March 14, 2008.
The spreadsheet was created in September 2008 by Bear Stearns in response to a request by the SEC Divi-
sion of Trading and Markets. The large volume of novations away from Bear Stearns during the week of
March 10, 2008 and the previous week was confirmed by the New York Federal Reserve and Interna-
tional Swaps and Derivatives Association. (New York Federal Reserve personnel, interview by FCIC;
ISDA personnel, interviews by FCIC, May 13 and 27, 2010).
57. Brian Peters, email to Matthew Eichner, March 11, 2008.
58. Stuart Smith, email to Bear Stearns, March 11, 2008; Marvin Woolard, email Stuart Smith et al.,
March 11, 2008; Kyle Bass, interview by FCIC, April 30, 2010.
59. Bass, interview.
60. Debby LaMoy, email to Faina Epshteyn, March 12, 2008; Faina Epshteyn, email to Debby LaMoy,
March 12, 2008.
61. Marvin Woolard, email to Stuart Smith et al., March 12, 2008.
62. CNBC video, Schwartz and CNBC’s David Faber, original air date March 12, 2008.
63. Yalman Onaran, “Bear Stearns Investor Lewis May Increase His Stake,” Bloomberg News, March
11, 2008.
64. Matthew Eichner, email to Erik Sirri, Robert Colby, and Michael Macchiaroli, March 12, 2008.
65. Minutes of Special Meeting of Bear Stearns Board of Directors, March 13, 2008, pp. 1–2.
66. Upton, interview.
67. Matthew Eichner, email to Erik Sirri, Robert Colby, and Michael Macchiaroli, March 12, 2008.
68. Alan Schwartz, interview by FCIC; Matthew Eichner, email to Erik Sirri, Robert Colby, and
Michael Macchiaroli, March 13, 2008.
69. Upton, interview.
70. Minutes of Special Meeting of Bear Stearns Board of Directors, March 13, 2008 (“[Schwartz] said
there had been seventeen billion dollars in cash with a two billion eight hundred million dollar backstop,
unsecured line. The Board was told that twelve to fifteen billion dollars had gone out of TBSCI in the last
two days and that TBSCI had received a billion dollars in margin calls”).
71. Upton, interview; Goebel, Gaffney, and Lind, interview; Steven Meier, interview by FCIC, March
15, 2010; Michael Macchiaroli, interview by FCIC, April 13, 2010.
72. Christopher Cox, written testimony for the FCIC, Hearing on the Shadow Banking System, day 1,
session 3: SEC Regulation of Investment Banks, May 5, 2010, p. 6.
73. Timeline Regarding Bear Stearns Companies Inc., April 3, 2008, produced by SEC.
74. Jamie Dimon, interview by FCIC, October 20, 2010.
75. Alan Schwartz, testimony before the FCIC, Hearing on the Shadow Banking System, day 1, session
2: Investment Banks and the Shadow Banking System, May 5, 2010, transcript, p. 167; Schwartz, inter-
view.
76. Schwartz., interview.
77. Ibid.; Molinaro, interview; Alix, interview.
78. John Chrin, interview by FCIC, April 28, 2010.
79. Dimon, interview by FCIC, October 20, 2010; minutes of Special Meeting of Bear Stearns Board of
Directors, March 16, 2008.
80. Federal Reserve, “Report Pursuant to Section 129 of the Emergency Economic Stabilization Act of
2008: Loan to Facilitate the Acquisition of The Bear Stearns Companies, Inc. by JP Morgan & Co.,” pp. 1,
4; Ernst & Young, “Project LLC: Summary of Findings and Observations Report,” June 26, 2008, p. 10.
608 Notes to Chapter 16

81. Contrary to what is stated in the board minutes (Special Meeting of Bear Stearns Board of Direc-
tors, March 16, 2008, p. 5), when FCIC staff interviewed Schwartz he said that the $2 a share price came
from JP Morgan, not Paulson. Schwartz also told staff that because Bear did not receive “a lot of compet-
ing offers,” it had to accept JP Morgan’s offer of $2 a share.
82. Chrin, interview.
83. Alan Schwartz, testimony before the FCIC, Hearing on the Shadow Banking System, day 1, session
2: Investment Banks and the Shadow Banking System, May 5, 2010, transcript, p. 142.
84. Macchiaroli, interview.
85. Ben Bernanke, closed-door session with FCIC, November 17, 2009.
86. Ibid.
87. Timothy Geithner, president, Federal Reserve Bank of New York, “Actions by the New York Fed in
Response to Liquidity Pressures in Financial Markets,” prepared testimony before the Senate Committee
on Banking, Housing, and Urban Affairs, 110th Cong., 2nd sess., April 3, 2008, p. 10.
88. Henry Paulson, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, ses-
sion 1: Perspective on the Shadow Banking System, May 6, 2010, transcript, pp. 68, 59, 78.

Chapter 16
1. David Wong, interview by FCIC, October 15, 2010.
2. Josh Fineman and Yalman Onaran, “Lehman’s Fuld Says ‘Worst Is Behind Us’ in Crisis (Update3),
Bloomberg, April 15, 2008.
3. Henry Paulson, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session
1: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 28.
4. Viral V. Acharya and T. Sabri Öncü, “The Dodd-Frank Wall Street Reform and Consumer Protec-
tion Act and a Little Known Corner of Wall Street: The Repo Market,” Regulating Wall Street, July 16,
2010.
5. Sandie O’Connor, JP Morgan, interview by FCIC, March 4, 2010.
6. Jamie Dimon, interview by FCIC, October 20, 2010.
7. Adam Copeland, Antoine Martin, Michael Walker, “The Tri-Party Repo Market Before the 2010
Reforms,” FRBNY Staff Report No. 477, November 2010, p. 24.
8. Steven Meier, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 3:
Institutions Participating in the Shadow Banking System, May 6, 2010, transcript, p. 276.
9. William Dudley, interview by FCIC, October 15, 2010.
10. Darryll Hendricks, interview by FCIC, August 6, 2010.
11. James Cayne, testimony before the FCIC, Hearing on the Shadow Banking System, day 1, session
2: Investment Banks and the Shadow Banking System, May 5, 2010, transcript, p. 168.
12. Seth Carpenter, interview by FCIC, September 20, 2010.
13. Federal Reserve, “Regulatory Reform: Primary Dealer Credit Facility (PCDF),” Usage of Federal
Reserve Credit and Liquidity Facilities, data available at www.federalreserve.gov/newsevents/
reform_pdcf.htm.
14. Anton R. Valukas, Report of Examiner, In re Lehman Brothers Holdings Inc., et al., Chapter 11
Case No. 08-13555 (JMP), (Bankr. S.D.N.Y.), March 11, 2010, 4:1396–98; quotation, 1396 (hereafter cited
as Valukas; available at http://lehmanreport.jenner.com/).
15. William Dudley, email to Chairman, June 17, 2008.
16. Dimon, interview.
17. Ibid.
18. Hendricks, interview.
19. Lucinda Brickler, email to Patrick Parkinson, July 11, 2008; Lucinda Brickler et al., memorandum
to Timothy Geithner, July 11, 2008.
20. The $200 billion figure is noted in Patrick Parkinson, email to Ben Bernanke et al., July 20, 2008.
21. Brickler et al., memorandum, p. 1.
22. Patrick Parkinson, email to Lucinda Brickler, July 11, 2008.
23. Patrick Parkinson, email to Ben Bernanke et al., July 20, 2008.
24. Ibid.
 Notes to Chapter 16 609

25. Based on chart in Federal Reserve Bank of New York, Developing Metrics for the Four Largest Secu-
rities Firms, August 2008, p. 5.
26. Ibid.
27. Tobias Adrian, Christopher Burke, and James McAndrews, “The Federal Reserve’s Primary Dealer
Credit Facility,” Federal Reserve Bank of New York, Current Issues in Economics and Finance 15, no. 4
(August 2009): 2.
28. Erik Sirri, interview by FCIC, April 9, 2010, p. 3.
29. Fed Chair Ben Bernanke, “Lessons from the Failure of Lehman Brothers,” testimony before the
House Financial Services Committee, 111th Cong., 2nd sess., April 20, 2010, p. 1.
30. Valukas, 1:8 n. 30: Examiner’s Interview of Timothy F. Geithner, Nov. 24, 2009, p. 4.
31. Valukas, 4:1486.
32. Sirri, interview.
33. William Brodows and Til Schuermann, Federal Reserve Bank of New York, “Primary Dealer Mon-
itoring: Initial Assessment of CSEs,” May 12, 2008, slides 9–10, 15–16.
34. Federal Reserve Bank of New York, “Primary Dealer Monitoring: Liquidity Stress Analysis,” June
25, 2008, p. 3.
35. Ibid., p. 5.
36. Valukas, 4:1489.
37. Ibid., 4:1496, 1497.
38. Christopher Cox, statement before the House Financial Services Committee, 111th Cong., 2nd
sess., April 20, 2010, p. 5.
39. Patrick Parkinson, email to Steven Shafran, August 8, 2008.
40. Counterparty Risk Management Policy Group, “Toward Greater Financial Stability: A Private Sec-
tor Perspective, The Report of the CRMPG II,” July 27, 2005.
41. Federal Reserve Bank of New York, “Statement Regarding Meeting on Credit Derivatives,” Sep-
tember 15, 2005; Federal Reserve Bank of New York, “New York Fed Welcomes New Industry Commit-
ments on Credit Derivatives,” March 13, 2006; Federal Reserve Bank of New York, “Third Industry
Meeting Hosted by the Federal Reserve Bank of New York,” September 27, 2006.
42. See Comptroller of the Currency, “OCC’s Quarterly Report on Bank Trading and Derivatives Ac-
tivities, First Quarter 2009,” Table 1; the figures in the text are reached by subtracting exchange traded fu-
tures and options from total derivatives.
43. Chris Mewbourne, interview by FCIC, July 28, 2010.
44. This figure compares with a low in 2005, at the height of the mortgage boom, of $7 billion in prob-
lem assets. “Problem” institutions are those with financial, operational, or managerial weaknesses that
threaten their continued financial viability; they are rated either a 4 or 5 under the Uniform Financial In-
stitutions Rating System. FDIC reporting for insured institutions—i.e., the regulated banking and thrift
industry overall. See Quarterly Banking Profile: Fourth Quarter 2007= FDIC Quarterly 2, no. 1 (Decem-
ber 31, 2007): 1, 4; Quarterly Banking Profile: First Quarter 2008 = FDIC Quarterly 2, no. 2 (March 31,
2008): 2, 4; Quarterly Banking Profile: Second Quarter 2008 = FDIC Quarterly 2, no. 3 (June 30, 2008): 1.
45. By 2009, the problem list would swell to 702 banks, with assets of $403 billion. Quarterly Banking
Profile: Fourth Quarter 2009 = FDIC Quarterly 4, no. 1 (December 31, 2009): 4.
46. Quarterly Banking Profile: First Quarter 2008, p. 4.
47. Roger Cole, interview by FCIC, August 2, 2010.
48. FCIC interview with Michael Solomon and Fred Phillips-Patrick, September 20, 2010.
49. Federal Reserve Bank of New York, letter to Charles Prince, April 9, 2007.
50. Federal Reserve Bank of New York, Federal Reserve Board, Office of the Comptroller of the Cur-
rency, Securities and Exchange Commission, U.K. Financial Services Authority, and Japan Financial
Services Authority, “Notes on Senior Supervisors’ Meetings with Firms,” November 19, 2007, p. 3.
51. Federal Reserve Board, “FRB New York 2009 Operations Review: Close Out Report,” p. 3.
52. Timothy Geithner, testimony before the FCIC, Hearing on the Shadow Banking System, day 2,
session 1: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 210.
53. Steve Manzari and Dianne Dobbeck, interview by FCIC, April 26, 2010.
54. Federal Reserve Board, “Wachovia Case Study,” November 12 and 13, p. 20;
55. Angus McBryde, interview by FCIC, July 30, 2007.
610 Notes to Chapter 17

56. Thompson received a severance package worth about $8.7 million in compensation and acceler-
ated vesting of stock. In addition, he negotiated himself three years of office space and a personal assis-
tant at Wachovia’s expense. Thompson had previously received more than $21 million in salary and stock
compensation in 2007 and more than $23 million in 2006; his total compensation from 2002 through
2008 exceeded $112 million.
57. Federal Reserve Bank of Richmond, letter to Wachovia, July 22, 2008, pp. 3–5.
58. Comptroller of the Currency, letter to Wachovia, August 4, 2008, with Report of Examination; let-
ter, pp. 8, 3.
59. Ibid., pp. 3–6.
60. Ibid., letter, p. 2; Report of Examination, p. 18.
61. Ibid., Report of Examination, p. 12.
62. “Home Loans Discussion,” materials prepared for WaMu Board of Directors meeting, April 18,
2006, p. 4; Senate Permanent Subcommittee on Investigations, Wall Street and the Financial Crisis: The
Role of High Risk Home Loans, 111th Cong., 2nd sess., April 13, 2010, Exhibits, p. 83.
63. Senate Permanent Subcommittee on Investigations, Wall Street and the Financial Crisis: Role of the
Bank Regulators, 111th Cong., 2nd sess., April 16, 2010, Exhibits, p. 6.
64. OTS Regional Director Darrel Dochow, letter to FDIC Regional Director Stan Ivie, July 22, 2008.
65. Offices of Inspector General, Department of the Treasury and Federal Deposit Insurance Corpo-
ration, “Evaluation of Federal Regulatory Oversight of Washington Mutual Bank,” Report No. EVAL 10-
002, April 2010, pp. 31, 12.
66. FDIC, Confidential Problem Bank Memorandum, September 8, 2008, p. 4.
67. Treasury and FDIC IGs, “Evaluation of Federal Regulatory Oversight of WaMu,” p. 39.
68. Confidential OTS Memorandum to FDIC Regional Director, September 11, 2008; Treasury and
FDIC IGs, “Evaluation of Federal Regulatory Oversight of WaMu,” pp. 45–47.
69. Quoted in Damian Paletta, “FDIC Presses Bank Regulators to Use Warier Eye,” Wall Street Journal,
August 19, 2008.
70. Sheila Bair, interview by FCIC, August 18, 2010.
71. Treasury and FDIC IGs, “Evaluation of Federal Regulatory Oversight of WaMu,” p. 3.
72. Comptroller of the Currency, Large Bank Supervision: Comptroller’s Handbook, January 2010, p. 3.
73. Cole, interview.
74. Rich Spillenkothen, “Observations and Perspectives of the Director of Banking Supervision and
Regulation at the Federal Reserve Board from 1991 to 2006 on the Performance of Prudential Supervi-
sion in the Years Preceding the Financial Crisis,” paper prepared for the FCIC, May 21, 2010, p. 24.
75. Doug Roeder, interview by FCIC, August 4, 2010.
76. “Treasury Releases Blueprint for Stronger Regulatory Structure,” Treasury Department press re-
lease, March 31, 2008.

Chapter 17
1. Henry Paulson, interview by FCIC, April 2, 2010; Henry Paulson, On The Brink: Inside the Race to
Stop the Collapse of the Global Financial System (New York: Business Plus, 2010), p. 57.
2. Paulson, interview.
3. James Lockhart, testimony before the FCIC, Hearing on Subprime Lending and Securitization and
Government-Sponsored Enterprises (GSEs), day 3, session 2: Office of Federal Housing Enterprise Over-
sight, April 9, 2010, transcript, p. 163.
4. Daniel Mudd, letter to James Lockhart, August 1, 2007, p. 1.
5. Ibid., pp. 1, 5.
6. Daniel Mudd, letter to shareholders, in Fannie Mae, “2007 Annual Report,” p. 3.
7. Thomas Lund, interview by FCIC, March 4, 2010.
8. Robert Levin, interview by FCIC, March 17, 2010.
9. James Lockhart, letter to Daniel Mudd, August 10, 2007, p. 1.
10. James Lockhart, letter to Senator Charles Schumer, August 10, 2007.
11. James Lockhart, written testimony for the FCIC, Hearing on Subprime Lending and Securitiza-
tion and Government-Sponsored Enterprises (GSEs), day 3, session 2: Office of Federal Housing Enter-
prise Oversight, April 4, 2010, pp. 12, 2, 12.
 Notes to Chapter 17 611

12. Ibid., pp. 2, 4, 7.

13. Paulson, interview.
14. David Nason, Tony Ryan, and Jeremiah Norton, Treasury officials, interview by FCIC, March 12,
2010.
15. James Lockhart, quoted in Steven Sloan, “Setting an OFHEO Plan, But Wishing Otherwise,”
American Banker, December 21, 2007.
16. Fannie Mae, “Single-Family Book Characteristics Report,” September 2008.
17. “OFHEO Provides Flexibility on Fannie Mae, Freddie Mac Mortgage Portfolios,” OFHEO news re-
lease, September 19, 2007, p. 1.
18. Lockhart, written testimony for the FCIC, April 4, 2010, p. 13.
19. Ben Bernanke, quoted in Eric Dash, “Fannie Mae to Be Allowed to Expand Its Portfolio,” New
York Times, September 20, 2007.
20. Senator Charles E. Schumer, letter to OFHEO Director James B. Lockhart III, February 25, 2008;
Schumer continued, “If you have decided that you will be keeping the capital surcharge in place . . . , I
would like an explanation as to why you think upholding that restriction outweighs the importance of
providing capital relief that could better position the GSEs to provide rescue products for borrowers
stuck in unaffordable loans.”
21. “Fannie Mae Reports 2007 Financial Results,” Fannie Mae press release, February 17, 2008.
22. Daniel Mudd, interview by FCIC, March 26, 2010.
23. Robert Steel, email to Jeremiah Norton, February 28, 2008.
24. Michael Farrell, email to Robert Steel, March 6, 2008.
25. Emails between Robert K. Steel and Daniel Mudd, March 7, 2008.
26. Daniel Mudd, email to Robert Levin, March 7, 2008.
27. “Fannie Mae Insolvency and Its Consequences,” p. 1; attachment to email from Jason Thomas to
Robert Steel, March 8, 2008.
28. Robert Steel, email to David Nason, Tony Ryan, Jeremiah Norton, and Neel Kashkari, subject: “re:
GSEs,” March 16, 2008.
29. James Lockhart, interview by FCIC, March 19, 2010.
30. Paulson, interview.
31. James Lockhart, email to Daniel H. Mudd, Robert Steel, and Dick Syron, subject: “Re: announce-
ment draft,” March 17, 2008.
32. Ibid.
33. “OFHEO, Fannie Mae and Freddie Mac Announce Initiative to Increase Mortgage Market Liquid-
ity,” OFHEO news release, March 19, 2008.
34. Paulson, interview.
35. Joshua Rosner, “OFHEO Got Rolled,” GrahamFisher Weekly Spew, March 19, 2008.
36. Donald Bisenius, interview by FCIC, September 29, 2010.
37. “Freddie Mac CEO Richard Syron Talks about the Stock Slide,” PBS Nightly Business Report,
Wednesday, August 6, 2008, transcript.
38. Lockhart, interview.
39. Daniel Mudd, letters to James Lockhart, August 1, 2008, and August 15, 2008.
40. Timothy P. Clark (senior adviser, Division of Banking and Supervision, Federal Reserve Board)
and Scott Alvarez (general counsel, Federal Reserve Board), interview by FCIC, February 23, 2010.
41. “Board Grants Federal Reserve Bank of New York the Authority to Lend to Fannie Mae and Fred-
die Mac Should Such Lending Prove Necessary,” Federal Reserve Board press release, July 13, 2008.
42. Alvarez, interview.
43. Treasury Secretary Henry Paulson, testimony on GSE initiatives, Recent Developments in U.S. Fi-
nancial Markets and the Regulatory Responses to Them, Senate Committee on Banking, Housing, and Ur-
ban Affairs, 110th Cong., 2nd sess., July 15, 2008.
44. “Statement by Daniel H. Mudd, President and CEO,” Fannie Mae press release, July 13, 2008.
45. Clark, interview
46. Mudd, interview.
47. Clark, interview.
48. Susan Eckert, Kevin Bailey, and other OCC staff, interview by FCIC, February 19, 2010.
612 Notes to Chapter 17

49. Ibid.
50. Office of the Comptroller of the Currency, “Observations—Allowance Process and Methodology,”
August 2008 (last revised September 8, 2008), p. 3.
51. Paulson, interview.
52. Christopher H. Dickerson (FHFA Acting Deputy Director, Division of Enterprise Regulation), let-
ter to Daniel H. Mudd (President and CEO of Fannie Mae), “Re: Notice of Proposed Capital Classifica-
tion at June 30, 2008,” August 22, 2008, pp. 1, 2; Christopher H. Dickerson (FHFA Acting Deputy
Director, Division of Enterprise Regulation), letter to Richard F. Syron (President and CEO of Freddie
Mac), “Re: Notice of Proposed Capital Classification at June 30, 2008,” August 22, 2008.
53. “Draft—Mid-year Letter,” pp. 11–13 (quotation, p. 13), attached to Christopher H. Dickerson, let-
ter to Daniel H. Mudd, September 4, 2008.
54. Dickerson to Mudd, September 4, 2008; Christopher H. Dickerson, letter to Richard Syron, Sep-
tember 4, 2008, with “Draft Mid Year Letter” attached.
55. “Draft—Mid-year Letter” (Fannie), pp. 5–7.
56. Ibid., p. 5.
57. Ibid., p. 6.
58. Ibid., pp. 9–10.
59. “Draft Mid Year Letter” (Freddie), pp. 1, 1–2, 7.
60. Ibid., p. 8.
61. Mudd, interview.
62. Christopher H. Dickerson to James B. Lockhart III, memorandum, “Proposed Appointment of the
Federal Housing Finance Agency as Conservator for the Federal Home Loan Mortgage Corporation,”
September 6, 2008 (hereafter Freddie conservatorship memorandum); Christopher H. Dickerson to
James B. Lockhart III, memorandum, Proposed Appointment of the Federal Housing Finance Agency as
Conservator for the Federal National Mortgage Association,” September 6, 2008 (hereafter Fannie con-
servatorship memorandum).
63. Paulson, interview; Lockhart, interview; Paulson, On the Brink, p. 8.
64. Lockhart, testimony before the FCIC, April 9, 2010, transcript, p. 191.
65. Paulson, interview; Paulson, On the Brink, p. 10.
66. Paulson, On the Brink, p. 10.
67. Lund, interview.
68. Levin, interview.
69. Mudd, interview.
70. FHFA, Fannie conservatorship memorandum, pp. 2, 29.
71. FHFA, Freddie conservatorship memorandum, pp. 3, 29.
72. Syron, interview.
73. Daniel Mudd, testimony before the FCIC, Hearing on Subprime Lending and Securitization and
Government-Sponsored Enterprises (GSEs), day 3,” session 1: Fannie Mae, April 9, 2010, transcript,
p. 38.
74. Paul Nash, FDIC, letter to FCIC, providing responses to follow-up questions to Sheila Bair’s testi-
mony during the September 2, 2010, hearing, p. 5.
75. Paulson, interview.
76. Neel Kashkari, interview by FCIC, November 2, 2010.
77. Tom Baxter, interview by FCIC, April 30, 2010; Kevin Warsh, interview by FCIC, October 28,
2010.
78. Warsh, interview.
79. Lockhart, testimony before the FCIC, April 9, 2010, transcript, p. 232.
80. Staff of the Federal Reserve System, Division of Banking Supervision and Regulation, memoran-
dum to the Board of Governors, “Stress Scenarios on Bank Exposures to Government Sponsored Enter-
prise (GSE) Debt,” January 24, 2005, p. 5.
81. Daniel Mudd, written testimony for the FCIC, Hearing on Subprime Lending and Securitization
and Government-Sponsored Enterprises (GSEs), day 3, session 1: Fannie Mae, April 9, 2010, p. 3.
82. John Kerr, Scott Smith, Steve Corona (FHFA examination manager), and Alfred Pollard (FHFA
general counsel), group interview by FCIC, March 12, 2010.
 Notes to Chapter 18 613

83. Lockhart, interview.

84. Edward DeMarco, interview by FCIC, March 18, 2010.
85. Mudd, interview.
86. Henry Cisneros, interview by FCIC, October 13, 2010.
87. Mudd, testimony before the FCIC, April 9, 2010, transcript, p. 104.
88. Robert Levin, testimony before the FCIC, Hearing on Subprime Lending and Securitization and
Government-Sponsored Enterprises (GSEs), day 3, session 1: Fannie Mae, April 9, 2010, transcript,
p. 104.

Chapter 18
1. Joseph Sommer, counsel, Federal Reserve Bank of New York, email to Patrick M. Parkinson, deputy
research director, Board of Governors of the Federal Reserve System, et al., “Re: another option we
should present re triparty?” July 13, 2008.
2. James Dimon, interview by FCIC, October 20, 2010.
3. Barry Zubrow, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of
Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 1, ses-
sion 2: Lehman Brothers, September 1, 2010, p. 212.
4. Richard S. Fuld Jr., testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact
of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 1,
session 2: Lehman Brothers, September 1, 2010, p. 148. See also Fuld’s written testimony at same hearing,
p. 6.
5. Ben Bernanke, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of
Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 2, ses-
sion 1: The Federal Reserve, September 2, 2010, transcript, pp. 26, 89.
6. Kenneth D. Lewis, interview by FCIC, October 22, 2010.
7. Bernanke, testimony before the FCIC, September 2, 2010, p. 22.
8. Bernanke told the examiner that the Federal Reserve, the SEC, and “markets in general” viewed
Lehman as the next most vulnerable investment bank because of its funding model. Anton R. Valukas,
Report of Examiner, In re Lehman Brothers Holdings Inc., et al., Debtors, Chapter 11 Case No. 08-13555
(JMP), (Bankr. S.D.N.Y.), March 11, 2010, 2:631 (hereafter cited as Valukas); see also 1:5 and n. 16, 2:609
and nn. 2133–34, 4:1417 and n. 5441, 4:1482 and n. 5728, 4:1494, and 5:1663 and n. 6269. Paulson, 2:632.
Geithner told the examiner that following Bear Stearns’s near collapse, he considered Lehman to be the
“most exposed” investment bank, 2:631; see also 1:5 and n. 16, 2:609, 4:1417 and n. 5441, 4:1482 and
n. 5728, 4:1491 and n. 5769, and 5:1663 and n. 6269. Cox reported that after Bear Stearns collapsed,
Lehman was the SEC’s “number one focus”; 1:5 and n. 16, and p. 1491 and n. 5769; see also 2:609, 631.
9. Timothy Geithner, quoted in Valukas, 1:8 and n. 30, 4:1496.
10. Donald L. Kohn, email to Bernanke, “Re: Lehman,” June 13, 2008. Valukas, 2:615; 2:609 and n.
2134.
11. Harvey R. Miller, bankruptcy counsel for Lehman Brothers, interview by FCIC, August 5, 2010;
Lehman board minutes, September 14, 2008, p. 34.
12. Erik R. Sirri, interview by FCIC, April 1, 2010.
13. Paolo R. Tonucci, interview by FCIC, August 6, 2010.
14. Specifically, Lehman drew $1.6 billion on March 18; $2.3 billion on March 19 and 20; $2.7 billion
on March 24; $2.1 billion on March 25 and 26; and $2 billion on April 16. Lehman Brothers, “Presenta-
tion to the Federal Reserve: Update on Capital, Leverage & Liquidity,” May 28, 2008, p. 15. See also
Robert Azerad, vice president, Lehman Brothers, “2008 Q2—Liquidity Position (June 6, 2008),” p. 3. Af-
ter its bankruptcy, Lehman drew $28 billion, $19.7 billion, and $20.4 billion, on September 15, 16, and
17, until Barclays replaced the Fed in providing financing. Valukas, 4:1399. See also David Weisbrod,
senior vice president, Treasury and Securities Services–Risk Management, JPMorgan Chase & Co., email
to James Dimon et al., “Re: TriParty Close,” September 15, 2008.
15. Thomas A. Russo, former vice chairman and chief legal officer, Lehman Brothers, email to
Richard S. Fuld Jr., forwarding article by John Brinsley (originally sent to Russo by Robert Steel), “Paul-
son Says Investment Banks Making Progress in Raising Funds,” Bloomberg, June 13, 2008 (quoting
Robert Steel), June 13, 2008.
614 Notes to Chapter 18

16. Richard S. Fuld Jr., interview by FCIC, April 28, 2010.

17. Valukas, 2:713 and nn. 2764–65, 2:715 and n. 2774. See also Russo, email to Fuld, “Fw: Rumors of
hedge fund putting together a group to have another run at Lehman,” March 20, 2008 (forwarding dis-
cussions with SEC regarding short sellers).
18. Dan Chaudoin, Bruce Karpati, and Stephanie Shuler, Division of Enforcement, SEC, interview by
FCIC, April 6, 2010; Mary L. Schapiro, chairman, SEC, written responses to written questions—specifically,
response to question 13—from FCIC, asked after the hearing on January 14, 2010.
19. Jesse Eisinger, “The Debt Shuffle: Wall Street Cheered Lehman’s Earnings, but There Are Ques-
tions about Its Balance Sheet,” Portfolio.com, March 20, 2008.
20. David Einhorn, Greenlight Capital, “Private Profits and Socialized Risk,” speech at Grant’s Spring
Investment Conference, April 8, 2008, p. 9. See also David Einhorn, “Accounting Ingenuity,” speech at Ira
W. Sohn Investment Research Conference, May 21, 2008, pp. 3–4.
21. Nell Minow, interview by FCIC, September 13, 2010.
22. Nell Minow, testimony before the House Committee on Oversight and Government Reform,
Hearing on Lehman Brothers, 110th Cong., 2nd sess., October 6, 2008.
23. Kirsten J. Harlow, email to Timothy Geithner et al., “On-Site Primary Dealer Update: June 16,”
June 16, 2008.
24. William Dudley, email to Timothy Geithner, Donald Kohn, and others, June 17, 2008.
25. Kirsten J. Harlow, email to Kevin D. Coffey, examining officer, FRBNY, et al., “On-Site Primary
Dealer Update: June 19,” June 19, 2008.
26. Thomas Fontana, Citigroup, email to Christopher M. Foskett, Citigroup, et al., June 12, 2008.
27. Tim Clark, Federal Reserve, email to Kevin Coffey, Federal Reserve, et al., June 20, 2008.
28. Federal Reserve Bank of New York, “Primary Dealer Monitoring: Liquidity Stress Analysis,” June
25, 2008.
29. Based on chart in Federal Reserve Bank of New York, “Developing Metrics for the Four Largest
Securities Firms,” August 2008, p. 9.
30. Federal Reserve Bank of New York, “Primary Dealer Monitoring: Liquidity Stress Analysis,” June
25, 2008.
31. Karl Mocharko, assistant vice president and senior trader, Federated Investors, Inc., email to Gail
Shanley, Federated Investors, Inc., et al., “Re: Federated SubCustodial Agreement—JPMC’s comments,”
July 10, 2008; Charles Witek, Federated Investors, Inc., email to George V. Van Schaick, Lehman Broth-
ers, et al., “FW: Federated SubCustodial Agreement—JPMC’s comments,” April 23, 2008. Despite the
FRBNY’s observation, Federated did not fully terminate its repo relationships with Lehman. In fact, as of
September 12, Federated’s repo exposure to Lehman was $2 billion, as reported in the Commission’s
Market Risk Survey of money market mutual funds.
32. Patrick M. Parkinson, email to David Marshall, et al., July 11, 2008; David Marshall, email to
Patrick M. Parkinson, July 11, 2008.
33. Valukas, 4:1497–98 (quoting Timothy Geithner); see also Bart McDade, president and chief oper-
ating officer, Lehman Brothers, interview by FCIC, April 16, 2010.
34. William Dudley, email to Geithner et al., “Re: Lehman Good Bank/Bad Bank idea discussed last
night,” July 15, 2008.
35. Patrick M. Parkinson, email to Steven Shafran, Department of the Treasury, et al., “Fw: Gameplan
and Status to Date,” August 19, 2008.
36. Patrick M. Parkinson, email to Steven Shafran, August 11, 2008.
37. Patrick M. Parkinson, email to Arthur Angulo, Theodore Lubke, Til Schuermann, and William
Brodows, August 15, 2010.
38. William Brodows, email to Patrick Parkinson, August 15, 2008.
39. Ibid.
40. Ibid.
41. Parkinson, email to Steven Shafran, August 19, 2008.
42. Ibid.
43. Steven Shafran, email to Patrick M. Parkinson, August 28, 2008.
44. Patrick M. Parkinson, email to Theodore Lubke, September 5, 2008.
 Notes to Chapter 18 615

45. Emil Cornejo, senior vice president, Department of the Treasury, Lehman Brothers, email to Janet
Birney, senior vice president, Department of the Treasury, Lehman Brothers, et al., “JP Morgan Agenda
forwarded for our review. FYI,” September 3, 2008. See Lehman Briefing Memorandum, September 4,
2008; JP Morgan Agenda, September 4, 2008.
46. Meg McConnell, FRBNY, email to Arthur Angulo et al., “Meeting tomorrow at 9:00,” September 8,
2008.
47. Ibid.
48. Patrick M. Parkinson, email to Steven Shafran, “Re: now I am on a conf call,” September 9, 2008.
49. Henry M. Paulson Jr., On the Brink: Inside the Race to Stop the Collapse of the Global Financial Sys-
tem (New York: Business Plus, 2010), p. 178; Rita C. Proctor, assistant to the chairman, Board of Gover-
nors of the Federal Reserve, email to Donald L. Kohn et al., “This evening’s conference call will take place
at 5 P.M. instead of 6 P.M.,” September 9, 2008.
50. Jim Wilkinson, email to Michele Davis, September 9, 2008.
51. Barry Zubrow, interview by FCIC, August 19, 2010.
52. Paul, Weiss, counsel to Steven Black, letter to FCIC, August 27, 2007, written responses to FCIC
questions in email of August 26, 2007, p. 6.
53. John J. Hogan, JPMorgan Chase & Co., email to Steven D. Black, September 9, 2008, 7:07 P.M.;
Steven Black, email to John Hogan, September 9, 2008, 8:24 P.M. See also Valukas, 4:1139, 1140 and
n. 4204, and 1141.
54. Complaint, In re Lehman Brothers Holdings, Inc., et al., against JPMorgan Chase Bank, N.A.,
Chapter 11 Case No. 08-13555 (JMP) (Bankr. S.D.N.Y. May 26, 2010), pp. 14–15 (hereafter cited as
Lehman Complaint).
55. Ibid.
56. Black responses, August 27, 2010, p. 6.
57. Matthew Rutherford, email to Tony Ryan, Department of the Treasury, et al., September 10, 2008.
58. Mark VanDerWeide, assistant general counsel, Board of Governors of the Federal Reserve System,
email to Scott G. Alvarez, general counsel, Board of Governors of the Federal Reserve System, “lehman,”
September 10, 2008.
59. Patricia Mosser, email to William Dudley et al., “thoughts on Lehman,” September 10, 2008.
60. See Michael Nelson, counsel and vice president, FRBNY, email to Christine Cumming, first vice
president, FRBNY, et al., “revised Liquidation Consortium gameplan + questions,” September 10, 2008,
(attaching game plan),
61. See Patrick M. Parkinson, email to Donald Kohn et al., “Fw: revised Liquidation Consortium
gameplan + questions,” September 11, 2008 (attaching game plan).
62. Ibid.; Thomas Baxter, interview by FCIC, August 11, 2010.
63. Ken Lewis, interview by FCIC, October 22, 2010.
64. Susan McCabe, Goldman Sachs Group, Inc., email to William Dudley et al., “Hope you have the
Radar screens on early this morning,” September 11, 2008.
65. Rita C. Proctor, email to Bernanke, “Fw: Financial Markets Conference Call 9/11/08,” September
11, 2008 (forwarding to Chairman Bernanke materials for the conference call).
66. Hayley Boesky, vice president, Markets Group, FRBNY, email to Meg McConnell et al., forwarding
Louis Bacon, email to Hayley Boesky, “FW: Options for short-circuiting the market,” September 11, 2008,
10:46 A.M.
67. Email chain between Jamie McAndrews, Tobias Adrian, Patrick Parkinson and Jeff Stehm, sub-
ject : “Fw : Default Management Group 9 Sep 2008.doc,” September 11, 2008.
68. Hayley Boesky, email to Debby Perelmuter, senior vice president, FRBNY, et al., “Panic,” Septem-
ber 11, 2008.
69. Jane Buyers-Russo, managing director, JP Morgan, email to Paolo R. Tonucci, “Fw: Letter to
Lehman,” Sept. 11, 2008, (attaching JPMorgan Chase & Co.’s September 11, 2008, Notice to Lehman
Brothers Holdings Inc.).
70. Jane Buyers-Russo, email to Bryn Thomas, executive director, Broker Dealer Group, JPMorgan
Chase & Co., et al., “Re: Lehman Brothers TriParty Collateral,” September 12, 2008.
71. Paolo R. Tonucci, interview by FCIC, August 6, 2010.
72. See Valukas, 4:1158–65, 1162 and n. 4304.
616 Notes to Chapter 18

73. Lehman Complaint, pp. 22–23, paragraphs 68, 71.

74. Barry Zubrow, written testimony for the FCIC, Hearing on Too Big to Fail: Expectations and Im-
pact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis,
day 1, session 2: Lehman Brothers, September 1, 2010, p. 7.
75. Richard S. Fuld, interview by FCIC, August 24, 2010.
76. Lehman Complaint, p. 23, paragraph 70.
77. Jim Wilkinson, email to Abby Aderman, Russell Reynolds Associates, “Re: Paulson Statement on
Treasury and FHFA Action to Protect Financial Markets and Taxpayers,” September 12, 2008.
78. Kevin M. Warsh, e-mail to J. Nellie Liang, senior associate director, Division of Research and Sta-
tistics, Board of Governors of the Federal Reserve System, September 12, 2008.
79. Valukas, 2:618.
80. Harvey R. Miller, interview by FCIC, August 5, 2010.
81. Tom Baxter, “Speaking notes: Financial Community Meeting,” attached to email from Helen Ay-
ala, NYFRB, to Steven Shafron, Treasure, September 12, 2008.
82. Thomas C. Baxter, interview by FCIC, August 11, 2010.
83. H. Rodgin Cohen, interview by FCIC, August 5, 2010.
84. Parkinson, email to Kohn et al., September 11, 2008.
85. Financial Services Authority of the United Kingdom, “Statement of the Financial Services Author-
ity” before the Lehman bankruptcy examiner, pp. 4–5, paragraph 23.
86. Paulson, On the Brink, p. 193.
87. Patrick M. Parkinson, email to Lucinda Brickler, senior vice president, payments policy, FRBNY,
“Re: triparty repo thoughts for this weekend,” September 12, 2008.
88. Patrick M. Parkinson, interview by FCIC, August 24, 2010; see also Patrick M. Parkinson, email to
Lucinda Brickler et al., “Re: another option we should present re triparty?” July 13, 2008.
89. John Thain, interview by FCIC, September 17, 2010.
90. Christopher Tsuboi, examiner, bank supervision/operational risk, FRBNY, email to Alejandro La-
Torre, assistant vice president, Credit, Investment and Payment Risk Group, FRBNY, “memo re:
Lehman’s inter-company default scenario,” September 13, 2008.
91. Scott Alvarez, email to Ben Bernanke et al., “Re: Fw: today at 7:00 p.m. w/Chairman Bernanke,
Vice Chairman Kohn and Others,” September 13, 2008.
92. Scott Alvarez, email to Mark VanDerWeide, “Re: tri-party,” September 13, 2008.
93. Bart McDade, interview by FCIC, August 9, 2010.
94. Baxter, interview.
95. Paulson, On the Brink, p. 207.
96. Baxter, interview; Robert Diamond, interview by FCIC, November 15, 2010.
97. Paulson, On the Brink, pp. 212–13.
98. Financial Services Authority of the United Kingdom, “Statement of the Financial Services Author-
ity” before the Lehman bankruptcy examiner, p. 9, paragraph 48.
99. Paulson, On the Brink, pp. 209–10. See also Baxter, interview.
100. Baxter, interview.
101. Jim Wilkinson, email to Jes Staley, September 14, 2008, 7:46 A.M.
102. Jim Wilkinson, email to Jes Staley, September 14, 2008, 9:00 A.M.
103. Paulson, On the Brink, p. 210.
104. Alistair Darling, quoted in United Kingdom Press Association, “Darling Vetoed Lehman Bros
Takeover,” Belfast Telegraph, October 9, 2010.
105. H. Rodgin Cohen, interview by FCIC, August 5, 2010.
106. Bart McDade, interview by FCIC, August 9, 2010.
107. Alex Kirk, interview by FCIC, August 16, 2010; McDade, interview, August 9, 2010.
108. Baxter, interview.
109. Thomas C. Baxter, letter to FCIC, October 15, 2010, attaching Exhibit 6, James P. Bergin, email to
William Dudley et al., “Bankruptcy,” September 14, 2008. See also Kirk, interview.
110. Ibid., attaching Exhibit 5, Lehman Brothers Holdings Inc., “Minutes of the Board of Directors,
September 14, 2008,” p. 2.
111. Ibid., attaching Exhibits 2 and 8.
 Notes to Chapter 19 617

112. On September 15, 2008, LBI borrowed $28 billion from PDCF against $31.7 billion of collateral;
on September 16, 2008, LBI borrowed $19.7 billion against $23 billion of collateral; and on September 17,
2008, LBI borrowed $20.4 billion against $23.3 billion of collateral. See Valukas, 4:1399 and nn. 5374–75.
113. Kirk, interview.
114. Miller, interview.
115. Kirk, interview.
116. Miller, interview. In his interview, Kirk told FCIC staff that he thought there were more than 1
million derivatives contracts.
117. McDade, interview, August 9, 2010.
118. Baxter, interview.
119. Harvey R. Miller, written testimony for the FCIC, Hearing on Too Big to Fail: Expectations and
Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis,
day 1, session 2: Lehman Brothers, September 1, 2010, p. 8.
120. Miller, interview.
121. Ibid.
122. Ibid.
123. Ben S. Bernanke, closed-door session with FCIC, November 17, 2009.
124. Ibid.
125. Henry M. Paulson Jr., written testimony for the FCIC, Hearing on the Shadow Banking System,
day 2, session 1: Perspective on the Shadow Banking System, May 6, 2010, p. 55.
126. Miller, written testimony for the FCIC, September 1, 2010, p. 14.
127. Ibid., p. 18.
128. Ibid., pp. 6, 12–13, 15, 11, 15.
129. Bernanke, testimony before the FCIC, September 2, 2010, transcript, p. 23.
130. Ben Bernanke, email to Kevin Warsh, member, Board of Governors of the Federal Reserve Sys-
tem, September 14, 2008.
131. Bernanke, testimony before the FCIC, September 2, 2010, p. 22.
132. Ibid., p. 24.
133. Ben Bernanke, “U.S. Financial Markets,” testimony before the Senate Committee on Banking,
Housing, and Urban Affairs, 110th Cong., 2nd sess., September 23, 2008.
134. 12 U.S.C. § 343(A), as added by act of July 21, 1932 (47 Stat. 715); and amended by acts of August
23, 1935 (49 Stat. 714), December 19, 1991 (105 Stat. 2386), and July 21, 2010 (124 Stat. 2113).
135. Scott G. Alvarez et al., memorandum, “Authority of the Federal Reserve to provide extensions of
credit in connection with a commercial paper funding facility (CPFF),” March 9, 2009, p. 7.
136. Fuld, written testimony for the FCIC, September 1, 2010, pp. 7, 6, 3.
137. Bernanke, closed-door session with FCIC.
138. Ben S. Bernanke, chairman of the Federal Reserve, letter to Phil Angelides, chairman of the
FCIC, December 21, 2010.
139. Thain, interview.
140. Ibid.
141. Ibid.
142. Dimon, interview.
143. Scott G. Alvarez, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Im-
pact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis,
day 1, session 1: Wachovia Corporation, September 1, 2010, transcript, p. 95. See also Baxter, letter to
FCIC, October 15, 2010, p. 6.

Chapter 19
1. Federal Reserve Bank of New York, notes about AIG meeting, September 12, 2008.
2. Ibid.
3. Ibid.
4. “AIG Commercial Paper Outstanding & Maturities—week of Sept 15th,” September 16, 2008, pro-
duced by JPMorgan.
5. American International Group, Inc., Form 10-Q for the quarterly period ended June 30, 2008.
618 Notes to Chapter 19

6. FRBNY, notes about AIG meeting.

7. Goldman Sachs International, Collateral Invoice (margin call) to AIG Financial Products Corp.,
July 27, 2007; data on collateral exposures and multisector CDOs supplied by AIG (see Timeline of
Goldman Sachs/AIG collateral calls, pp. 50, 392, 404, available at the FCIC website at http://fcic.gov/
hearings/pdfs/2010–0701-AIG-Goldman-supporting-docs.pdf); FRBNY, notes about AIG meeting.
8. Alejandro LaTorre, email to Christine Cumming, Timothy Geithner, William Dudley, et al., “Up-
date on AIG,” September 12, 2008.
9. FRBNY, notes about AIG meeting.
10. Mark Hutchings, interview by FCIC, June 22, 2010.
11. Eric Dinallo, testimony before the FCIC, Hearing on the Role of Derivatives in the Financial Cri-
sis, day 2, session 2: Derivatives: Supervisors and Regulators, July 1, 2010, transcript, pp. 3,16.
12. Michael Moriarty, testimony before the Congressional Oversight Panel, Hearing on American
International Group, 111th Cong., 2nd sess., May 26, 2010, p. 4.
13. Dinallo, testimony before the FCIC, July 2, 2010, pp. 16–17.
14. FRBNY, notes about AIG meeting.
15. Ibid.
16. “Systemic Impact of AIG Bankruptcy,” attachment to FRBNY internal email from Alejandro La-
Torre to Timothy Geithner, September 16, 2008.
17. FRBNY, internal memo about August 11, 2008, meeting with the AIG team of the Office of Thrift
Supervision.
18. Ibid.
19. FRBNY, internal document about AIG, August 14, 2008.
20. Ibid.
21. Goldman Sachs, company update on AIG, August 18, 2008.
22. Ira Selig, email to Kevin Coffey, “Goldman Report on AIG,” August 18, 2008.
23. FRBNY, internal document about AIG, September 2, 2008.
24. Ibid.
25. Ibid.; Goldman Sachs, company update on AIG, August 18, 2008.
26. FRBNY, notes about AIG meeting, September 12, 2008.
27. Ibid.
28. “AIG Commercial Paper Outstanding & Maturities—week of Sept 15th,” September 16, 2008.
29. FRBNY, notes about AIG meeting, September 12, 2008.
30. Hayley Boesky, email to Bill Dudley et al., “AIG panic,” September 12, 2008.
31. FRBNY, emails of September 12 and 13, 2008.
32. Thomas Baxter, interview by FCIC, April 30, 2010.
33. Robert Willumstad, interview by FCIC, November 15, 2010.
34. Patricia Mosser, email to Alejandro LaTorre et al., re: AIG/Board call, September 13, 2008,
12:54 P.M.
35. Patricia Mosser, email to Alejandro Latorre et al., September 13, 2008, 7:26 P.M.
36. FRBNY, internal memo about AIG, September 14, 2008.
37. Adam Ashcraft, email to Alejandro LaTorre et al., “AIG and the discount window,” September 14,
2008.
38. Alejandro LaTorre, email to Adam Ashcraft et al., September 14, 2008.
39. Ibid.
40. J. C. Flowers, interview by FCIC, October 7, 2010.
41. Robert Willumstad, interview by FCIC, November 15, 2010.
42. Ibid.
43. Goldman Sachs International, Collateral Invoice to AIG Financial Products Group, September 15,
2008.
44. Data supplied by AIG (Tab 31 of the AIG/Goldman Sachs collateral call timeline).
45. Baxter, interview.
46. See Sarah Dahlgren, FRBNY, interview by FCIC, April 30, 2010.
47. Ibid.
48. Alexander J. Psomas, email to NY Bank Sup AIG Monitoring and Analysis, September 15, 2005.
 Notes to Chapter 20 619

49. Fed Chairman Ben Bernanke, letter to FCIC Chairman Phil Angelides, December 21, 2010.
50. Federal Reserve Board of Governors, press release, September 16, 2008.
51. Congressional Oversight Panel, “The AIG Rescue, Its Impact on Markets, and the Government’s
Exit Strategy,” June 10, 2010, p. 98.
52. Ibid., executive summary, pp. 1, 8.
53. Treasury spokesman Andrew Williams, quoted in Hugh Son, “AIG’s Rescue Had ‘Poisonous’ Ef-
fect, U.S. Panel Says (Update1),” Bloomberg, June 10, 2010.
54. Scott M. Polakoff, “American International Group’s Impact on the Global Economy: Before, dur-
ing, and after Federal Intervention,” testimony before the. House Committee on Financial Services, Sub-
committee on Capital Markets, Insurance, and Government Sponsored Enterprises, 111th Cong., 1st
sess., March 18, 2009.
55. John Reich, interview by FCIC, May 4, 2010.
56. Michael E. Finn, prepared testimony before the Congressional Oversight Panel, May 26, 2010.
57. C. K. Lee, interview by FCIC, April 28, 2010. See also Memorandum of Understanding between
Scott M. Albinson, managing director, OTS, and Danièle Nouy, secrétaire général de la Commission
Bancaire, April 11, 2005.
58. OTS, Memo to Commission Bancaire regarding its supervisory role, January 2005.
59. Reich, interview.
60. Joseph Gonzalez, interview by FCIC, May 7, 2010.
61. Ibid.
62. OTS, Targeted Review of AIG Financial Products Corp., July 13, 2007.
63. AIG/Goldman Sachs collateral call timeline, p. 50.
64. Brad Waring, interview by FCIC, May 7, 2010.
65. Reich, interview.
66. Ibid.
Chapter 20
1. John J. Mack, written testimony for the FCIC, First Public Hearing of the FCIC, day 1, panel 1: Fi-
nancial Institution Representatives, January 13, 2010, p. 6.
2. Jamie Dimon, interview by FCIC, October 20, 2010.
3. Timothy Geithner, interview by FCIC, November 17, 2009.
4. Timothy Geithner, quoted by Robert Schmidt, “Geithner Slams Bonuses, Says Banks Would Have
Failed (Update2),” Bloomberg, December 4, 2009.
5. Ben Bernanke, closed-door session with FCIC, November 17, 2009.
6. Specifically, the Fed broadened the PDCF to match the types of collateral that the two major clear-
ing banks accepted in the tri-party repo system, including non-investment-grade securities and equities;
previously, PDCF collateral had been limited to investment-grade debt securities. The Fed similarly
broadened the TSLF to include all investment-grade debt securities; previously, TSLF collateral had been
limited to Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed se-
curities. The Fed also increased both the frequency of TSLF auctions, to weekly instead of every two
weeks, and their size. Federal Reserve Board press release, September 14, 2008.
7. On September 30, Goldman Sachs had a $15 billion balance in TSLF, and a $16.5 billion balance in
PDCF. Federal Reserve Board, “Regulatory Reform: Usage of Federal Reserve Credit and Liquidity Facil-
ities,” PDCF.
8. Lehman initially asserted that there were around 930,000 derivative transactions at the time of
bankruptcy. See Debtors’ Motion for an Order pursuant to Sections 105 and 365 of the Bankruptcy Code
to Establish Procedures for the Settlement or Assumption and Assignment of Prepetition Derivatives
Contracts, Lehman Brothers Holdings Inc., et al, No. 08-13555 (Bankr. S.D.N.Y. Nov. 13, 2008), p. 4. See
also Anton R. Valukas, Report of Examiner, In re Lehman Brothers Holdings Inc., et al., Chapter 11 Case
No. 08-13555 (JMP), (Bankr. S.D.N.Y.), March 11, 2010, 2:573. By November 13, 2008, a special facility to
unwind derivatives trades with Lehman had successfully terminated most of the 930,000 derivative con-
tracts. Nevertheless, in January 2009, Lehman’s counsel reported that 18,000 derivatives contracts had
not been terminated. Moreover, there are massive unresolved claims relating to over-the-counter deriva-
tives in the bankruptcy proceeding: as of May 2010, banks had filed more than $50 billion in claims for
losses related to derivatives contracts with Lehman. See Debtors’ Motion for an Order pursuant to
620 Notes to Chapter 20

Sections 105 and 365 of the Bankruptcy Code to Establish Procedures for the Settlement or Assumption
and Assignment of Prepetition Derivatives Contracts, Lehman Brothers Holdings Inc., et al., No. 08-
13555 (Bankr. S.D.N.Y. Nov. 13, 2008) [Docket No. 1498], p. 4; Debtors’ Motion for an Order Approving
Consensual Assumption and Assignment of Prepetition Derivatives Contracts, Lehman Brothers Hold-
ings Inc., et al., No. 08-13555 (Bankr. S.D.N.Y. Jan. 16, 2009) [Docket No.2561], p. 3.
9. Money market fund holdings of all types of taxable commercial paper decreased from $671 billion
at the end of August 2008 to $505 billion at the end of September (data provided by ICI/Crane to the
FCIC). BNY Mellon, in its role as tri-party clearing bank, reported that Treasury-backed repos rose from
$195 billion (13%) to $466 billion (27%) of its tri-party business between March 31 and December 31,
2008 (data provided by BNY Mellon to the FCIC).
10. Harvey Miller, interview by FCIC, August 5, 2010.
11. The Reserve Fund, Semi-annual report to shareholders, March 2006.
12. Complaint, SEC v. Reserve Management Company Inc., Resrv Partners Inc., Bruce Bent Sr., Bruce
Bent II, and The Reserve Primary Fund (S.D.N.Y. May 5, 2009), p. 12 (para. 35); “Fidelity, BlackRock,
Dreyfus, Reserve Make Big Gains Past 12 Months,” Crane Data News Archives, September 12, 2008.
13. The Reserve Primary Fund management, interview by FCIC, March 25, 2010.
14. SEC Complaint against Reserve Management Company Inc., pp. 2, 18 (paras. 3, 59), p. 30 (para.
101); The Reserve, “The Primary Fund: Plan of Liquidation and Distribution of Assets,” December 3,
2008, p. 2.
15. SEC Complaint, pp. 26–33 (paras. 88–113); The Reserve, “The Primary Fund: Plan of Liquida-
tion,” p. 2.
16. SEC Complaint, p. 35 (para. 121). The SEC notes that the Primary Fund likely broke the buck
prior to 11:00 A.M. on September 16 because of the redemption requests and the valuation of Lehman’s
debt; moreover, RMCI announced on November 26, 2008, that owing to an administrative error, its NAV
should have been calculated as $0.99 between 11:00 A.M. and 4:00 P.M. on September 16 (pp. 34–33, paras.
119, 120).
17. Moody’s Investors Service articles, “Sponsor Support Key to Money Market Funds,” August 9,
2010, p. 4; “Moody’s Proposes New Money Market Fund Rating Methodology and Symbols,” September
7, 2010.
18. Patrick McCabe and Michael Palumbo, interview by FCIC, September 28, 2010.
19. Ibid.
20. Investment Company Institute, Historical Weekly Money Market Data. While nongovernment
funds lost $434 billion during the period between September 10 and October 1, 2008, government
funds—investing in Treasuries and GSE debt—increased by $357 billion during the same period.
21. McCabe and Palumbo, interview.
22. FCIC survey of money market mutual funds. Holdings for the five firms decreased from $58 bil-
lion to $29 billion from September 12, 2008, to September 19, 2008. See FCIC website for details.
23. Timothy Geithner, testimony before the FCIC, Hearing on the Shadow Banking System, day 2,
session 2: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 135.
24. McCabe and Palumbo, interview.
25. “Treasury Announces Guaranty Program for Money Market Funds,” Treasury Department press
release, September 19, 2008. President George W. Bush approved the use of existing authorities by Secre-
tary Henry M. Paulson Jr. to make available as necessary the assets of the Exchange Stabilization Fund
(ESF) for up to $50 billion to guarantee payments to support money market mutual funds. The original
objective of the ESF, established by the Gold Reserve Act of 1934, was to stabilize the value of the dollar
in the depths of the Depression. It authorized the treasury secretary, with the approval of the president, to
“deal in gold, foreign exchange, and other instruments of credit and securities” to promote international
financial stability.
26. The program was called the Asset-Backed Commercial Paper Money Market Mutual Fund Liq-
uidity Facility (AMLF).
27. Neel Kashkari, interview by FCIC, November 2, 2010.
28. John Mack, interview by FCIC, November 2, 2010.
29. New York Federal Reserve, internal email, October 22, 2008, p. 2.
30. David Wong, email to Fed and SEC officials, September 15, 2008.
 Notes to Chapter 20 621

31. Jonathan Stewart, FRBNY, internal email, September 17, 2008.

32. One year later, the Senior Supervisors Group—a cross-agency task force looking back on the
causes of the financial crisis—would write, “Before the crisis [at the investment banks post-Lehman],
many broker-dealers considered the prime brokerage business to be either a source of liquidity or a liq-
uidity-neutral business. As a result, the magnitude and unprecedented severity of events in September–
October 2008 were largely unanticipated.” Senior Supervisors Group, “Risk Management Lessons from
the Global Banking Crisis of 2008,” October 21, 2009, p. 9.
33. Jonathan Wood, Whitebox Advisors, interview by FCIC, August 11, 2010.
34. The FCIC surveyed hedge funds that survived the crisis. Those in the three largest quartiles
ranked by size received investor redemption requests averaging 20% of their assets in the fourth quarter
of 2008 (the first available redemption date after the Lehman bankruptcy).
35. IFSL Research, “Hedge Funds 2009,” April 2009.
36. David Wong, treasurer of Morgan Stanley, interview by FCIC, October 15, 2010.
37. Mack, interview.
38. Wong, interview.
39. Patrice Maher (Morgan Stanley), email to William Brodows (Federal Reserve BNY) et al., Septem-
ber 28, 2008, with data in an attachment. Hedge fund values are the Prime Brokerage Outflows (NY+In-
ternational).
40. Wong, interview.
41. Matthew Eichner, internal email, September 16, 2008.
42. Angela Miknius, email to NY Bank Sup, September 18, 2008.
43. Amy G. White, internal NYFBR email, September 19, 2008.
44. Morgan Stanley, “Liquidity and Financing Activity: 08/28/08,” “Liquidity and Financing Activity:
09/18/08,” “Liquidity and Financing Activity: 10/03/08,” reports to the New York Federal Reserve.
45. Morgan Stanley Corporate Treasury, “Meeting with Federal Reserve: September 20, 2008,” attach-
ment to Morgan Stanley email to NYFRB, September 20, 2008, including “Forward Forecast.”
46. Morgan Stanley Corporate Treasury, “Liquidity Landscape: 09/12–09/18/2008,” in attachment to
Morgan Stanley email to NYFRB, September 20, 2008; Amy White, internal NYFRB emails, September
16 and 19, 2008.
47. Lloyd Blankfein, testimony before the FCIC, First Public Hearing of the FCIC, day 1, panel 1: Fi-
nancial Institution Representatives, January 13, 2010, transcript, pp. 34–35.
48. Bernanke, closed-door session.
49. Thomas Baxter, interview by FCIC, April 30, 2010.
50. The switch to bank holding company status required a simple charter change. Both Morgan and
Goldman already owned banks that they had chartered as industrial loan companies, a type of bank that
is allowed to accept FDIC-insured deposits without having any Fed supervision over the bank’s parent or
other affiliated companies.
51. Federal Reserve, “Discount Window Payment System Risk: Getting Started,” last updated Novem-
ber 17, 2009.
52. Mack, interview.
53. Mack, interview.
54. Wong, interview.
55. Amy G. White, internal FRBNY email, September 19, 2008.
56. It should be borne in mind that lack of regulation of this market rendered it extremely opaque.
Shortcomings in transparency, lack of reporting requirements, and limited data collection by third par-
ties make it difficult to document and describe the various market trading problems that emerged during
the crisis.
57. Michael Masters, testimony before the FCIC, Hearing on the Role of Derivatives in the Financial
Crisis, day 1, session 1: Overview of Derivatives, June 30, 2010, transcript, p. 26.
58. Depository Trust and Clearing Corporation data provided to the FCIC.
59. “The Global OTC Derivatives Market at End-June 1998,” Bank of International Settlements press
release, December 13, 1998; “OTC derivatives market activity in the second half of 2008,” Bank of Inter-
national Settlements press release, May 9, 2009, p. 7.
622 Notes to Chapter 20

60. “Triennial and Regular OTC Derivatives Market Statistics,” Bank of International Settlements
press release, November 16, 2010, p. 7.
61. Moody’s, “Moody’s downgrades WaMu Ratings; outlook negative,” September 11, 2008.
62. “OTS Fact Sheet on Washington Mutual Bank,” OTS 08–046A, September 25, 2008, p. 3.
63. Jamie Dimon, interview by FCIC, October 20, 2010.
64. Sheila Bair, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of
Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 2: ses-
sion 2: Federal Deposit Insurance Corporation, September 2, 2010, exchange between Bair and Commis-
sioner Douglas Holtz-Eakin, pp. 134, 149.
65. Scott Alvarez, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of
Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 1, Ses-
sion 1: Wachovia Corporation, September 1, 2010, transcript, p. 84.
66. Kashkari, interview.
67. Greg Feldberg, “Wachovia Case Study,” presentation at LBO Supervision Conference, November
12–13, 2008, Atlanta, Georgia, p. 15. These rules, embodied in section 23A of the Federal Reserve Act,
limit the support that a depository institution can provide to related companies in the same corporate
structure; they are aimed at protecting FDIC-insured depositors from activities that occur outside of the
bank itself. Exemptions have the effect of funding affiliate, nonbank assets within the federal safety net of
insured deposits; they create liquidity for the parent company and/or key affiliates (and reduce bank liq-
uidity) during times of market stress.
68. Robert Steel, interview by FCIC, August 18, 2010.
69. Scott Alvarez, written testimony for the FDIC, September 1, 2010, p. 4.
70. Robert Steel, written testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Im-
pact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis,
day 1, session 1: Wachovia Corporation, September 1, 2010, p. 2.
71. David Wilson, interview by FCIC, August 4, 2010.
72. Sheila Bair, interview by FCIC, August 18, 2010.
73. Richard Westerkamp, Federal Reserve Bank of Richmond, interview by FCIC, August 13, 2010.
74. Wachovia was unable to roll $1.1 billion of asset-backed commercial paper that Friday; James
Wigand and Herbert Held, memo to the FDIC Board of Directors, September 29, 2008, p. 2. On brokered
certificates of deposit, see Westerkamp, interview.
75. John Corston, acting deputy director, Division of Supervision and Consumer Protection, FDIC,
written testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordi-
nary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 1, Session 1:
Wachovia Corporation, September 1, 2010, p. 4.
76. Wilson, interview.
77. Rich Westerkamp, email to FCIC, November 2, 2010. Westerkamp said that the estimate of early
redemption requests was based on a phone conversation with officials in Wachovia’s treasury depart-
ment, describing their conversations with investors; the figures were never verified.
78. Bair, interview.
79. Robert Steel, interview by FCIC, August 18, 2010.
80. Bair, interview; Steel, interview; FDIC staff, interview by FCIC re Wachovia, July 16, 2010.
81. Alvarez, written testimony for the FCIC, September 1, 2010, p. 5.
82. Steel, interview.
83. Ibid.
84. Wigand and Held, memo to the FDIC board, September 29, 2008, pp. 2, 4–5.
85. Federal Reserve staff, memo to the Board of Governors, subject: “Considerations Regarding In-
voking the Systemic Risk Exception for Wachovia Bank, NA,” September 28, 2008, p. 7.
86. John A. Beebe, Market Risk Team Leader, Federal Reserve Bank of Richmond, memo to Jennifer
Burns, VP-LCBO, “Wachovia Large Funds Providers,” September 27, 2008, pp. 1–2.
87. Federal Reserve staff, memo to the Board of Governors, subject: “Considerations Regarding In-
voking the Systemic Risk Exception for Wachovia Bank, NA,” September 28, 2008, p. 7.
88. Bair, interview; minutes of the telephonic meeting of Federal Deposit Insurance Corporation
Board of Directors, September 29, 2008, p. 8.
 Notes to Chapter 20 623

89. Bair, interview.

90. FDIC memo to the FDIC Board of Directors, p. 8; Corston, written testimony for the FDIC, Sep-
tember 1, 2010, p. 10.
91. Specifically, under Wachovia’s proposal, the FDIC would provide credit protection on $200 billion
of loans, while Wachovia would absorb the first $25 billion in losses and the FDIC would potentially in-
cur losses on the balance of the $200 billion. To offset that risk, Wachovia proposed that the FDIC receive
$10 billion in preferred stock and warrants on common shares (FDIC memo to the FDIC Board of Direc-
tors, p. 8).
92. The FDIC board has five members: the comptroller of the currency, the director of OTS, and three
other members appointed by the president. In Too Big to Fail: The Inside Story of How Wall Street and
Washington Fought to Save the Financial System from Crisis—and Themselves (New York: Viking, 2009),
Andrew Ross Sorkin (p. 497) wrote that before the September 29, 2008, FDIC board meeting, New York
Federal Reserve Governor Geithner and other officials had a conference call with Bair (Paulson recused
himself) during which Geithner urged Bair to help Citigroup acquire Wachovia by guaranteeing some of
its potential losses. Geithner argued that allowing the FDIC to take over Wachovia would have the effect
of wiping out shareholders and bond holders, which, he was convinced, would only spook the markets.
He was still furious with Bair for the way she had abruptly taken over Washington Mutual, which had
had a deleterious effect on investor confidence.
93. Federal Deposit Insurance Corporation Board of Directors meeting, September 29, 2008, tran-
script, pp. 21–22.
94. Minutes of telephonic meeting of the FDIC board, September 29, 2008, p. 8.
95. Ibid.; the $34.6 billion figure is as of September 30, 2008 (FDIC staff, memo to the Board of Direc-
tors, subject: “Third Quarter 2008 CFO Report to the Board,” November 21, 2008, p. 1).
96. Minutes of telephonic meeting of the FDIC board, September 29, 2008, p. 8.
97. Bair, interview.
98. Steel, written testimony for the FCIC, September 1, 2010, p. 4. On the board’s vote and the agree-
ment in principle, see Steel, interview; see also Affidavit of Robert K. Steel, dated October 5, 2008, filed in
Wachovia Corp. v. Citigroup, Inc., Case No. 08-cv-085093-SAS (S.D.N.Y.), pp. 3–4 and exhibit A.
99. Fed Chairman Ben Bernanke, letter to FCIC Chairman Phil Angelides, December 21, 2010.
100. Wachtell, Lipton, Rosen & Katz, on behalf of Wells, letter to Division of Corporation Finance,
SEC, November 17, 2008, p. 3.
101. Richard Kovacevich, interview by FCIC, August 24, 2010.
102. Bair, interview.
103. Steel, interview.
104. Bair, interview. In his interview, Treasury’s Kashkari told the FCIC that he disagreed. He felt that
the highest priority was to transfer the risk of banks’ troubled assets from the financial system to the gov-
ernment. Citigroup’s FDIC-assisted acquisition would have removed potential losses on $270 billion of
assets from the financial system by transferring those potential losses to the FDIC.
105. “Wells Fargo, Wachovia Agree to Merge: Creating Premier Coast-To-Coast Financial Services
Franchise without Government Assistance,” Wells Fargo press release, October 3, 2008.
106. Rich Delmar, Treasury Office of the Inspector General, interview by FCIC, August 25, 2010; Rich
Delmar, memorandum for Inspector General Eric M. Thorson, “Inquiry Regarding IRS Notice 2008-83,”
September 3, 2009, pp. 3, 5, 11–12.
107. Richard Levy, interview by FCIC, August 19, 2010.
108. “Statement by Secretary Henry M. Paulson, Jr. on Comprehensive Approach to Market Develop-
ments,” Treasury Department press release, September 19, 2008.
109. Senators Christopher J. Dodd and Richard C. Shelby, remarks before the Senate Committee on
Banking, Housing, and Urban Affairs, Turmoil in U.S. Credit Markets: Recent Actions Regarding Govern-
ment-Sponsored Entities, Investment Banks, and Other Financial Institutions, 110th Cong., 2nd sess., Sep-
tember 23, 2008, transcript, pp. 3, 6.
110. Secretary Henry Paulson, testimony before the Senate Banking Committee, Turmoil in the U.S.
Credit Markets, transcript, p. 37.
111. Fed Chairman Ben Bernanke, “Economic Outlook,” testimony before the Joint Economic Com-
mittee, 110th Cong., 2nd sess., September 24, 2008, transcript.
624 Notes to Chapter 20

112. Fed Chairman Ben Bernanke, testimony before the House Financial Services Committee, The
Future of Financial Services: Exploring Solutions for the Market Crisis, September 24, 2008, transcript,
p. 48.
113. Mel Martinez, interview by FCIC, September 28, 2010.
114. The TARP legislation, drafted as the Emergency Economic Stabilization Act of 2008, was cou-
pled in Public Law 110-343 with several other vote-attracting acts, including the Energy Improvement
and Extension Act of 2008, the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, the Paul
Wellstone and Pete Domenici Mental Health Parity and Addiction Equity Act of 2008, and the Heartland
and Hurricane Ike Disaster Relief Act of 2008. Congress originally said that the deposit insurance cap
would revert to $100,000 at the beginning of 2010, but later extended the deadline through the end of
2013.
115. The quotation is part of the formal title of Public Law 110-343, of which the TARP legislation—
officially named the Emergency Economic Stabilization Act of 2008—is a part.
116. “Board Announces Creation of the Commercial Paper Funding Facility (CPFF) to Help Provide
Liquidity to Term Funding Markets,” Federal Reserve Board press release, October 7, 2008. The CPFF
complemented the Fed’s other commercial paper program, the AMLF, which was created shortly after the
Reserve Primary Fund broke the buck. While the AMLF targeted money market mutual funds, the CPFF
aimed to create liquidity for qualified commercial paper issuers.
117. Federal Reserve Board, “Commercial Paper Funding Facility (CPFF).”
118. Ken Lewis from Bank of America, Robert Kelly from BNY Mellon, Vikram Pandit from Citi-
group, Lloyd Blankfein from Goldman, Jamie Dimon from JP Morgan, John Thain from Merrill, John
Mack from Morgan Stanley, Ronald Logue from State Street, and Richard Kovacevich from Wells.
119. Paulson, testimony before the FCIC, May 6, 2010, transcript, p. 70. Former assistant treasury sec-
retary Phillip Swagel argued, “There is no authority in the United States to force a private institution to
accept government capital” (“The Financial Crisis: An Inside View,” Brookings Papers on Economic Ac-
tivity, conference draft, Spring 2009, pp. 33–34).
120. Henry Paulson, On The Brink: Inside the Race to Stop the Collapse of the Global Financial System
(New York: Business Plus, 2010), p. 365.
121. Dimon, interview.
122. The Temporary Liquidity Guarantee Program consisted of two programs, the Temporary Debt
Guarantee Program (TDGP) and the Transaction Account Guarantee Program (TAGP). The TDGP at its
highest point in May 2009 guaranteed $346 billion in outstanding senior debt; see “FDIC Announces
Plan to Free Up Bank Liquidity,” FDIC press release, October 14, 2008. The TAGP guaranteed $834 bil-
lion in deposits at the end of 2009.
123. “Factsheet on Capital Purchase Program,” FinancialStability.gov, updated October 3, 2010.
124. “Remarks by Secretary Henry M. Paulson, Jr. on Financial Rescue Package and Economic Up-
date,” Treasury Department press release, November 12, 2008.
125. Paulson, testimony before the FCIC, May 6, 2010, transcript, p. 70.
126. U.S. Treasury Department Office of Financial Stability, “Troubled Asset Relief Program”; Trans-
actions Report for Period Ending December 31, 2008: Capital Purchase Program;” “Factsheet on Capital
Purchase Program.”
127. U.S. Treasury Department Office of Financial Stability, “Troubled Asset Relief Program: Transac-
tions Report for Period Ending October 15, 2010: Capital Purchase Program.”
128. Office of the Special Inspector General for the Troubled Asset Relief Program, “Initial Report to
the Congress,” February 6, 2009, p. 6.
129. Congressional Oversight Panel, “September Oversight Report: Assessing the TARP on the Eve of
Its Expiration,” September 16, 2010, p. 27.
130. Office of Financial Stability, “Troubled Asset Relief Program: Two Year Retrospective,” October
2010, pp. 15, 51; AIG, “What AIG Owes the U.S. Government,” updated September 30, 2010.
131. Congressional Oversight Panel, “September Oversight Report,” p. 27; Office of Financial Stabil-
ity, “Troubled Asset Relief Program: Two Year Retrospective,” p. 18; “Taxpayers Receive $10.5 Billion in
Proceeds Today from Final Sale of Treasury Department Citigroup Common Stock,” Treasury Depart-
ment press release, December 10, 2010.
 Notes to Chapter 20 625

132. Office of the Special Inspector General for the Troubled Asset Relief Program, “Quarterly Report
to Congress,” October 26, 2010, table 2.1, p. 46 (obligation figures as of October 3, 2010, and expenditure
figures as of September 30, 2010).
133. The money market funding is through the Asset-backed Commercial Paper Money Market Mu-
tual Fund Liquidity Facility (AMLF); FCIC staff calculations.
134. Board of Governors of the Federal Reserve System, “Regulatory Reform: Agency Mortgage-
backed Securities (MBS) Purchase Program.”
135. The Fed had created the first Maiden Lane vehicle in March to take $29 billion in assets off the
balance sheet of Bear Stearns, as described in chapter 15. See “AIG RMBS LLC Facility: Terms and Con-
ditions,” December 16, 2008; “AIG Discloses Counterparties to CDS, GIA and Securities Lending Trans-
actions,” AIG press release, March 15, 2009, Attachment D: Payments to AIG Securities Lending
Counterparties.
136. Federal Reserve Bank of New York, “Maiden Lane III: Transaction Overview”; Federal Reserve
and Treasury Department press release, November 10, 2008; “AIG CDO LLC Facility: Terms and Condi-
tions,” Federal Reserve Bank of New York press release, December 3, 2008; FRBNY, “Maiden Lane Trans-
actions.” $27.1 billion was paid to 16 counterparties and $2.5 billion was paid to AIGFP as an adjustment
to reflect overcollateralization.
137. Office of the Special Inspector General for the Troubled Asset Relief Program, “Factors Affecting
Efforts to Limit Payments to AIG Counterparties,” SIGTARP-10-003, November 17, 2009, pp. 19–20.
138. Blankfein, testimony before the FCIC, January 13, 2010, transcript, pp. 90–93.
139. Data provided to Goldman Sachs to the FCIC.
140. David Viniar, testimony before the FCIC, Hearing on the Role of Derivatives in the Financial
Crisis, day 2, session 1: American International Group, Inc. and Goldman Sachs Group, Inc., July 1, 2010,
transcript, p. 148.
141. Goldman Sachs, email to FCIC, July 15, 2010.
142. Ibid.; and data provided by Goldman Sachs to the FCIC.
143. SIGTARP, “Factors Affecting Efforts to Limit Payments to AIG Counterparties,” pp. 15–16, 18.
The report said counterparties insisted on 100% coverage because (1) concessions “would mean giving
away value and voluntarily taking a loss, in contravention of their fiduciary duty to their shareholders”;
(2) they had a “reasonable expectation” that AIG would not default on further obligations, given the gov-
ernment assistance; (3) costs already incurred to protect against a possible AIG default “would be exacer-
bated if they were paid less than par value”; and (4) they were “contractually entitled” to receive the par
value of the credit default swap contracts.
144. “In other words, the decision to acquire a controlling interest in one of the world’s most complex
and most troubled corporations was done with almost no independent consideration of the terms of the
transaction or the impact that those terms might have on the future of AIG” (ibid., p. 28).
145. Ibid., summary, p. 1.
146. Congressional Oversight Panel, “June Oversight Report: The AIG Rescue, Its Impact on Markets,
and the Government’s Exit Strategy,” June 10, 2010, pp. 10, 8.
147. Suzanne Kapner, “US Congressional Panel Attacks AIG Rescue,” Financial Times, June 10, 2010.
148. Baxter, interview.
149. Sarah Dahlgren, interview by FCIC, April 30, 2008.
150. SIGTARP, “Factors Affecting Efforts to Limit Payments to AIG Counterparties,” p. 29.
151. Timothy Geithner, quoted in Jody Shenn, Bob Ivry, and Alan Katz, “AIG 100-Cents Fed Deal
Driven by France Belied by French Banks,” Bloomberg Businessweek, January 20, 2010.
152. E.g., Baxter, interview; Jim Mahoney, Federal Reserve Bank of New York, interview by FCIC,
April 30, 2010; Michael Alix, Federal Reserve Bank of New York, interview by FCIC, April 30, 2010.
153. Dahlgren, interview.
154. Baxter, interview.
155. GAO, “Federal Financial Assistance: Preliminary Observations on Assistance Provided AIG,”
GAO-09–4907 (Testimony: Before the Subcommittee on Capital Markets, Insurance, and Government
Sponsored Enterprises, House Committee on Financial Services), March 18, 2009, p. 2; Federal Reserve
press release, September 16, 2008.
156. AIG, “What AIG Owes the US Government,” updated September 30, 2010.
626 Notes to Chapter 20

157. Edward J. Kelly III, interview by FCIC, March 3, 2010.

158. Roger Cole, interview by FCIC, August 2, 2010.
159. Kelly, interview.
160. James R. Wigand and Herbert J. Held, memorandum to the FDIC Board of Directors, regarding
recommendation for systemic risk determination for Citigroup, November 23, 2008, p. 5.
161. Kelly, interview.
162. Mark D. Richardson, email to John H. Corston, Jason C. Cave, et al., subject: “RE: CONFIDEN-
TIAL—Citigroup—Deterioration of Stock Price and CDS Spreads,” November 20, 2008; Mark
D. Richardson, email, to John H. Corston, Jason C. Cave, et al., subject: “11-21-08 Citi Liquidity call
notes,” November 21, 2008.
163. Wigand and Held, November memo to the FDIC board regarding Citigroup, p. 5.
164. Bernanke, closed-door session.
165. Arthur J. Murton, email to John V. Thomas, Michael H. Krimminger, et al., subject: “RE: Pro-
posed Conduit,” November 22, 2008; Michael H. Krimminger, email to Arthur J. Murton, John
V. Thomas, et al., subject: “RE: Proposed Conduit,” November 22, 2008.
166. Vikram Pandit, testimony before the Congressional Oversight Panel, Citigroup and the Troubled
Asset Relief Program, 111th Cong., 2nd sess., March 4, 2010, transcript, p. 79.
167. Kelly, interview.
168. GAO, “Federal Deposit Insurance Act: Regulators’ Use of Systemic Risk Exception Raises Moral
Hazard Concerns and Opportunities Exist to Clarify the Provision,” GAO-10–100 (Report to Congres-
sional Committees), April 2010, p. 2.
169. Wigand and Held, memo to the FDIC board regarding Citigroup, pp. 9, 10.
170. Department of the Treasury response to Congressional Oversight Panel, Questions for the
Record, p. 3, Citigroup and the Troubled Asset Relief Program, March 4, 2010, p. 44.
“Joint Statement by Treasury, Federal Reserve, and the FDIC on Citigroup,” joint press release,
November 23, 2008.
171. “Joint Statement on Citigroup.”
172. In total, Citigroup received almost $40 billion in capital benefits from the November 2008 gov-
ernment assistance. Half of the capital benefits were from Treasury’s $20 billion TARP investment in Citi-
group preferred stock; $16 billion of the capital benefits were derived from a change in the risk weighting
of the ring-fenced assets. In addition, Citigroup issued Treasury and the FDIC $7 billion in preferred
stock as payment for the guarantee on the ring fence; the result, after accounting for the insurance feature
of the arrangement, was a $3.5 billion increase in capital for Citigroup.
173. Kelly, interview.
174. The warrants gave the government the right to buy 254 million shares at $10.61 a share; at the
time, the stock was trading at $3.76 (Congressional Oversight Panel, “November Oversight Report:
Guarantees and Contingent Payments in TARP and Related Programs,” November 6, 2009, pp. 18–19).
175. FDIC Board of Directors meeting, closed session, November 23, 2008, transcript, p. 14.
176. Ibid., pp. 27–28.
177. Office of Financial Stability, “Troubled Asset Relief Program: Two Year Retrospective,” October
2010, p. 30; “Taxpayers receive $10.5 billion in proceeds today from final sale of Treasury Department
Citigroup common stock,” Treasury Department press release, December 10, 2010.
178. “Merrill Lynch Reports Third Quarter 2008 Net Loss from Continuing Operations of $5.1 Bil-
lion,” Merrill Lynch press release, October 16, 2008, p. 4; Merrill Lynch, 3Q 2008 Earnings Call transcript,
October 16, 2008, p. 2.
179. Federal Reserve System, “Order Approving Bank of America Corporation Acquisition of a Sav-
ings Association and an Industrial Loan Company,” November 26, 2008, pp. 7, 9. To approve such a pro-
posal, the Bank Holding Company Act requires the Fed to determine that a transaction “can reasonably
be expected to produce benefits to the public, such as greater convenience, increased competition, or
gains in efficiency, that outweigh possible adverse effects, such as undue concentration of resources, de-
creased or unfair competition.” 12 U.S.C. 1843(j)(2)(A).
180. Timothy J. Mayopoulous, former general counsel of Bank of America, written testimony before
the House Oversight Committee, Bank of America and Merrill Lynch: How Did a Private Deal Turn into a
Federal Bailout? Part IV, 111th Cong., 1st sess., November 17, 2009.
 Notes to Chapter 20 627

181. Ken Lewis, deposition In Re: Executive Compensation Investigation: Bank of America–Merrill
Lynch, February 26, 2009, p. 9, available from House Committee on Oversight and Government Reform
and the Subcommittee on Domestic Policy, Bank of America and Merrill Lynch: How Did A Private Deal
Turn into a Federal Bailout? 111th Cong., 1st sess., June 11, 2009.
182. Bank of America, 4Q 2008 Earnings Call transcript, January 16, 2009, p. 16.
183. Ibid., pp. 3, 10, 16.
184. John Thain, interview by FCIC, September 17, 2009.
185. Complaint, SEC v. Bank of America (S.D.N.Y. Jan. 12, 2010); Final Consent Judgment As to De-
fendant Bank of America (S.D.N.Y. Feb. 4, 2010).
186. Ken Lewis, interview by FCIC, October 22, 2010.
187. Lewis, deposition In Re: Executive Compensation Investigation: Bank of America—Merrill Lynch,
pp. 34, 38; Henry Paulson, written testimony before the House Committee on Oversight and Govern-
ment Reform and the Subcommittee on Domestic Policy, Bank of America and Merrill Lynch: How Did a
Private Deal Turn into a Federal Bailout? Part III, 111th Cong., 1st sess., July 16, 2009, p. 22.
188. Paulson, written testimony before the House Oversight Committee, July 16, 2009, p. 23 (quota-
tion); Ben Bernanke, written testimony before the House Committee on Oversight and Government Re-
form and the Subcommittee on Domestic Policy, Bank of America and Merrill Lynch: How Did a Private
Deal Turn into a Federal Bailout? Part II, 111th Cong., 1st sess., June 25, 2009, p. 18.
189. Lewis, interview.
190. Thain, interview
191. Paulson, written testimony before the House Oversight Committee, July 16, 2009, pp. 19, 25.
192. Chairman Ben Bernanke, email to General Counsel Scott Alvarez, “Re: Fw: BAC,” December 23,
2008, available from House Oversight Committee, Bank of America and Merrill Lynch: How Did a Private
Deal Turn into a Federal Bailout? Part II, June 25, 2009, p. 73; Representative Edolphus Towns, in ibid.,
p. 2.
193. Lewis, interview.
194. Minutes of a Special Meeting of Board of Directors of Bank of America Corporation, December
22, 2008, available in House Committee on Oversight and Government Reform, June 11, 2009, p. 183.
195. Minutes of a Special Meeting of the Bank of America board, December 30, 2008, available in
ibid., p. 188.
196. Lewis, interview.
197. See Department of the Treasury, Office of Financial Stability, “Troubled Assets Relief Program:
Transactions Report, for Period Ending November 16, 2010,” November 18, 2010. In addition to drawing
on these funds, it was also a “substantial user” of the Fed’s various liquidity programs. The holding com-
pany and its subsidiaries had already borrowed $55 billion through the Term Auction Facility. It had also
borrowed $15 billion under the Fed’s Commercial Paper Funding Facility and $20 billion under the
FDIC’s debt guarantee program. And newly acquired Merrill Lynch had borrowed another $21 billion
from the Fed’s two Bear Stearns–era repo-support programs. Yet despite Bank of America’s recourse to
these programs, the regulators worried that it would experience liquidity problems if the fourth-quarter
earnings were weak.
198. The amount of FDIC-guaranteed debt that can be issued by each eligible entity, or its cap, is
based on the amount of senior unsecured debt outstanding as of September 30, 2008.
199. FRB and OCC staff, memorandum to Rick Cox, FDIC, subject: “Bank of America Corporation
(BAC) Funding Vulnerabilities and Implications for Other Financial Market Participants,” January 10,
2009, p. 2.
200. Sheila C. Bair, FDIC Chairman, written testimony before the House Committee on Oversight
and Government Reform and the Subcommittee on Domestic Policy, Bank of America and Merrill Lynch:
How Did a Private Deal Turn into a Federal Bailout? Part V, 110th Cong., 1st sess., December 11, 2009,
p. 2.
201. FRB and OCC staff memo to Rick Cox, “Bank of America Corporation (BAC) Funding Vulnera-
bilities,” pp. 2, 4; Mitchell Glassman, Sandra Thompson, Arthur Murton, and John Thomas, memoran-
dum to the FDIC Board of Directors, subject: Bank of America, etc., January 15, 2009, pp. 8, 9.
202. Bair, written testimony before the House Oversight Committee, December 11, 2009, p. 3.
628 Notes to Chapter 21

203. Glassman et al., memo to the FDIC board, January 15, 2009, p. 3. They agreed to this 25/75 split
because 25% of the assets for the ring fence were from depository institutions and 75% were not. See
closed meeting of the FDIC Board of Directors, January 15, 2009, transcript, p. 18.
204. Closed meeting of the FDIC board, January 15, 2009, transcript, p. 24. According to the FDIC
staff, “Liquidity pressure may increase to critical levels following the announcement of fourth quarter
2008 operating results that are significantly worse than market expectations. Market reaction to BAC’s
operating results may have systemic consequences given the size of the institution and the volume of
counterparty transactions involved. Without a systemic risk determination . . . significant market disrup-
tion may ensue as counterparties lose confidence in BAC’s ability to fund ongoing operations. . . . [Eco-
nomic developments] point to a clear relationship between the financial market turmoil of recent months
and impaired economic performance that could be expected to worsen further if BAC and its insured
subsidiaries were allowed to failed. Such an event would significantly undermine business and consumer
confidence.” Glassman et al., memo to the FDIC board, January 15, 2009, pp. 13–14.

Chapter 21
1. Brian Moynihan, written testimony for the FCIC, First Public Hearing of the Financial Crisis In-
quiry Commission, day 1, session 1: Financial Institution Representatives, January 13, 2010, p. 1.
2. Clarence Williams, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—
Sacramento, session 4: Impact of the Financial Crisis on Sacramento Neighborhoods and Families, Sep-
tember 23, 2010, p. 8; and testimony before the FCIC, transcript, pp. 259–60.
3. Ed Lazear, interview by FCIC, November 10, 2010.
4. Jeannie McDermott, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—
Greater Bakersfield, session 6: Forum for Public Comment, September 7, 2010, transcript, pp. 211–13.
5. Marie Vasile, testimony before the FCIC, in ibid., transcript, pp. 244–51.
6. “National Delinquency Survey,” Mortgage Bankers Association, Fourth Quarter 2007, March 2008,
p. 4; Third Quarter 2010, November 2010, p. 4.
7. CoreLogic, “U.S. Housing and Mortgage Trends: August 2010,” November 2010, p. 5.
8. Jeremy Aguero, principal analyst, Applied Analysis, written testimony for the FCIC, Hearing on the
Impact of the Financial Crisis—State of Nevada, session 1: Economic Analysis of the Impact of the Fi-
nancial Crisis on Nevada, September 8, 2010, p. 3.
9. Mauricio Soto, “How Is the Financial Crisis Affecting Retirement Savings?” Urban Institute, De-
cember 10, 2008, available at www.urban.org/url.cfm?ID=901206.
10. Steven K. Paulson, “Auditors Say Colorado Pension Plan Recovering,” Associated Press, August 16,
2010.
11. Charles S. Johnson, “Montana Pension Funds Growing but Haven’t Made Up Losses,” The Billings
Gazette, May 18, 2009.
12. The Conference Board news release, May 27, 2008.
13. The Conference Board news release, December 28, 2010.
14. Gregory D. Bynum, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—
Greater Bakersfield, session 3: Residential and Community Real Estate, September 7, 2010, transcript,
p. 102.
15. Board of Governors of the Federal Reserve System, October 2010 Senior Loan Officer Opinion
Survey on Bank Lending Practices, Net Percentage of Domestic Respondents Tightening Standards on
Consumer Loans, Credit Cards, November 8, 2010.
16. American Bankruptcy Institute, “Annual Business and Non-business Filings by Year (1980–2009).”
17. Jeff Agosta, conference call with FCIC, February 25, 2010.
18. American Bankruptcy Institute, “Annual Business and Non-Business Filings by Year (1980–
2009).”
19. Board of Governors of the Federal Reserve System, July 2007 Senior Loan Officer Opinion Survey
on Bank Lending Practices, August 13, 2007, p. 13.
20. Liz Moyer, “Revolver at the Heads,” Forbes, October 7, 2008. Gannett Corporation withdrew $1.2
billion, FairPoint Communications withdrew $200 million, and Duke Energy withdrew $1 billion.
21. Murillo Campello, John R. Graham, and Campbell R. Harvey, “The Real Effects of Financial Con-
straints: Evidence from a Financial Crisis,” Journal of Financial Economics 97 (2010): 476.
 Notes to Chapter 21 629

22. Board of Governors of the Federal Reserve System, January 2009 Senior Loan Officer Opinion
Survey, fourth-quarter 2008, p. 8.
23. Elizabeth Duke, governor, Federal Reserve Board, “Small Business Lending,” testimony before the
House Committee on Financial Services and Committee on Small Business, February 26, 2010, p. 1.
24. National Federation of Independent Businesses, “NFIB Small Business Economic Trends,” De-
cember 2010, p. 12.
25. Ben Bernanke, “Restoring the Flow of Credit to Small Business,” speaking at the Federal Reserve
Meeting Series: “Addressing the Financing Needs of Small Businesses,” Washington, DC, July 12, 2010.
26. C. R. “Rusty” Cloutier, past chairman, Independent Community Bankers of America, testimony
before the FCIC, First Public Hearing of the FCIC, day 1, panel 3: Financial Crisis Impacts on the Econ-
omy, January 13, 2010, transcript, p. 194.
27. Federal Reserve Statistical Release, E.2 Survey of Terms of Business Lending, E.2 Chart Data:
“Commercial and Industrial Loan Rates Spreads over Intended Federal Funds Rate, by Loan Size,” spread
for all sizes.
28. William J. Dennis Jr., “Small Business Credit in a Deep Recession,” National Federation of Inde-
pendent Businesses, February 2010, p. 18.
29. Jerry Jost, interview by FCIC, August 20, 2010.
30. Board of Governors of the Federal Reserve System, Senior Loan Officer Opinion Survey on Bank
Lending Practices, April 2010.
31. Board of Governors of the Federal Reserve System, Senior Loan Officer Opinion Survey on Bank
Lending Practices, July 2010.
32. Emily Maltby, “Small Biz Loan Failure Rate Hits 12%,” CNN Money, February 25, 2009; “SBA
Losses Climb 154% in 2008,” Coleman Report (www.colemanpublishing.com/public/343.cfm).
33. Michael A. Neal, chairman and CEO, GE Capital, testimony before the FCIC, Hearing on the
Shadow Banking System, day 2, session 3: Institutions Participating in the Shadow Banking System, May
6, 2010, transcript, p. 242.
34. GE, 2008 Annual Report, p. 38.
35. Mark S. Barber, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, ses-
sion 3: Institutions Participating in the Shadow Banking System, May 6, 2010, transcript, p. 263.
36. International Monetary Fund, International Financial Statistics database, World Exports.
37. International Monetary Fund, International Financial Statistics, World Tables: Exports, World Ex-
ports.
38. Jane Levere, “Office Deals, 19 Months Apart, Show Market’s Move,” New York Times, August 10,
2010.
39. National Association of Realtors, Commercial Real Estate Quarterly Market Survey, December
2010, pp. 4, 5.
40. Brian Gordon, principal, Applied Analysis, testimony before the FCIC, Hearing on the Impact of
the Financial Crisis—State of Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Es-
tate, September 8, 2010, transcript, p. 155.
41. Anton Troianovski, “High Hopes as Builders Bet on Skyscrapers,” Wall Street Journal, September
29, 2010.
42. Ibid.; Gregory Bynum, president, Gregory D. Bynum & Associates, Inc., testimony before the
FCIC, Hearing on the Impact of the Financial Crisis—Greater Bakersfield, session 3: Residential and
Community Real Estate, September 7, 2010, transcript, pp. 77–80, 77–78.
43. Federal Deposit Insurance Commission, “Failed Bank List,” January 2, 2010.
44. February Oversight Report, “Commercial Real Estate Losses and the Risk to Financial Stability,”
Congressional Oversight Panel, February 10, 2010, pp. 2, 41, 45.
45. TreppWire, “CMBS Delinquency Rate Nears 9%, Up 21 BPs in August after Leveling in July, Rate
Now 8.92%” Monthly Delinquency Report, September 2010, p. 1.
46. Allen Kenney, “CRE Mortgage Default Rate to Double by 2010,” REIT.com, June 18, 2009. See also
“Default Rates Reach 16-Year High,” Globe St., February 24, 2010.
47. Ibid. Green Street Advisors, “Commercial Property Values Gain More Than 30% from ‘09 Lows,”
December 2, 2010, pp. 3, 1.
630 Notes to Chapter 21

48. “Moody’s/REAL Commercial Property Price Indices, December 2010,” Moody’s Investors Service
Special Report, December 21, 2010; Moody’s Investors Service, “US Commercial Real Estate Prices Rise
1.3% in October,” December 20, 2010.
49. Congressional Oversight Panel, “Commercial Real Estate Losses,” February Oversight Report,
February 10, 2010, pp. 2–3.
50. Dr. Kenneth T. Rosen, chairman, Fisher Center for Real Estate and Economics, University of Cali-
fornia at Berkeley, slides in testimony before the FCIC, First Public Hearing of the FCIC, day 1, panel 3:
Financial Crisis Impacts on the Economy, January 13, 2010.
51. Elizabeth McNichol, Phil Oliff, and Nicholas Johnson, “States Continue to Feel Recession’s Im-
pact,” Center on Budget and Policy Priorities, December 16, 2010.
52. Bruce Wagstaff, Sacramento Countywide Services Agency, testimony before the FCIC, Hearing on
the Impact of the Financial Crisis—Sacramento, session 4: The Impact of the Financial Crisis on Sacra-
mento Neighborhoods and Families, September 23, 2010, transcript, p. 234.
53. Sujit CanagaRetna, interview by FCIC, November 18, 2010.
54. McNichol, Oliff, and Johnson, “States Continue to Feel Recession’s Impact.”
55. “NCSL Fiscal Brief: Projected State Revenue Growth in FY 2011 and Beyond,” National Confer-
ence of State Legislatures, September 29, 2010, p. 1.
56. Ibid.
57. State of California, Legislative Analyst’s Office, “The 2011–12 Budget: California’s Fiscal Outlook.”
58. Kaiser Commission on Medicaid and the Uninsured, “Medicaid Enrollment: December 2009 Data
Snapshot,” September 2010, pp. 1, 3.
59. Kaiser Commission on Medicaid and the Uninsured, “Hoping for Economic Recovery, Preparing
for Health Reform: A Look at Medicaid Spending, Coverage and Policy Trends,” September 30, 2010,
pp. 16, 25.
60. National League of Cities, “Recession’s Effects Intensify in Cities,” October 6, 2010.
61. Christopher W. Hoene and Michael A. Pagano, “City Fiscal Conditions in 2010,” National League
of Cities, October 2010, p. 3.
62. Ibid., pp. 7, 2.
63. Alan S. Blinder and Mark Zandi, “How the Great Recession Was Brought to an End,” Moody’s An-
alytics, July 27, 2010, p. 1.
64. Donald L. Kohn, vice chairman, Federal Reserve Board of Governors, “The Federal Reserve’s Pol-
icy Actions during the Financial Crisis and Lessons for the Future,” speech at Carleton University, Ot-
tawa, Canada, May 13, 2010.
65. U.S. Department of the Treasury, Office of Financial Stability, “Troubled Asset Relief Program:
Two Year Retrospective,” October 2010, p. 8.
66. Congressional Budget Office, “Report on the Troubled Asset Relief Program,” November 2010.
67. White House Office of Management and Budget, FY2011 Budget Historical Tables, Section 1,
Table 1.1—Summary of Receipts, Outlays, and Surpluses or Deficits (–):1789–2015, Total Budget Deficit.
68. FDIC, “Failed Bank List.”
69. “Quarterly Banking Profile: Third Quarter 2010,” FDIC Quarterly 4, no. 4 (2010): 4.
70. FDIC, “Quarterly Banking Profile: First Quarter 2009,” FDIC Quarterly 3, no. 2 (2009): 1, and
“Quarterly Banking Profile: First Quarter 2010,” FDIC Quarterly 4, no. 2 (2010); Board of Governors of
the Federal Reserve System, Profit and Balance Sheet Developments at U.S. Commercial Banks in 2009.
71. FDIC, Statistics on Depository Institutions, Income and Expense, All Commercial Banks—Assets
more than $1B—National, Standard Report #1 (reports issued on 3/31/2010 and 3/31/2009). Profit is
logged as “Net income attributable to bank.”
72. FDIC, Statistics on Depository Institutions, Income and Expense, All Commercial Banks—Assets
less than $100M and Assets $100M to $1B; Standard Report #1 (reports issued on 3/31/2010 and
3/31/2009). Profit is logged as “Net income attributable to bank.”
73. “Wall Street Bonuses Rose Sharply in 2009,” New York State Comptroller Thomas P. DiNapoli
press release, February 23, 2010.
74. N.Y. State Comptroller Thomas P. DiNapoli, “Economic Trends in New York State,” October 2010.
 Notes to Chapter 22 631

Chapter 22
1. FCIC calculations based on estimates from Hope Now and Moodys.com.
2. Mortgage Bankers Association National Delinquency Survey (the source for the rest of the delin-
quency and foreclosure rates in this chapter).
3. Julia Gordon, Center for Responsible Lending, “HAMP, Servicer Abuses, and Foreclosure Preven-
tion Strategies,” testimony before the Congressional Oversight Panel for the Troubled Asset Relief Pro-
gram (TARP), COP Hearing on TARP Foreclosure Mitigation Programs, 111th Cong., 2nd sess., October
27, 2010, pp. 5, 30; CRL testimony based on Rod Dubitsky, Larry Yang, Stevan Stevanovic, and Thomas
Suehr, “Foreclosure Update: Over 8 Million Foreclosures Expected,” Credit Suisse (December 4, 2008),
and Jan Hatzius and Michael A. Marschoun, “Home Prices and Credit Losses: Projections and Policy Op-
tions,” Goldman Sachs Global Economics Paper (January 13, 2009), p. 16.
4. “RealtyTrac Year-End Report Shows Record 2.8 Million U.S. Properties with Foreclosure Filings in
2009—An Increase of 21 Percent from 2008 and 120 Percent from 2007,” RealtyTrac, January 14, 2010.
5. “Delinquencies and Loans in Foreclosure Decrease, but Foreclosure Starts Rise in Latest MBA Na-
tional Delinquency Survey,” MBA press release, November 18, 2010.
6. Mark Fleming, chief economist, CoreLogic, testimony before the FCIC, Hearing on the Impact of
the Financial Crisis—Sacramento, session 1: Overview of the Sacramento Housing and Mortgage Mar-
kets and the Impact of the Financial Crisis on the Region, September 23, 2010, transcript, p. 14.
7. FCIC staff estimates based on analysis of BlackBox data.
8. Laurie S. Goodman, senior managing director, Amherst Securities Group LP, written testimony be-
fore the House Financial Services Committee, The Private Sector and Government Response to the Mort-
gage Foreclosure Crisis,” 111th Cong., 1st sess., December 8, 2009, p. 3.
9. The index declined from 200.4 in April 2006 to 136.6 in March 2009, a decline of 31.8%.
10. “New CoreLogic Data Shows Third Consecutive Quarterly Decline in Negative Equity,” CoreLogic
Inc., December 13, 2010, p. 1; nationally, third-quarter figures were an improvement from 11.0 million
residential properties—23%—in negative equity in the second quarter of 2010.
11. Jim Rokakis, treasurer of Cuyahoga County, Ohio, interview by FCIC, November 8, 2010.
12. Cuyahoga County experienced 13,943 foreclosure filings in 2006, 14,946 in 2007, 13,858 in 2008,
and 14,171 in 2009. “Ohio County Foreclosure Filings (1995–2009): Cuyahoga County,” Policy Matters
Ohio.
13. Rokakis, interview.
14. The United States Conference of Mayors, “Impact of the Mortgage Foreclosure Crisis on Vacant
and Abandoned Properties in Cities: A 77-City Survey,” June 2010, pp. 3–4.
15. Guy Cecala, prepared testimony for the Congressional Oversight Panel for the Troubled Asset Re-
lief Program (TARP), COP Hearing on TARP Foreclosure Mitigation Programs, 111th Cong., 2nd sess.,
October 27, 2010, p. 2.
16. John Taylor, interview by FCIC, October 27, 2010.
17. Congressional Oversight Panel, “December Oversight Report: A Review of Treasury’s Foreclosure
Prevention Programs,” December 14, 2010, pp. 4, 7, 18.
18. HOPE NOW, “Industry Extrapolations and Metrics (October 2010),” December 6, 2010, p. 3.
19. New Jersey HomeKeeper Program, New Jersey Housing and Mortgage Financing Agency, ap-
proved September 23, 2010.
20. Kirsten Keefe, presentation to the meeting of the Federal Reserve System’s Consumer Advisory
Council, Washington, D.C., March 25, 2010, transcript, p. 34.
21. Diane E. Thompson, testimony to the Senate Committee on Banking, Housing, and Urban Af-
fairs, Problems in Mortgage Servicing from Modification to Foreclosure, 111th Cong., 2nd sess., November
16, 2010, p. 3.
22. See, for example, National Consumer Law Center, “Why Servicers Foreclose When They Should
Modify and Other Puzzles of Servicer Behavior,” October 2009.
632 Notes to Chapter 22

23. Joseph H. Evers, Office of the Comptroller of the Currency, deputy comptroller for large bank su-
pervision, written testimony before the Congressional Oversight Panel for the Troubled Asset Relief Pro-
gram (TARP), COP Hearing on TARP Foreclosure Mitigation Programs, 111th Cong., 2nd sess., October
27, 2010, pp. 7–10. The OCC reported that mortgage servicers have modified 1,239,896 loans since early
2008. By the end of the second quarter of 2010, more than 26% of the modifications were seriously delin-
quent; 9% were in the process of foreclosure; and 4% had completed foreclosure. The OCC examined
modified loans that were 60 or more days delinquent that were modified during the second quarter of
2009, to determine when after loan modification that serious delinquency recurred. At 12 months after
modification, 43% of loans were delinquent by two or more months; at nine months after modification,
41% were in arrears; at six months, 34%; and at three months after a loan change, nearly 19% were delin-
quent. The OCC noted that more recent modifications have performed better than earlier modifications.
24. Julia Gordon, senior policy counsel, Center for Responsible Lending, written testimony before the
Congressional Oversight Panel for the Troubled Asset Relief Program (TARP), COP Hearing on TARP
Foreclosure Mitigation Programs, 111th Cong., 2nd sess., October 27, 2010, p. 11.
25. David J. Grais, partner with Grais & Ellsworth LLP, interview by FCIC, November 2, 2010.
26. Calculation by Laurie Goodman, senior managing director, Amherst Securities. See PowerPoint
presentation to the Grais and Ellsworth LLP conference “Robosigners and Other Servicing Failures: Pro-
tecting the Rights of RMBS Investors,” October 27, 2010 (http://video.remotecounsel.com/
mediasite/Viewer/?peid=12e6411377a744b9a9f2eefd1093871c1d).
27. Grais, interview.
28. Goodman testimony before the House Financial Services Committee, December 8, 2009.
29. See Deposition of Jeffrey Stephan, GMAC Mortgage LLC v. Ann M. Neu a/k/a Ann Michelle
Perez, No. 50 2008 CA040805XXXX MB (Fla. Cir. Ct. Dec. 10, 2009), pp. 7, 10.
30. See, for example, Dwayne Ransom Davis and Melisa Davis v. Countrywide Home Loans, Inc.;
Bank of America, N.A.; BAC GP LLC; and BAC Home Loans Servicing, LP, 1:10-cv-01303-JMS-DML
(S.D. Ind. October 19, 2010).
31. Congressional Oversight Panel, “November Oversight Report: Examining the Consequences of
Mortgage Irregularities for Financial Stability and Foreclosure Mitigation,” November 16, 2010, p. 20.
32. See, e.g., Mortg. Elec. Registry Sys. v. Johnston, No. 420-6-09 Rdcv (Rutland Co. Vt. Super. Ct. Oct.
28, 2009), holding that MERS did not have standing to initiate foreclosure because the note and mortgage
had been separated.
33. The Honorable F. Dana Winslow, written testimony before the House Committee on the Judiciary,
Foreclosed Justice: Causes and Effects of the Foreclosure Crisis, 111th Cong., 2nd sess., December 2, 2010,
pp. 2, 4.
34. Order, Objection to Claims of Citibank, N.A. 4-6-10, (Bankr. E.D. Cal. May 20, 2010), p. 3. The or-
der cites In re Foreclosure Cases, 521 F. Supp. 2d 650 (S.D. Oh. 2007); In re Vargas, 396 B.R. 511, 520
(Bankr. C.D. Cal. 2008); Landmark Nat’l Bank v. Kesler, 216 P.3d 158 (Kan. 2009); LaSalle Bank v. Lamy,
824 N.Y.S.2d 769 (N.Y. Sup. Ct. 2006).
35. Winslow, written testimony before the House Committee on the Judiciary, pp. 2–3.
36. See John T. Kemp v. Countrywide Home Loans, Inc., Case No. 08-18700-JHW (D. N.J.), pp. 7–8.
37. Grais, interview.
38. Adam J. Levitin, associate professor of law, Georgetown University Law Center, testimony to Sen-
ate Committee on Banking, Housing, and Urban Affairs, Problems in Mortgage Servicing from Modifica-
tion to Foreclosure, 111th Cong., 2nd sess., November 16, 2010, p. 20.
39. Congressional Oversight Panel, “November Oversight Report,” pp. 5, 7.
40. Katherine Porter, professor of law, University of Iowa College of Law, written testimony before the
Congressional Oversight Panel for the Troubled Asset Relief Program (TARP), COP Hearing on TARP
Foreclosure Mitigation Programs, October 27, 2010, p. 8.
41. Levitin, written testimony before the Senate Committee on Banking, Housing, and Urban Affairs,
p. 20.
42. Erika Poethig, written testimony for the House Subcommittee on Housing and Community Op-
portunity, Impact of the Foreclosure Crisis on Public and Affordable Housing in the Twin Cities, 111th
Cong., 2nd sess., January 23, 2010, p. 5.
 Notes to Chapter 22 633

43. National Association for the Education of Homeless Children and Youth (NAEHCY) and First Fo-
cus, “A Critical Moment: Child and Youth Homelessness in Our Nation’s Schools,” July 2010, p. 2. In early
2010, NAEHCY and First Focus conducted a survey of 2,200 school districts. When they were asked the
reasons for the increased enrollment of students experiencing homelessness, 62% cited the economic
downturn, 40% attributed it to greater school and community awareness of homelessness, and 38% cited
problems stemming from the foreclosure crisis.
44. Dr. Heath Morrison, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—
State of Nevada, session 4: The Impact of the Financial Crisis on Nevada Public and Community Services,
September 8, 2010, transcript, pp. 261–64.
45. Gail Burks, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—State of
Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Estate, September 8, 2010, tran-
script, pp. 230–31.
46. Karen Mann, president and chief appraiser, Mann and Associates Real Estate Appraisers & Con-
sultants, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—Sacramento,
session 2: Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacramento Region, Sep-
tember 23, 2010, p. 12; oral testimony, p. 66.
47. Dawn Hunt, homeowner in Cape Coral, FL, interview by FCIC, December 20, 2010.
48. Zip code 33991, default, foreclosures and REO, S&P Global Data Solutions RMBS database, July
2010.
49. Hunt, interview.
 INDEX

The index is available online at www.publicaffairsbooks.com/fcicindex.pdf