in 2004, and terminated by the SEC in 2008, after the financial crisis. The alternative net capital rules for brokerdealers
were terminated at the same time.
13 Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).
14 The financial crisis has not reversed this trend; it has accelerated it. By the end of 2008, Bank of America had
purchased Countrywide and Merrill Lynch; Wells Fargo had acquired Wachovia Bank; and JPMorgan Chase had
Over the last ten years, some U.S. financial institutions have not only grown larger and
more complex, but have also engaged in higher risk activities. The last decade has witnessed an
explosion of so-called “innovative” financial products with embedded risks that are difficult to
analyze and predict, including collateralized debt obligations, credit default swaps, exchange
traded funds, commodity and swap indices, and more. Financial engineering produced these
financial instruments which typically had little or no performance record to use for risk
management purposes. Some U.S. financial institutions became major participants in the
development of these financial products, designing, selling, and trading them in U.S. and global
In addition, most major U.S. financial institutions began devoting increasing resources to
so-called “proprietary trading,” in which the firm’s personnel used the firm’s capital to gain
investment returns for the firm itself rather than for its clients. Traditionally, U.S. banks, brokerdealers,
and investment banks had offered investment advice and services to their clients, and did
well when their clients did well. Over the last ten years, however, some firms began referring to
their clients, not as customers, but as counterparties. In addition, some firms at times developed
and used financial products in transactions in which the firm did well only when its clients, or
counterparties, lost money. Some U.S. banks also sponsored affiliated hedge funds, provided
them with billions of dollars in client and bank funds, and allowed the hedge funds to make high
risk investments on the bank’s behalf, seeking greater returns.
By 2005, as U.S. financial institutions reached unprecedented size and made increasing
use of complex, high risk financial products, government oversight and regulation was
increasingly incoherent and misguided.
B. High Risk Mortgage Lending
The U.S. mortgage market reflected many of the trends affecting the U.S. financial
system as a whole. Prior to the early 1970s, families wishing to buy a home typically went to a
local bank or mortgage company, applied for a loan and, after providing detailed financial
information and a down payment, qualified for a 30-year fixed rate mortgage. The local bank or
mortgage company then typically kept that mortgage until the homeowner paid it off, earning its
profit from the interest rates and fees paid by the borrower.
Lenders were required to keep a certain amount of capital for each loan they issued,
which effectively limited the number of loans one bank could have on its books. To increase
their capital, some lenders began selling the loans on their books to other financial institutions
that wanted to service the loans over time, and then used the profits to make new loans to
prospective borrowers. Lenders began to make money, not from holding onto the loans they
originated and collecting mortgage payments over the years, but from the relatively short term
fees associated with originating and selling the loans.
purchased Washington Mutual and Bear Stearns, creating the largest banks in U.S. history. By early 2009, each
controlled more than 10% of all U.S. deposits. See, e.g., “Banks ‘Too Big To Fail’ Have Grown Even Bigger:
Behemoths Born of the Bailout Reduce Consumer Choice, Tempt Corporate Moral Hazard,” Washington Post
(8/28/2009). Those banks plus Citigroup also issued one out of every two mortgages and two out of every three
credit cards. Id.
By 2003, many lenders began using higher risk lending strategies involving the
origination and sale of complex mortgages that differed substantially from the traditional 30-year
fixed rate home loan. The following describes some of the securitization practices and higher
risk mortgage products that came to dominate the mortgage market in the years leading up to the
Securitization. To make home loans sales more efficient and profitable, banks began
making increasing use of a mechanism now called “securitization.” In a securitization, a
financial institution bundles a large number of home loans into a loan pool, and calculates the
amount of mortgage payments that will be paid into that pool by the borrowers. The securitizer
then forms a shell corporation or trust, often offshore, to hold the loan pool and use the mortgage
revenue stream to support the creation of bonds that make payments to investors over time.
Those bonds, which are registered with the SEC, are called residential mortgage backed
securities (RMBS) and are typically sold in a public offering to investors. Investors typically
make a payment up front, and then hold onto the RMBS securities which repay the principal plus
interest over time. The amount of money paid periodically to the RMBS holders is often referred
to as the RMBS “coupon rate.”
For years, securitization worked well. Borrowers paid their 30-year, fixed rate mortgages
with few defaults, and mortgage backed securities built up a reputation as a safe investment.
Lenders earned fees for bundling the home loans into pools and either selling the pools or
securitizing them into mortgage backed securities. Investment banks also earned fees from
working with the lenders to assemble the pools, design the mortgage backed securities, obtain
credit ratings for them, and sell the resulting securities to investors. Investors like pension funds,
insurance companies, municipalities, university endowments, and hedge funds earned a
reasonable rate of return on the RMBS securities they purchased.
Due to the 2002 Treasury rule that reduced capital reserves for securitized mortgages,
RMBS holdings also became increasingly attractive to banks, which could determine how much
capital they needed to hold based on the credit ratings their RMBS securities received from the
credit ratings agencies. According to economist Arnold Kling, among other problems, the 2002
rule “created opportunities for banks to lower their ratio of capital to assets through structured
financing” and “created the incentive for rating agencies to provide overly optimistic assessment
of the risk in mortgage pools.”15
High Risk Mortgages. The resulting increased demand for mortgage backed securities,
joined with Wall Street’s growing appetite for securitization fees, prompted lenders to issue
mortgages not only to well qualified borrowers, but also higher risk borrowers. Higher risk
borrowers were often referred to as “subprime” borrowers to distinguish them from the more
creditworthy “prime” borrowers who traditionally qualified for home loans. Some lenders began
15 “Not What They Had In Mind: A History of Policies that Produced the Financial Crisis of 2008,” September
2009, Mercatus Center, http://mercatus.org/sites/default/files/publication/NotWhatTheyHadInMind(1).pdf.
to specialize in issuing loans to subprime borrowers and became known as subprime lenders.16
Federal law does not define subprime loans or subprime borrowers, but in 2001, guidance
issued by federal banking regulators defined subprime borrowers as those with certain credit risk
characteristics, including one or more of the following: (1) two or more 30-day delinquencies in
the last 12 months, or one or more 60-day delinquencies in the last 24 months; (2) a judgment or
foreclosure in the prior 24 months; (3) a bankruptcy in the last five years; (4) a relatively high
default probability as evidenced by, for example, a credit score below 660 on the FICO scale; or
(5) a debt service-to-income ratio of 50% or more.
Subprime loans provided new fuel for the securitization engines on Wall Street.
17 Some financial institutions reduced that
definition to any borrower with a credit score below 660 or even 620 on the FICO scale;18 while
still others failed to institute any explicit definition of a subprime borrower or loan.19 Credit
scores are an underwriting tool used by lenders to evaluate the likelihood that a particular
individual will repay his or her debts. FICO credit scores, developed by the Fair Issacs
Corporation, are the most widely used credit scores in U.S. financial markets and provide scores
ranging from 300 to 850, with the higher scores indicating greater creditworthiness.20
High risk loans were not confined, however, to those issued to subprime borrowers.
Some lenders engaged in a host of risky lending practices that allowed them to quickly generate
a large volume of high risk loans to both subprime and prime borrowers. Those practices, for
example, required little or no verification of borrower income, required borrowers to provide
little or no down payments, and used loans in which the borrower was not required to pay down
the loan amount, and instead incurred added debt over time, known as “negative amortization”
loans. Some lenders offered a low initial “teaser rate,” followed by a higher interest rate that
16 A Federal Reserve Bank of New York research paper identifies the top ten subprime loan originators in 2006 as
HSBC, New Century, Countrywide, Citigroup, WMC Mortgage, Fremont, Ameriquest Mortgage, Option One,
Wells Fargo, and First Franklin. It identifies the top ten originators of subprime mortgage backed securities as
Countrywide, New Century, Option One, Fremont, Washington Mutual, First Franklin, Residential Funding Corp.,
Lehman Brothers, WMC Mortgage, and Ameriquest. “Understanding the Securitization of Subprime Mortgage
Credit,” by Adam Ashcraft and Til Schuermann, Federal Reserve Bank of New York Staff Report No. 318, (3/2008)
17 Interagency “Expanded Guidance for Subprime Lending Programs, (1/31/2001) at 3. See also “Understanding the
Securitization of Subprime Mortgage Credit,” by Adam Ashcraft and Til Schuermann, Federal Reserve Bank of
New York Staff Report No. 318, (3/2008) at 14.
18 See, e.g., 1/2005 “Definition of Higher Risk Lending,” chart from Washington Mutual Board of Directors Finance
Committee Discussion, JPM_WM00302979, Hearing Exhibit 4/13-2a; 4/2010 “Evaluation of Federal Regulatory
Oversight of Washington Mutual Bank,” report prepared by the Offices of Inspector General at the Department of
the Treasury and Federal Deposit Insurance Corporation, at 8, Hearing Exhibit 4/16-82.
19 See, e.g., Countrywide Financial Corporation, as described in SEC v. Mozilo, Case No. CV09-03994 (USDC CD
Calif.), Complaint (June 4, 2009), at ¶¶ 20-21.
20 To develop FICO scores, Fair Isaac uses proprietary mathematical models that draw upon databases of actual
credit information to identify factors that can reliably be used to predict whether an individual will repay outstanding
debt. Key factors in the FICO score include an individual’s overall level of debt, payment history, types of credit
extensions, and use of available credit lines. See “What’s in Your FICO Score,” Fair Isaac Corporation,
http://www.myfico.com/CreditEducation/WhatsInYourScore.aspx. Other types of credit scores have also been
developed, including the VantageScore developed jointly by the three major credit bureaus, Equifax Inc., Experian
Group Ltd., and TransUnion LLC, but the FICO score remains the most widely used credit score in U.S. financial
took effect after a specified event or period of time, to enable borrowers with less income to
make the initial, smaller loan payments. Some qualified borrowers according to whether they
could afford to pay the lower initial rate, rather than the higher rate that took effect later,
expanding the number of borrowers who could qualify for the loans. Some lenders deliberately
issued loans that made economic sense for borrowers only if the borrowers could refinance the
loan within a few years to retain the teaser rate, or sell the home to cover the loan costs. Some
lenders also issued loans that depended upon the mortgaged home to increase in value over time,
and cover the loan costs if the borrower defaulted. Still another risky practice engaged in by
some lenders was to ignore signs of loan fraud and to issue and securitize loans suspected of
containing fraudulent borrower information.
These practices were used to qualify borrowers for larger loans than they could have
otherwise obtained. When borrowers took out larger loans, the mortgage broker typically
profited from higher fees and commissions; the lender profited from higher fees and a better
price for the loan on the secondary market; and Wall Street firms profited from a larger revenue
stream to support bigger pools of mortgage backed securities.
The securitization of higher risk loans led to increased profits, but also injected greater
risks into U.S. mortgage markets. Some U.S. lenders, like Washington Mutual and Countrywide,
made wholesale shifts in their loan programs, reducing their sale of low risk, 30-year, fixed rate
mortgages and increasing their sale of higher risk loans.21
After 2000, the number of high risk loans increased rapidly, from about $125 billion in
dollar value or 12% of all U.S. loan originations in 2000, to about $1 trillion in dollar value or
34% of all loan originations in 2006.
Because higher risk loans required
borrowers to pay higher fees and a higher rate of interest, they produced greater initial profits for
lenders than lower risk loans. In addition, Wall Street firms were willing to pay more for the
higher risk loans, because once securitized, the AAA securities relying on those loans typically
paid investors a higher rate of return than other AAA investments, due to the higher risk
involved. As a result, investors were willing to pay more, and mortgaged backed securities
relying on higher risk loans typically fetched a better price than those relying on lower risk loans.
Lenders also incurred little risk from issuing the higher risk loans, since they quickly sold the
loans and kept the risk off their books.
22 Altogether from 2000 to 2007, U.S. lenders originated
about 14.5 million high risk loans.23
21 See, e.g., “Shift to Higher Margin Products,” chart from Washington Mutual Board of Directors meeting, at
JPM_WM00690894, Hearing Exhibit 4/13-3 (featuring discussion of the larger “gain on sale” produced by higher
risk home loans); “WaMu Product Originations and Purchases By Percentage - 2003-2007,” chart prepared by the
Subcommittee, Hearing Exhibit 4/13-1i (showing how higher risk loans grew from about 19% to about 55% of
WaMu’s loan originations); SEC v. Mozilo, Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at
¶¶ 17-19 (alleging that higher risk loans doubled at Countrywide, increasing from about 31% to about 64% of its
The majority of those loans, 59%, were used to refinance
22 8/2010 “Nonprime Mortgages: Analysis of Loan Performance, Factors Associated with Defaults, and Data
Sources,” Government Accountability Office (GAO), Report No. GAO-10-805 at 1. These figures include subprime
loans, Alt A, and option payment loans, but not home equity loans, which means the totals for high risk loans are
23 Id. at 5.
an existing loan, rather than buy a new home.24
“refinanced their mortgages at a higher amount than the loan balance to convert their
home equity into money for personal use (known as ‘cash-out refinancing’). Of the
subprime mortgages originated from 2000 through 2007, 55 percent were for cash-out
refinancing, 9 percent were for no-cash-out refinancing, and 36 percent were for a home
In addition, according to research performed by
GAO, many of these borrowers:
Some lenders became known inside the industry for issuing high risk, poor quality loans,
yet during the years leading up to the financial crisis were able to securitize and sell their home
loans with few problems. Subprime lenders like Long Beach Mortgage Corporation, New
Century Financial Corporation, and Fremont Loan & Investment, for example, were known for
issuing poor quality subprime loans.26
These three lenders and others issued a variety of nontraditional, high risk loans whose
subsequent delinquencies and defaults later contributed to the financial crisis. They included
hybrid adjustable rate mortgages, pick-a-payment or option ARM loans, interest-only loans,
home equity loans, and Alt A and stated income loans. Although some of these loans had been
in existence for years, they had previously been restricted to a relatively small group of
borrowers who were generally able to repay their debts. In the years leading up to the financial
crisis, however, lenders issued these higher risk loans to a wide variety of borrowers, including
subprime borrowers, who often used them to purchase more expensive homes than they would
have been able to buy using traditional fixed rate, 30-year loans.
Despite their reputations for poor quality loans, leading
investment banks continued to do business with them and helped them sell or securitize hundreds
of billions of dollars in home mortgages.
Hybrid ARMs. One common high risk loan used by lenders in the years leading up to
the financial crisis was the short term hybrid adjustable rate mortgage (Hybrid ARM), which was
offered primarily to subprime borrowers. From 2000 to 2007, about 70% of subprime loans
were Hybrid ARMs.27
24 7/28/2009 “Characteristics and Performance of Nonprime Mortgages,” GAO, Report No. GAO-09-848R at 24,
Hybrid ARMs were often referred to “2/28,” “3/27,” or “5/25” loans.
These 30-year mortgages typically had a low fixed teaser rate, which then reset to a higher
floating interest rate, after two years for the 2/28, three years for the 3/27, or five years for the
5/25. The initial loan payment was typically calculated by assuming the initial low, fixed
interest rate would be used to pay down the loan. In some cases, the loan used payments that
initially covered only the interest due on the loan and not any principal; these loans were called
“interest only” loans. After the fixed period for the teaser rate expired, the monthly payment was
typically recalculated using the higher floating rate to pay off the remaining principal and interest
owing over the course of the remaining loan period. The resulting monthly payment was much
25 Id. at 7.
26 For more information about Long Beach, see Chapter III of this Report. For more information about New
Century and Fremont, see section (D)(2)(c)-(d) of Chapter IV.
27 8/2010 “Nonprime Mortgages: Analysis of Loan Performance, Factors Associated with Defaults, and Data
Sources,” GAO, Report No. GAO-10-805 at 5, 11.
larger and sometimes caused borrowers to experience “payment shock” and default on their
loans. To avoid the higher interest rate and the larger loan payment, many of the borrowers
routinely refinanced their loans; when those borrowers were unable to refinance, many were
unable to afford the higher mortgage payment and defaulted.
Pick-A-Payment or Option ARMs. Another common high risk loan, offered to both
prime and subprime borrowers during the years leading up to the financial crisis, was known as
the “pick-a-payment” or “option adjustable rate mortgage” (Option ARM). According to a 2009
“[P]ayment-option ARMs were once specialized products for financially sophisticated
borrowers but ultimately became more widespread. According to federal banking
regulators and a range of industry participants, as home prices increased rapidly in some
areas of the country, lenders began marketing payment-option ARMs as affordability
products and made them available to less-creditworthy and lower-income borrowers.”28
Option ARMs typically allowed the borrower to pay an initial low teaser rate, sometimes
as low as a 1% annual rate for the first month, and then imposed a much higher interest rate
linked to an index, while also giving the borrower a choice each month of how much to pay
down the outstanding loan balance. These loans were called “pick-a-payment” or “option”
ARMs, because borrowers were typically allowed to choose among four alternatives: (1) paying
the fully amortizing amount needed to pay off the loan in 30 years; (2) paying an even higher
amount to pay off the loan in 15 years; (3) paying only the interest owed that month and no
principal; or (4) making a “minimum” payment that covered only a portion of the interest owed
and none of the principal. If the minimum payment option were selected, the unpaid interest
would be added to the loan principal. If, each month, the borrower made only the minimum
payment, the loan principal would increase rather than decrease over time, creating a negatively
Typically, after five years or when the loan principal reached a designated threshold, such
as 110%, 115%, or 125% of the original loan amount, the loan would “recast.” The borrower
would then be required to make the fully amortizing payment needed to pay off the remaining
loan amount within the remaining loan period. The new monthly payment amount was typically
much greater, causing payment shock and increasing loan defaults. For example, a borrower
taking out a $400,000 loan, with a teaser rate of 1.5% and subsequent interest rate of 6%, might
have a minimum payment of $1,333. If the borrower then made only the minimum payments
until the loan recast, the new payment using the 6% rate would be $2,786, an increase of more
than 100%. What began as a 30-year loan for $400,000 became a 25-year loan for $432,000. To
avoid having the loan recast, option ARM borrowers typically sought to refinance their loans. At
some lenders, a significant portion of their option ARM business consisted of refinancing
Home Equity Loans. A third type of high risk loan that became popular during the
years leading up to the financial crisis was the home equity loan (HEL). HELs provided loans
287/28/2009 “Characteristics and Performance of Nonprime Mortgages,” GAO, Report No. GAO-09-848R at 12-13.
secured by the borrower’s equity in his or her home, which served as the loan collateral. HELs
typically provided a lump sum loan amount that had to be repaid over a fixed period of time,
such as 5, 10, or 30 years, using a fixed interest rate, although adjustable rates could also be
used. A related loan, the Home Equity Line of Credit (HELOC), created a revolving line of
credit, secured by the borrower’s home, that the borrower could use at will, to take out and repay
various levels of debt over time, typically using an adjustable rate of interest. Both HELs and
HELOCs created liens against the borrower’s house which, in the event of a default, could be
sold to repay any outstanding loan amounts.
During the years leading up to the financial crisis, lenders provided HELs and HELOCs
to both prime and subprime borrowers. They were typically high risk loans, because most were
issued to borrowers who already had a mortgage on their homes and held only a limited amount
of equity. The HEL or HELOC was typically able to establish only a “second lien” or “second
mortgage” on the property. If the borrower later defaulted and the home sold, the sale proceeds
would be used to pay off the primary mortgage first, and only then the HEL or HELOC. Often,
the sale proceeds were insufficient to repay the HEL or HELOC loan. In addition, some lenders
created home loan programs in which a HEL was issued as a “piggyback loan” to the primary
home mortgage to finance all or part of the borrower’s down payment.29 Taken together, the
HEL and the mortgage often provided the borrower with financing equal to 85%, 90%, or even
100% of the property’s value.30
Alt A Loans. Another type of common loan during the years leading up to the financial
crisis was the “Alt A” loan. Alt A loans were issued to borrowers with relatively good credit
histories, but with aggressive underwriting that increased the risk of the loan.
The resulting high loan-to-value ratio, and the lack of borrower
equity in the home, meant that, if the borrower defaulted and the home had to be sold, the sale
proceeds were unlikely to be sufficient to repay both loans.
31 For example, Alt
A loans often allowed borrowers to obtain 100% financing of their homes, to have an unusually
high debt-to-income ratio, or submit limited or even no documentation to establish their income
levels. Alt A loans were sometimes referred to as “low doc” or “no doc” loans. They were
originally developed for self employed individuals who could not easily establish their income
by producing traditional W-2 tax return forms or pay stubs, and so were allowed to submit
“alternative” documentation to establish their income or assets, such as bank statements.32 The
reasoning was that other underwriting criteria could be used to ensure that Alt A loans would be
repaid, such as selecting only borrowers with a high credit score or with a property appraisal
showing the home had substantial value in excess of the loan amount. According to GAO, from
2000 to 2006, the percentage of Alt A loans with less than full documentation of the borrower’s
income or assets rose from about 60% to 80%.33
29 7/28/2009 “Characteristics and Performance of Nonprime Mortgages,” GAO, Report No. GAO-09-848R at 9.
30 Id. GAO determined that, in 2000, only about 2.4% of subprime loans had a combined loan-to-value ratio,
including both first and second home liens, of 100%, but by 2006, the percentage had climbed tenfold to 29.3%.
31 Id. at 1. GAO treated both low documentation loans and Option ARMs as Alt A loans. This Report considers
Option ARMs as a separate loan category.
32 See id. at 14.
Stated Income Loans. Stated income loans were a more extreme form of low doc Alt A
loans, in that they imposed no documentation requirements and required little effort by the lender
to verify the borrower’s income. These loans allowed borrowers simply to “state” their income,
with no verification by the lender of the borrower’s income or assets other than to consider the
income’s “reasonableness.” They were sometimes called “NINA” loans, because “No Income”
and “No Assets” of the borrower were verified by the lender. They were also referred to as “liar
loans,” since borrowers could lie about their incomes, and the lender would make little effort to
substantiate the claimed income. Many lenders believed they could simply rely on the other
underwriting tools, such as the borrower’s credit score and the property appraisal, to ensure the
loans would be repaid. Once rare and reserved only for wealthier borrowers, stated income loans
became commonplace in the years leading up to the financial crisis. For example, at Washington
Mutual Bank, one of the case studies in this Report, by the end of 2007, stated income loans
made up 50% of its subprime loans, 73% of its Option ARMs, and 90% of its home equity
Nationwide, the percentage of high risk loans issued with low or no documentation of
borrower income or assets was less dramatic. According to GAO, for example, from 2000 to
2006, the nationwide percentage of subprime loans with low or no documentation of borrower
income or assets grew from about 20% to 38%.35
Volume and Speed. When lenders kept on their books the loans they issued, the
creditworthiness of those loans determined whether the lender would turn a profit. Once lenders
began to sell or securitize most of their loans, volume and speed, as opposed to creditworthiness,
became the keys to a profitable securitization business.
In addition, in the years leading up to the financial crisis, investors that might normally
insist on purchasing only high quality securities, purchased billions of dollars in RMBS
securities containing poor quality, high risk loans, in part because those securities bore AAA
ratings from the credit rating agencies, and in part because the securities offered higher returns
compared to other AAA rated investments. Banks also bought investment grade RMBS
securities to take advantage of their lower capital requirements. Increasingly, the buyers of
RMBS securities began to forego detailed due diligence of the RMBS securities they purchased.
Instead, they, like the lenders issuing the mortgages, operated in a mortgage market that came to
be dominated by volume and speed, as opposed to credit risk.
Lenders that produced a high volume of loans could sell pools of the loans to Wall Street
or to government sponsored entities like Fannie Mae and Freddie Mac. Likewise, they could
securitize the loans and work with Wall Street investment banks to sell the securities to investors.
These lenders passed on the risk of nonpayment to third parties, and so lost interest in whether
the sold loans would, in fact, be repaid. Investment banks that securitized the loans garnered
fees for their services and also typically passed on the risk of nonpayment to the investors who
34 4/2010 “Evaluation of Federal Regulatory Oversight of Washington Mutual Bank,” prepared by the Offices of
Inspector General at the Department of the Treasury and Federal Deposit Insurance Corporation, at 10, Hearing
35 7/28/2009 “Characteristics and Performance of Nonprime Mortgages,” GAO, Report No. GAO-09-848R at 14.
bought the mortgage backed securities. The investment banks were typically interested in loan
repayment rates only to the extent needed to ensure defaulting loans did not cause losses to the
mortgage backed securities they sold. Even some of the investors who purchased the mortgage
backed securities lost interest in their creditworthiness, so long as they could buy “insurance” in
the form of credit default swaps that paid off if a mortgage backed security defaulted.
To ensure an ongoing supply of loans for sale, lenders created compensation incentives
that encouraged their personnel to quickly produce a high volume of loans. They also
encouraged their staffs to issue or purchase higher risk loans, because those loans produced
higher sale prices on Wall Street. Loan officers, for example, received more money per loan for
originating higher risk loans and for exceeding established loan targets. Loan processing
personnel were compensated according to the speed and number of the loans they processed.
Loan officers and their sales associates received still more compensation, often called yield
spread premiums, if they charged borrowers higher interest rates or points than required in the
lender’s rate sheets specifying loan prices, or included prepayment penalties in the loan
agreements. The Subcommittee’s investigation found that lenders employed few compensation
incentives to encourage loan officers or loan processors to produce high quality, creditworthy
loans in line with the lender’s credit requirements.
As long as home prices kept rising, the high risk loans fueling the securitization markets
produced few problems. Borrowers who could not make their loan payments could refinance
their loans or sell their homes and use the sale proceeds to pay off their mortgages. As this chart
shows, over the ten years before the crisis hit, housing prices shot up faster than they had in
decades, allowing price increases to mask problems with the high risk loans being issued.36
36 See “Estimation of Housing Bubble: Comparison of Recent Appreciation vs. Historical Trends,” chart prepared by
Paulson & Co. Inc., Hearing Exhibit 4/13-1j.
Borrowers were able to pay for the increasingly expensive homes, in part, because of the
exotic, high risk loans and lax loan underwriting practices that allowed them to buy more house
than they could really afford.
C. Credit Ratings and Structured Finance
Despite the increasing use of high risk loans to support mortgage related securities,
mortgage related securities continued to receive AAA and other investment grade ratings from
the credit rating agencies, indicating they were judged to be safe investments. Those credit
ratings gave a sense of security to investors and enabled investors like pension funds, insurance
companies, university endowments, and municipalities, which were often required to hold safe
investments, to continue to purchase mortgage related securities.
Credit Ratings Generally. A credit rating is an assessment of the likelihood that a
particular financial instrument, such as a corporate bond or mortgage backed security, may
default or incur losses.37
Credit ratings are issued by private firms that have been officially designated by the SEC
as Nationally Recognized Statistical Rating Organizations (NRSROs). NRSROs are usually
referred to as “credit rating agencies.” While there are ten registered credit rating agencies in the
United States, the market is dominated by just three: Moody’s Investors Service, Inc.
(Moody’s); Standard & Poor’s Financial Services LLC (S&P); and Fitch Ratings Ltd. (Fitch).
A high credit rating indicates that a debt instrument is expected to be
repaid and so qualifies as a safe investment.
By some accounts, these firms issue about 98% of the total credit ratings and collect 90% of total
credit rating revenue in the United States.39
Credit ratings use a scale of letter grades to indicate credit risk, ranging from AAA to D,
with AAA ratings designating the safest investments. Investments with AAA ratings have
historically had low default rates. For example, S&P reported that its cumulative RMBS default
rate by original rating class (through September 15, 2007) was 0.04% for AAA initial ratings and
1.09% for BBB.40
Investors often rely on credit ratings to gauge the safety of a particular investment. Some
institutional investors design an investment strategy that calls for acquiring assets with specified
credit ratings. State and federal law also restricts the amount of below investment grade bonds
that certain investors can hold, such as pension funds and insurance companies.
Financial instruments bearing AAA through BBB- ratings are generally
referred to as “investment grade,” while those with ratings below BBB- (or Baa3) are referred to
as “below investment grade” or sometimes as having “junk” status. Financial instruments that
default receive a D rating from Standard & Poor’s, but no rating at all from Moody’s.
Although the SEC has generally overseen the credit rating industry for many years, it had
no statutory basis to exercise regulatory authority until enactment of the Credit Rating Agency
Reform Act in September 2006. Concerned by the inflated credit ratings that had been issued for
Banks are also
limited by law in the amount of noninvestment grade bonds they can hold, and are typically
required to post additional capital for investments carrying riskier ratings. Because so many
federal and state statutes and regulations required financial institutions to hold securities with
investment grade ratings, the credit rating agencies were not only guaranteed a steady business,
but were encouraged to issue AAA and other investment grade ratings. Issuers of securities and
other financial instruments also worked hard to obtain favorable credit ratings to ensure more
investors could buy their products.
37 See 9/3/2009 “Credit Rating Agencies and Their Regulation,” prepared by the Congressional Research Service
Report No. R40613 (revised report issued 4/9/2010). For more information about the credit rating process and the
credit rating agencies, see Chapter V, below.
38 See 9/25/2008 “Credit Rating Agencies—NRSROs,” SEC, http://www.sec.gov/answers/nrsro.htm.
39 See 9/3/2009 “Credit Rating Agencies and Their Regulation,” prepared by the Congressional Research Service
Report No. R40613 (revised report issued 4/9/2010).
40 Prepared Statement of Vickie A. Tillman, Executive Vice President, Standard & Poor’s Credit Market Services,
“The Role of Credit Rating Agencies in the Structured Finance Market,” before the U.S. House of Representatives
Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, Cong.Hrg. 110-62
(9/27/2007), S&P SEC-PSI 0001945-71, at 51. (See Chapter V below.) See also 1/2007 “Annual 2006 Global
Corporate Default Study and Ratings Transitions,” S&P.
41 For more detail on these matters, see Chapter V, below.
bonds from Enron Corporation and other troubled corporations, Congress strengthened the
SEC’s authority over the credit rating industry. Among other provisions, the law established
criteria for the NRSRO designation and authorized the SEC to conduct examinations of credit
rating agencies. The law also, however, prohibited the SEC from regulating credit rating criteria
or methodologies used in credit rating models. In June 2007, the SEC issued implementing
regulations, which were essentially too late to affect the ratings already provided for mortgage
related securities. One month later, in July 2007, the credit rating agencies issued the first of
several mass downgrades of the ratings earlier issued for mortgage related securities.
Structured Finance. In recent years, Wall Street firms have devised increasingly
complex financial instruments for sale to investors. These instruments are often referred to as
structured finance. Because structured finance products are so complicated and opaque,
investors often place particular reliance on credit ratings to determine whether they should buy
Among the oldest types of structured finance products are RMBS securities. To create
these securities, issuers – often working with investment banks – bundle large numbers of home
loans into a loan pool, and calculate the revenue stream coming into the loan pool from the
individual mortgages. They then design a “waterfall” that delivers a stream of revenues in
sequential order to specified “tranches.” The first tranche is at the top of the waterfall and is
typically the first to receive revenues from the mortgage pool. Since that tranche is guaranteed
to be paid first, it is the safest investment in the pool. The issuer creates a security, often called a
bond, linked to that first tranche. That security typically receives a AAA credit rating since its
revenue stream is the most secure.
The security created from the next tranche receives the same or a lower credit rating and
so on until the waterfall reaches the “equity” tranche at the bottom. The equity tranche typically
receives no rating since it is the last to be paid, and therefore the first to incur losses if mortgages
in the loan pool default. Since virtually every mortgage pool has at least some mortgages that
default, equity tranches are intended to provide loss protection for the tranches above it. Because
equity tranches are riskier, however, they are often assigned and receive a higher rate of interest
and can be profitable if losses are minimal. One mortgage pool might produce five to a dozen or
more tranches, each of which is used to create a residential mortgage backed security that is rated
and then sold to investors.
Cash CDOs. Collateralized debt obligations (CDOs) are another type of structured
finance product whose securities receive credit ratings and are sold to investors. CDOs are a
more complex financial product that involves the re-securitization of existing income-producing
assets. From 2004 through 2007, many CDOs included RMBS securities from multiple
mortgage pools. For example, a CDO might contain BBB rated securities from 100 different
RMBS securitizations. CDOs can also contain other types of assets, such as commercial
mortgage backed securities, corporate bonds, or other CDO securities. These CDOs are often
called “cash CDOs,” because they receive cash revenues from the underlying RMBS bonds and
other assets. If a CDO is designed so that it contains a specific list of assets that do not change, it
is often called a “static” CDO; if the CDO’s assets are allowed to change over time, it is often
referred to as a “managed” CDO. Like an RMBS securitization, the CDO arranger calculates the
revenue stream coming into the pool of assets, designs a waterfall to divide those incoming
revenues among a hierarchy of tranches, and uses each tranche to issue securities that can then be
marketed to investors. The most senior tranches of a CDO may receive AAA ratings, even if all
of its underlying assets have BBB ratings.
Synthetic CDOs. Some investment banks also created “synthetic CDOs” which
mimicked cash CDOs, but did not contain actual mortgages or other assets that produced income.
Instead, they simply “referenced” existing assets and then allowed investors to use credit default
swaps to place bets on the performance of those referenced assets. Investors who bet that the
referenced assets would maintain or increase in value bought the CDO’s securities and, in
exchange, received periodic coupon payments to recoup their principal investment plus interest.
Investors who bet that the referenced assets would lose value or incur a specified negative credit
event purchased one or more credit default swap contracts referencing the CDO’s assets, and
paid monthly premiums to the CDO in exchange for obtaining a large lump sum payment if the
loss or other negative credit event actually occurred. Investors in synthetic CDOs who bet the
referenced assets would maintain or increase in value were said to be on the “long” side, while
investors who bet the assets would lose value or fail were said to be on the “short” side. Some
investment banks also created “hybrid CDOs” which contained some cash assets as well as credit
default swaps referencing other assets. Others created financial instruments called CDO squared
or cubed, which contained or referenced tranches from other CDOs.
Like RMBS mortgage pools and cash CDOs, synthetic and hybrid CDOs pooled the
payments they received, designed a waterfall assigning portions of the revenues to tranches set
up in a certain order, created securities linked to the various tranches, and then sold the CDO
securities to investors. Some CDOs employed a “portfolio selection agent” to select the initial
assets for the CDO. In addition, some CDOs employed a “collateral manager” to select both the
initial and subsequent assets that went into the CDO.
Ratings Used to Market RMBS and CDOs. Wall Street firms helped design RMBS
and CDO securities, worked with the credit rating agencies to obtain ratings for the securities,
and sold the securities to investors like pension funds, insurance companies, university
endowments, municipalities, and hedge funds. Without investment grade ratings, Wall Street
firms would have had a more difficult time selling structured finance products to investors,
because each investor would have had to perform its own due diligence review of the product. In
addition, their sales would have been restricted by federal and state regulations limiting certain
institutional investors to the purchase of instruments carrying investment grade credit ratings.
Still other regulations conditioned capital reserve requirements on the credit ratings assigned to a
bank’s investments. Investment grade credit ratings, thus, purported to simplify the investors’
due diligence review, ensured some investors could make a purchase, reduced banks’ capital
calls, and otherwise enhanced the sales of the structured finance products. Here’s how one
federal bank regulator’s handbook put it:
“The rating agencies perform a critical role in structured finance — evaluating the credit
quality of the transactions. Such agencies are considered credible because they possess
the expertise to evaluate various underlying asset types, and because they do not have a
financial interest in a security’s cost or yield. Ratings are important because investors
generally accept ratings by the major public rating agencies in lieu of conducting a due
diligence investigation of the underlying assets and the servicer.”42
The more complex and opaque the structured finance instruments became, the more reliant
investors were on high credit ratings for the instruments to be marketable.
In addition to making structured finance products easier to sell to investors, Wall Street
firms used financial engineering to combine AAA ratings – normally reserved for ultra-safe
investments with low rates of return – with high risk assets, such as the AAA tranche from a
subprime RMBS paying a relatively high rate of return. Higher rates of return, combined with
AAA ratings, made subprime RMBS and related CDOs especially attractive investments.
Record Ratings and Revenues. From 2004 to 2007, Moody’s and S&P produced a record
number of ratings and a record amount of revenues for rating structured finance products. A
2008 S&P submission to the SEC indicates, for example, that from 2004 to 2007, S&P issued
more than 5,500 RMBS ratings and more than 835 mortgage related CDO ratings.43 According
to a 2008 Moody’s submission to the SEC, from 2004 to 2007, Moody’s issued over 4,000
RMBS ratings and over 870 CDO ratings.44
Revenues increased dramatically over the same time period. The credit rating agencies
charged substantial fees to rate a product. To obtain a rating during the height of the market, for
example, S&P generally charged from $40,000 to $135,000 to rate tranches of an RMBS and
from $30,000 to $750,000 to rate the tranches of a CDO.45 Surveillance fees generally ranged
from $5,000 to $50,000 per year for mortgage backed securities.46 Over a five-year period,
Moody’s gross revenues from RMBS and CDO ratings more than tripled, going from over $61
million in 2002, to over $260 million in 2006.47
42 11/1997 Comptroller of the Currency Administrator of National Banks Comptroller’s Handbook, “Asset
Securitization,” at 11.
S&P’s revenue also increased. S&P’s gross
revenues for RMBS and mortgage related CDO ratings quadrupled, from over $64 million in
43 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 20. These numbers represent the
RMBS or CDO pools that were presented to S&P which then issued ratings for multiple tranches per RMBS or
CDO pool. (See Chapter V below.)
44 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212 and SEC_OCIE_CRA_011214.
These numbers represent the RMBS or CDO pools that were presented to Moody’s which then issued ratings for
multiple tranches per RMBS or CDO pool. The data Moody’s provided to the SEC on CDOs represented ABS
CDOs, some of which may not be mortgage related. However, by 2004, most, but not all, CDOs relied primarily on
mortgage related assets such as RMBS securities. Subcommittee interview of Gary Witt, former Managing Director
of Moody’s RMBS Group (10/29/2009). (See Chapter V below.)
45 “U.S. Structured Ratings Fee Schedule Residential Mortgage-backed Financings and Residential Servicer
Evaluations,” prepared by S&P, S&P-PSI 0000028-35; and “U.S. Structured Ratings Fee Schedule Collateralized
Debt Obligations Amended 3/7/2007,” prepared by S&P, S&P-PSI 0000036-50. (See Chapter V below.)
47 3/11/2008 compliance letter from Moody’s to SEC, SEC_OCIE_CRA_011212 and SEC_OCIE_CRA_011214.
The 2002 figure does not include gross revenue from CDO ratings as this figure was not readily available due to the
transition of Moody’s accounting systems. (See Chapter V below.)
2002, to over $265 million in 2006.48 Altogether, revenues from the three leading credit rating
agencies more than doubled from nearly $3 billion in 2002 to over $6 billion in 2007.49
Conflicts of Interest. Credit rating agencies are paid by the issuers seeking ratings for
the products they sell. Issuers and the investment banks want high ratings, whether to help
market their products or ensure they comply with federal regulations. Because credit rating
agencies issue ratings to issuers and investment banks who bring them business, they are subject
to an inherent conflict of interest that can create pressure on the credit rating agencies to issue
favorable ratings to attract business. The issuers and investment banks engage in “ratings
shopping,” choosing the credit rating agency that offers the highest ratings. Ratings shopping
weakens rating standards as the rating agencies who provide the most favorable ratings win more
business. In September 2007, Moody’s CEO described the problem this way: “What happened
in ’04 and ’05 with respect to subordinated tranches is that our competition, Fitch and S&P, went
nuts. Everything was investment grade.”50 In 2003, the SEC reported that “the potential
conflicts of interest faced by credit rating agencies have increased in recent years, particularly
given the expansion of large credit rating agencies into ancillary advisory and other businesses,
and the continued rise in importance of rating agencies in the U.S. securities markets.”51
Mass Downgrades. The credit ratings assigned to RMBS and CDO securities are
designed to last the lifetime of the securities. Because circumstances can change, however,
credit rating agencies conduct ongoing surveillance of each rated financial product to evaluate
the rating and determine whether it should be upgraded or downgraded. Prior to the financial
crisis, the numbers of downgrades and upgrades for structured finance ratings were substantially
From 2004 through the first half of 2007, Moody’s and S&P provided AAA ratings to a
majority of the RMBS and CDO securities issued in the United States, sometimes providing
AAA ratings to as much as 95% of a securitization.
Beginning in July 2007, however, Moody’s and S&P issued hundreds and then
thousands of downgrades of RMBS and CDO ratings, the first mass downgrades in U.S. history.
53 By 2010, analysts had determined that
over 90% of the AAA ratings issued to RMBS securities originated in 2006 and 2007 had been
downgraded to junk status.54
48 3/14/2008 compliance letter from S&P to SEC, SEC_OCIE_CRA_011218-59, at 18-19. (See Chapter V below.)
49 “Revenue of the Three Credit Rating Agencies: 2002-2007,” chart prepared by the Subcommittee using data from
http://thismatter.com/money, Hearing Exhibit 4/23-1g.
50 9/10/2007 Transcript of Raymond McDaniel at Moody’s MD Town Hall Meeting, Hearing Exhibit 4/23-98.
51 1/2003 “Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets,”
prepared by the SEC, at 40. The report continued: “[C]oncerns had been expressed that a rating agency might be
tempted to give a more favorable rating to a large issue because of the large fee, and to encourage the issuer to
submit future large issues to the rating agency.” Id. at 40 n.109.
52 See, e.g., “3/26/2010 “Fitch Ratings Global Structured Finance 2009 Transition and Default Study,” prepared by
53 See “MBS Ratings and the Mortgage Credit Boom,” Federal Reserve Bank of New York Staff Report no. 449,
May 2010, at 1.
54 See, e.g., “Percent of the Original AAA Universe Currently Rated Below Investment Grade,” chart prepared by
BlackRock Solutions, Hearing Exhibit 4/23-1i. See also 3/2008 “Understanding the Securitization of Subprime
Mortgage Credit,” Federal Reserve Bank of New York Staff Report no. 318, at 58 and chart 31 (“92 percent of 1st32
Moody’s and S&P began downgrading RMBS and CDO products in late 2006, when
residential mortgage delinquency rates and losses began increasing. Then, in July 2007, both
S&P and Moody’s initiated the first of several mass downgrades that shocked the financial
markets. On July 10, S&P placed on credit watch the ratings of 612 subprime RMBS with an
original value of $7.35 billion. Later that day, Moody’s downgraded 399 subprime RMBS with
an original value of $5.2 billion. Two days later, S&P downgraded 498 of the ratings it had
placed on credit watch.
In October 2007, Moody’s began downgrading CDOs on a daily basis, downgrading
more than 270 CDO securities with an original value of $10 billion. In December 2007,
Moody’s downgraded another $14 billion in CDOs, and placed another $105 billion on credit
watch. Moody’s calculated that, overall in 2007, “8725 ratings from 2116 deals were
downgraded and 1954 ratings from 732 deals were upgraded,”55 which means that it downgraded
over four times more ratings than it upgraded. On January 30, 2008, S&P either downgraded or
placed on credit watch over 8,200 ratings of subprime RMBS and CDO securities, representing
issuance amounts of approximately $270.1 billion and $263.9 billion, respectively.56
These downgrades created significant turmoil in the securitization markets, as investors
were required by regulations to sell off assets that had lost their investment grade status, holdings
at financial firms plummeted in value, and new securitizations were unable to find investors. As
a result, the subprime RMBS and CDO secondary markets slowed and then collapsed, and
financial firms around the world were left holding billions of dollars in suddenly unmarketable
RMBS and CDO securities.
D. Investment Banks
Historically, investment banks helped raise capital for business and other endeavors by
helping to design, finance, and sell financial products like stocks or bonds. When a corporation
needed capital to fund a large construction project, for example, it often hired an investment
bank either to help it arrange a bank loan or raise capital by helping to market a new issue of
shares or corporate bonds to investors. Investment banks also helped with corporate mergers and
acquisitions. Today, investment banks also participate in a wide range of other financial
activities, including offering broker-dealer and investment advisory services, and trading
derivatives and commodities. Many have also been active in the mortgage market and have
worked with lenders or mortgage brokers to package and sell mortgage loans and mortgage
backed securities. Investment banks have traditionally performed these services in exchange for
lien subprime deals originated in 2006 as well as … 91.8 percent of 2nd-lien deals originated in 2006 have been
55 2/2008 “Structured Finance Ratings Transitions, 1983-2007,” Credit Policy Special Comment prepared by
Moody’s, at 4.
56 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit N, Hearing Exhibit 4/23-108
(1/30/2008 “S&P Takes Action on 6,389 U.S. Subprime RMBS Ratings and 1,953 CDO Ratings,” S&P’s
RatingsDirect). Ratings may appear on CreditWatch when events or deviations from an expected trend occur and
additional information is needed to evaluate the rating.
If an investment bank agreed to act as an “underwriter” for the issuance of a new security
to the public, it typically bore the risk of those securities on its books until the securities were
sold. By law, securities sold to the public generally must be registered with the SEC.57
Registration statements explain the purpose of a proposed public offering, an issuer’s operations
and management, key financial data, and other important facts to potential investors. Any
offering document or prospectus provided to the investing public must also be filed with the
SEC. If an issuer decides not to offer a new security to the general public, it can still offer it to
investors through a “private placement.”58 Investment banks often act as the “placement agent”
in these private offerings, helping to design, market and sell the security to selected investors.
Solicitation documents in connection with private placements are not required to be filed with
the SEC. Under the federal securities laws, however, investment banks that act as an underwriter
or placement agent may be liable for any material misrepresentations or omissions of material
facts made in connection with a solicitation or sale of a security to an investor.59
In the years leading up to the financial crisis, RMBS securities were generally registered
with the SEC and sold in public offerings, while CDO securities were generally sold to investors
through private placements. Investment banks frequently served as the underwriter or placement
agent in those transactions, and typically sold both types of securities to large institutional
In addition to arranging for a public or private offering, some investment banks take on
the role of a “market maker,” standing willing and able to buy or sell financial products to their
clients or other market participants. To facilitate client orders to buy or sell those products, the
investment bank may acquire an inventory of them and make them available for client
transactions.60 By filling both buy and sell orders, market makers help create a liquid market for
the financial products and make it easier and more attractive for clients to buy and sell them.
Market makers typically rely on fees in the form of markups in the price of the financial products
for their profits.
At the same time, investment banks may decide to buy and sell the financial products for
their own account, which is called “proprietary trading.” Investment banks often use the same
inventory of financial products to carry out both their market-making and proprietary trading
activities. Investment banks that trade for their own account typically rely on changes in the
values of the financial products to turn a profit.
Inventories that are used for market making and short term proprietary trading purposes
are typically designated as a portfolio of assets “held for sale.” Investment banks also typically
maintain an inventory or portfolio of assets that they intend to keep as long term investments.
57 Securities Act of 1933, 15 U.S.C. § 77a (1933).
58 See, e.g., Securities Act of 1933 §§ 3(b) and 4(2); 17 CFR §230.501 et seq. (Regulation D).
59 Securities Act of 1933, §11, 15 U.S.C. § 77k; and Securities Exchange Act of 1934, § 10(b), 15 U.S.C. § 78j(b),
and Rule 10b-5 thereunder.
60 For a detailed discussion of market making, see “Study & Recommendations on Prohibitions on Proprietary
Trading & Certain Relationships with Hedge Funds & Private Equity Funds,” prepared by the Financial Stability
Oversight Council, at 28-29 (Jan. 18, 2011) (citing SEC Exchange Act Rel. No. 34-58775 (Oct. 14, 2008)).
This inventory or portfolio of long-term assets is typically designated as “held for investment,”
and is not used in day-to-day transactions.
Investment banks that carry out market-making and proprietary trading activities are
required—by their banking regulator in the case of banks and bank holding companies61 and by
the SEC in the case of broker-dealers62—to track their investments and maintain sufficient
capital to meet their regulatory requirements and financial obligations. These capital
requirements typically vary based on how the positions are held and how they are classified. For
example, assets that are “held for sale” or are in the “trading account” typically have lower
capital requirements than those that are “held for investment,” because of the expected lower
risks associated with what are expected to be shorter term holdings.
Many investment banks use complex automated systems to analyze the “Value at Risk”
(“VaR”) associated with their holdings. To reduce the VaR attached to their holdings,
investment banks employ a variety of methods to offset or “hedge” their risk. These methods
can include diversifying their assets, taking a short position on related financial products,
purchasing loss protection through insurance or credit default swaps, or taking positions in
derivatives whose values move inversely to the value of the assets being hedged.
Shorting the Mortgage Market. Prior to the financial crisis, investors commonly
purchased RMBS or CDO securities as long-term investments that produced a steady income. In
2006, however, the high risk mortgages underlying these securities began to incur record levels
of delinquencies. Some investors, worried about the value of their holdings, sought to sell their
RMBS or CDO securities, but had a difficult time doing so due to the lack of an active market.
Some managed to sell their high risk RMBS securities to investment banks assembling cash
Some investors, instead of selling their RMBS or CDO securities, purchased “insurance”
against a loss by buying a credit default swap (CDS) that would pay off if the specified securities
incurred losses or other negative credit events. By 2005, investment banks had standardized
CDS contracts for RMBS and CDO securities, making this a practical alternative.
Much like insurance, the buyer of a CDS contract paid a periodic premium to the CDS
seller, who guaranteed the referenced security against loss. CDS contracts referencing a single
security or corporate bond became known as “single name” CDS contracts. If the referenced
security later incurred a loss, the CDS seller had to pay an agreed-upon amount to the CDS buyer
to cover the loss. Some investors began to purchase single name CDS contracts, not as a hedge
to offset losses from RMBS or CDO securities they owned, but as a way to profit from particular
RMBS or CDO securities they predicted would lose money. CDS contracts that paid off on
securities that were not owned by the CDS buyer were known as “naked credit default swaps.”
61 See, e.g., 12 CFR part 3, Appendix A (for the Office of the Comptroller of the Currency), 12 CFR part 208,
Appendix A and 12 CFR part 225, Appendix A (for the Federal Reserve Board of Governors) and 12 CFR part 325,
Appendix A (for the Federal Deposit Insurance Corporation).
62 Securities Exchange Act of 1934, Rule 15c3-1.
Some investors purchased large numbers of these CDS contracts in a concerted strategy to profit
from mortgage backed securities they believed would fail.
Some investment banks took the CDS approach a step further. In 2006, a consortium of
investment banks led by Goldman Sachs and Deutsche Bank launched the ABX Index, which
created five indices that tracked the aggregate performance of a basket of 20 designated
subprime RMBS securitizations.63 Borrowing from longstanding practice in commodities
markets, investors could buy and sell contracts linked to the value of one of the ABX indices.
Each contract consisted of a credit default swap agreement in which the parties could essentially
wager on the rise or fall of the index value. According to a Goldman Sachs employee, the ABX
Index “introduced a standardized tool that allow[ed] clients to quickly gain exposure to the asset
class,” in this case subprime RMBS securities. An investor – or investment bank – taking a short
position in an ABX contract was, in effect, placing a bet that the basket of subprime RMBS
securities would lose value.
Synthetic CDOs provided still another vehicle for shorting the mortgage market. In this
approach, an investment bank created a synthetic CDO that referenced a variety of RMBS
securities. One or more investors could take the “short” position by paying premiums to the
CDO in exchange for a promise that the CDO would pay a specified amount if the referenced
assets incurred a negative credit event, such as a default or credit rating downgrade. If that event
took place, the CDO would have to pay an agreed-upon amount to the short investors to cover
the loss, removing income from the CDO and causing losses for the long investors. Synthetic
CDOs became a way for investors to short multiple specific RMBS securities that they expected
would incur losses.
Proprietary Trading. Financial institutions also built increasingly large proprietary
holdings of mortgage related assets. Numerous financial firms, including investment banks,
bought RMBS and CDO securities, and retained these securities in their investment portfolios.
Others retained these securities in their trading accounts to be used as inventory for short term
trading activity, market making on behalf of clients, hedging, providing collateral for short term
loans, or maintaining lower capital requirements. Deutsche Bank’s RMBS Group in New York,
for example, built up a $102 billion portfolio of RMBS and CDO securities, while the portfolio
at an affiliated hedge fund, Winchester Capital, exceeded $8 billion.64
63 Each of the five indices tracked a different tranche of securities from the designated 20 subprime RMBS
securitizations. One index tracked AAA rated securities from the 20 subprime RMBS securities; the second tracked
AA rated securities from the 20 RMBS securitizations; and the remaining indices tracked baskets of A, BBB, and
BBB rated RMBS securities. Every six months, a new set of RMBS securitizations was selected for a new ABX
index. See 3/2008 “Understanding the Securitization of Subprime Mortgage Credit,” prepared by Federal Reserve
Bank of New York, Report No. 318, at 26. Markit Group Ltd. administered the ABX Index which issued indices in
2006 and 2007, but has not issued any new indices since then.
Other financial firms,
including Bear Stearns, Citibank, JPMorgan Chase, Lehman Brothers, Merrill Lynch, Morgan
Stanley, and UBS also accumulated enormous propriety holdings in mortgage related products.
When the value of these holdings dropped, some of these financial institutions lost tens of
64 For more information, see Chapter VI, section discussing Deutsche Bank.
billions of dollars,65 and either declared bankruptcy, were sold off,66 or were bailed out by U.S.
taxpayers seeking to avoid damage to the U.S. economy as a whole.67
One investment bank, Goldman Sachs, built a large number of proprietary positions to
short the mortgage market.68 Goldman Sachs had helped to build an active mortgage market in
the United States and had accumulated a huge portfolio of mortgage related products. In late
2006, Goldman Sachs decided to reverse course, using a variety of means to bet against the
mortgage market. In some cases, Goldman Sachs took proprietary positions that paid off only
when some of its clients lost money on the very securities that Goldman Sachs had sold to them
and then shorted. Altogether in 2007, Goldman’s mortgage department made $1.2 billion in net
revenues from shorting the mortgage market.69 Despite those gains, Goldman Sachs was given a
$10 billion taxpayer bailout under the Troubled Asset Relief Program,70 tens of billions of
dollars in support through accessing the Federal Reserve’s Primary Dealer Credit Facility,71 and
billions more in indirect government support72
E. Market Oversight
to ensure its continued existence.
U.S. financial regulators failed to stop financial firms from engaging in high risk,
conflict-ridden activities. Those regulatory failures arose, in part, from the fragmented nature of
U.S. financial oversight as well as statutory barriers to regulating high risk financial products.
65 See, e.g., Goldman Sachs Group, Inc., 2008 Annual Report 27 (2009) (stating that the firm had “long proprietary
positions in a number of [its] businesses. These positions are accounted for at fair value, and the declines in the
values of assets have had a direct and large negative impact on [its] earnings in fiscal 2008.”); see also, Viral V.
Acharya and Matthew Richardson, “Causes of the Financial Crisis,” 21 Critical Review 195, 199-204 (2009) (citing
proprietary holdings of asset backed securities as one of the primary drivers of accumulated risks causing the
financial crisis); “Prop Trading Losses Ain’t Peanuts,” The Street (1/27/2010),
66 See, e.g., “Lehman Files for Bankruptcy; Merrill is Sold,” New York Times (9/14/2008); and discussion in
Chapter III of Washington Mutual Bank which was sold to JPMorgan Chase.
67 See, e.g., Capital Purchase Program Transactions, under the Troubled Asset Relief Program, U.S. Department of
the Treasury, at http://www.treasury.gov/initiatives/financial-stability/investmentprograms/
68 For more information, see Chapter VI, section describing Goldman Sachs.
69 Id. Goldman’s Structured Product Group Trading Desk earned $3.7 billion in net revenues, which was offset by
losses on other desks within the mortgage department, resulting in the $1.2 billion in total net revenues.
70 See, e.g., Capital Purchase Program Transactions, under the Troubled Asset Relief Program, U.S. Department of
the Treasury, available at http://www.treasury.gov/initiatives/financial-stability/investmentprograms/
cpp/Pages/capitalpurchaseprogram.aspx and an example of a transactions report at
71 See data available at http://www.federalreserve.gov/newsevents/reform_pdcf.htm showing Goldman Sachs’ use of
the Primary Dealer Credit Facility 85 times in 2008.
72 See, e.g., prepared statement of Neil Barofsky, Special Inspector General of the Troubled Asset Relief Program,
“The Federal Bailout of AIG,” before the House Committee on Oversight and Government Reform (1/27/2010),
http://oversight.house.gov/images/stories/Hearings/pdfs/20100127barofsky.pdf (noting that some firms, including
Goldman Sachs, disproportionately benefited from the federal government’s bailout of AIG).
Oversight of Lenders. At the end of 2005, the United States had about 8,800 federally
insured banks and thrifts,73 plus about 8,700 federally insured credit unions, many of which were
in the business of issuing home loans.74 On the federal level, these financial institutions were
overseen by five agencies: the Federal Reserve which oversaw state-chartered banks that were
part of the federal reserve system as well as foreign banks and others; the Office of the
Comptroller of the Currency (OCC) which oversaw banks with national charters; the Office of
Thrift Supervision (OTS) which oversaw federally-chartered thrifts; the National Credit Union
Administration which oversaw federal credit unions; and the Federal Deposit Insurance
Corporation (FDIC) which oversaw financial institutions that have federal deposit insurance
(hereinafter referred to as “federal bank regulators”).75 In addition, state banking regulators
oversaw the state-chartered institutions and at times took action to require federally-chartered
financial institutions to comply with certain state laws.
The primary responsibility of the federal bank regulators was to ensure the safety and
soundness of the financial institutions they oversaw. One key mechanism they used to carry out
that responsibility was to conduct examinations on a periodic basis of the financial institutions
within their jurisdiction and provide the results in an annual Report of Examination (“ROE”)
given to the Board of Directors at each entity. The largest U.S. financial institutions typically
operated under a “continuous exam” program, which required federal bank examiners to conduct
a series of specialized examinations during the year with the results from all of those
examinations included in the annual ROE.
Federal examination activities were typically led by an Examiner in Charge and were
organized around a rating system called CAMELS that was used by all federal bank regulators.
The CAMELS rating system evaluated a financial institution’s: (C) capital adequacy, (A) asset
quality, (M) management, (E) earnings, (L) liquidity, and (S) sensitivity to market risk.
CAMELS ratings are on a scale of 1 to 5, in which 1 signifies a safe and secure bank with no
cause for supervisory concern, 3 signifies an institution with supervisory concerns in one or more
areas, and 5 signifies an unsafe and unsound bank with severe supervisory concerns. In the
annual ROE, regulators typically provided a financial institution with a rating for each CAMELS
component, as well as an overall composite rating on its safety and soundness.
In addition, the FDIC conducted its own examinations of financial institutions with
federal deposit insurance. The FDIC reviews relied heavily on the examination findings and
ROEs developed by the primary regulator of the financial institution, but the FDIC assigned its
own CAMELS ratings to each institution. In addition, for institutions with assets of $10 billion
or more, the FDIC established a Large Insured Depository Institutions (“LIDI”) Program to
assess and report on emerging risks that may pose a threat to the federal Deposit Insurance Fund.
Under this program, the FDIC performed an ongoing analysis of emerging risks within each
73 See FDIC Quarterly Banking Profile, 1 (Fourth Quarter 2005) (showing that, as of 12/31/2005, the United States
had 8,832 federal and state chartered insured banks and thrifts).
74 See 1/3/2011 chart, “Insurance Fund Ten-Year Trends,” supplied by the National Credit Union Administration
(showing that, as of 12/31/2005, the United States had 8,695 federal and state credit unions).
75 The Dodd-Frank Act has since abolished one of these agencies, the Office of Thrift Supervision, and assigned its
duties to the OCC. See Chapter IV.
insured institution and assigned a quarterly risk rating, using a scale of A to E, with A being the
best rating and E the worst.
If a regulator became concerned about the safety or soundness of a financial institution, it
had a wide range of informal and formal enforcement actions that could be used to require
operational changes. Informal actions included requiring the financial institution to issue a
safety and soundness plan, memorandum of understanding, Board resolution, or commitment
letter pledging to take specific corrective actions by a certain date, or issuing a supervisory letter
to the financial institution listing specific “matters requiring attention.” These informal
enforcement actions are generally not made public and are not enforceable in court. Formal
enforcement actions included a regulator’s issuing a public memorandum of understanding,
consent order, or cease and desist order requiring the financial institution to stop an unsafe
practice or take an affirmative action to correct identified problems; imposing a civil monetary
penalty; suspending or removing personnel from the financial institution; or referring misconduct
for criminal prosecution.
A wide range of large and small banks and thrifts were active in the mortgage market.
Banks like Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo originated,
purchased, and securitized billions of dollars in home loans each year. Thrifts, whose charters
typically required them to hold 65% of their assets in mortgage related assets, also originated,
purchased, sold, and securitized billions of dollars in home loans, including such major lenders
as Countrywide Financial Corporation, IndyMac Bank, and Washington Mutual Bank. Some of
these banks and thrifts also had affiliates, such as Long Beach Mortgage Corporation, which
specialized in issuing subprime mortgages. Still more lenders operated outside of the regulated
banking system, including New Century Financial Corporation and Fremont Loan & Investment,
which used such corporate vehicles as industrial loan companies, real estate investment trusts, or
publicly traded corporations to carry out their businesses. In addition, the mortgage market was
populated with tens of thousands of mortgage brokers that were paid fees for their loans or for
bringing qualified borrowers to a lender to execute a home loan.76
Oversight of Securities Firms. Another group of financial institutions active in the
mortgage market were securities firms, including investment banks, broker-dealers, and
investment advisors. These security firms did not originate home loans, but typically helped
design, underwrite, market, or trade securities linked to residential mortgages, including the
RMBS and CDO securities that were at the heart of the financial crisis. Key firms included Bear
Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, and the asset
management arms of large banks, including Citigroup, Deutsche Bank, and JPMorgan Chase.
Some of these firms also had affiliates which specialized in securitizing subprime mortgages.
Securities firms were overseen on the federal level by the Securities and Exchange
Commission (SEC) whose mission is to “protect investors, maintain fair, orderly, and efficient
76 1/2009 “Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated
U.S. Financial Regulatory System,” prepared by the Government Accountability Office, Report No. GAO-09-216, at
markets, and facilitate capital formation.”77 The SEC oversees the “key participants in the
securities world, including securities exchanges, securities brokers and dealers, investment
advisors, and mutual funds,” primarily for the purpose of “promoting the disclosure of important
market related information, maintaining fair dealing, and protecting against fraud.”78
The securities firms central to the financial crisis were subject to a variety of SEC
regulations in their roles as broker-dealers, investment advisors, market makers, underwriters,
and placement agents. Most were also subject to oversight by state securities regulators.79 The
securities firms were required to submit a variety of public filings with the SEC about their
operations and in connection with the issuance of new securities. The SEC’s Office of
Compliance Inspections and Examinations (OCIE) conducted inspections of broker-dealers,
among others, to understand industry practices, encourage compliance, evaluate risk
management, and detect violations of the securities laws. In addition, under the voluntary
Consolidated Supervised Entities program, the SEC’s Division of Trading and Markets
monitored the investment activities of the largest broker-dealers, including Bear Stearns,
Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, Citigroup, and JP Morgan
Chase, evaluating their capital levels, use of leverage, and risk management.80
Like bank regulators, if the SEC became concerned about a particular securities firm, it
could choose from a range of informal and formal enforcement actions. Informal actions could
include issuing a “deficiency letter” identifying problems and requiring the securities firm to take
corrective action by a certain date. Formal enforcement actions, undertaken by the SEC’s
Division of Enforcement, could include civil proceedings before an administrative law judge; a
civil complaint filed in federal district court; civil fines; an order to suspend or remove personnel
from a firm or bar them from the brokerage industry; or a referral for criminal prosecution.
Common securities violations included selling unregistered securities, misrepresenting
information about a security, unfair dealing, price manipulation, and insider trading.81
Statutory and Regulatory Barriers. Federal and state financial regulators responsible
for oversight of banks, securities firms, and other financial institutions in the years leading to the
financial crisis operated under a number of statutory and regulatory constraints.
One key constraint was the sweeping statutory prohibition on the federal regulation of
any type of swap, including credit default swaps. This prohibition took effect in 2000, with
enactment of the Commodity Futures Modernization Act (CFMA).82
77 See SEC website, “About the SEC: What We Do,”
The key statutory section
explicitly prohibited federal regulators from requiring the registration of swaps as securities;
issuing or enforcing any regulations or orders related to swaps; or imposing any recordkeeping
79 Some firms active in the U.S. securities and mortgage markets, such as hedge funds, operated without meaningful
federal oversight by taking advantage of exemptions in the Investment Company Act of 1940.
80 See 9/2008 “SEC’s Oversight of Bear Stearns and Related Entities: The Consolidated Entity Program,” report
prepared by Office of the SEC Inspector General, Report No. 446-A.Report No. 446-A, (9/2008).
81 See SEC website, “About the SEC: What We Do,” www.sec.gov.
82 CFMA was included as a title of H.R. 4577, the Consolidated Appropriations Act of 2001, P.L.106-554.
requirements for swaps.83 In addition, the law explicitly prohibited regulation of any “‘interest
rate swap,’ including a rate floor, rate cap, rate collar, cross-currency rate swap, basis swap,
currency swap, equity index swap, equity swap, debt index swap, debt swap, credit spread, credit
default swap, credit swap, weather swap, or commodity swap.”84 These prohibitions meant that
federal regulators could not even ask U.S. financial institutions to report on their swaps trades or
holdings, much less regulate swap dealers or examine how swaps were affecting the mortgage
market or other U.S. financial markets.
As a result, the multi-trillion-dollar U.S. swaps markets operated with virtually no
disclosure requirements, no restrictions, and no oversight by any federal agency, including the
market for credit default swaps which played a prominent role in the financial crisis. On
September 23, 2008, in a hearing before the Senate Committee on Banking, Housing, and Urban
Affairs, then SEC Chairman Christopher Cox testified that, as a result of the statutory
prohibition, the credit default swap market “is completely lacking in transparency,” “is regulated
by no one,” and “is ripe for fraud and manipulation.”85 In a September 26, 2008 press release, he
discussed regulatory gaps impeding his agency and again raised the issue of swaps:
“Unfortunately, as I reported to Congress this week, a massive hole remains: the approximately
$60 trillion credit default swap market, which is regulated by no agency of government. Neither
the SEC nor any regulator has authority even to require minimum disclosure.”86 In 2010, the
Dodd-Frank Act removed the CFMA prohibition on regulating swaps.87
A second significant obstacle for financial regulators was the patchwork of federal and
state laws and regulations applicable to high risk mortgages and mortgage brokers. Federal bank
regulators took until October 2006, to provide guidance to federal banks on acceptable lending
practices related to high risk home loans.88 Even then, the regulators issued voluntary guidance
whose standards were not enforceable in court and failed to address such key issues as the
acceptability of stated income loans.89 In addition, while Congress had authorized the Federal
Reserve, in 1994, to issue regulations to prohibit deceptive or abusive mortgage practices –
regulations that could have applied across the board to all types of lenders and mortgage brokers
– the Federal Reserve failed to issue any until July 2008, after the financial crisis had already
83 CFMA, § 302, creating a new section 2A of the Securities Act of 1933.
84 CFMA, § 301, creating a new section 206A of the Gramm-Leach-Bliley Act.
85 Statement of SEC Chairman Christopher Cox, “Turmoil in U.S. Credit Markets: Recent Actions Regarding
Government Sponsored Entities, Investment Banks and Other Financial Institutions,” before the U.S. Senate
Committee on Banking, Housing and Urban Affairs, S.Hrg. 110-1012 (9/23/2008).
86 9/26/2008 SEC press release, “Chairman Cox Announces End of Consolidated Supervised Entities Program,”
87 Title VII of the Dodd-Frank Act.
88 10/4/2006 “Interagency Guidance on Nontraditional Mortgage Product Risks,” (NTM Guidance), 71 Fed. Reg.
192 at 58609.
89 For more information, see Chapter IV.
90 Congress authorized the Federal Reserve to issue the regulations in Section 151 of the Home Ownership and
Equity Protection Act of 1994 (HOEPA), P.L. 103-325. The Federal Reserve did not issue any regulations under
HOEPA, however, until July 2008, when it amended Regulation Z. The new rules primarily strengthened consumer
protections for “higher priced loans,” which included many types of subprime loans. See “New Regulation Z Rules
Enhance Protections for Mortgage Borrowers,” Consumer Compliance Outlook (Fourth Quarter 2008) (Among
A third problem, exclusive to state regulators, was a 2005 regulation issued by the OCC
to prohibit states from enforcing state consumer protection laws against national banks.91 After
the New York State Attorney General issued subpoenas to several national banks to enforce New
York’s fair lending laws, a legal battle ensued. In 2009, the Supreme Court invalidated the OCC
regulation, and held that states were allowed to enforce state consumer protection laws against
national banks.92 During the intervening four years, however, state regulators had been
effectively unable to enforce state laws prohibiting abusive mortgage practices against federallychartered
banks and thrifts.
Systemic Risk. While bank and securities regulators focused on the safety and
soundness of individual financial institutions, no regulator was charged with identifying,
preventing, or managing risks that threatened the safety and soundness of the overall U.S.
financial system. In the area of high risk mortgage lending, for example, bank regulators
allowed banks to issue high risk mortgages as long as it was profitable and the banks quickly
sold the high risk loans to get them off their books. Securities regulators allowed investment
banks to underwrite, buy, and sell mortgage backed securities relying on high risk mortgages, as
long as the securities received high ratings from the credit rating agencies and so were deemed
“safe” investments. No regulatory agency focused on what would happen when poor quality
mortgages were allowed to saturate U.S. financial markets and contaminate RMBS and CDO
securities with high risk loans. In addition, none of the regulators focused on the impact
derivatives like credit default swaps might have in exacerbating risk exposures, since they were
barred by federal law from regulating or even gathering data about these financial instruments.
F. Government Sponsored Enterprises
Between 1990 and 2004, homeownership rates in the United States increased rapidly
from 64% to 69%, the highest level in 50 years.93 While many highly regarded economists and
officials argued at the time that this housing boom was the result of healthy economic activity, in
retrospect, some federal housing policies encouraged people to purchase homes they were
ultimately unable to afford, which helped to inflate the housing bubble.
Fannie Mae and Freddie Mac. Two government sponsored entities (GSE), the Federal
National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation
(Freddie Mac), were chartered by Congress to encourage homeownership primarily by providing
a secondary market for home mortgages. They created that secondary market by purchasing
loans from lenders, securitizing them, providing a guarantee that they would make up the cost of
other requirements, the rules prohibited lenders “from making loans based on collateral without regard to [the
borrower’s] repayment ability,” required lenders to “verify income and obligations,” and imposed “more stringent
restrictions on prepayment penalties.” The rules also required lenders to “establish escrow accounts for taxes and
mortgage related insurance for first-lien loans.” In addition, the rules “prohibit[ed] coercion of appraisers, define[d]
inappropriate practices for loan servicers, and require[d] early truth in lending disclosures for most mortgages.”).
91 12 CFR § 7.4000.
92 Cuomo v. Clearing House Association, Case No. 08-453, 129 S.Ct. 2710 (2009).
93 U.S. Census Bureau, “Table 14. Homeownership Rates by Area: 1960 to 2009,”
any securitized mortgage that defaulted, and selling the resulting mortgage backed securities to
investors. Many believed that the securities had the implicit backing of the federal government
and viewed them as very safe investments, leading investors around the world to purchase them.
The existence of this secondary market encouraged lenders to originate more loans, since they
could easily sell them to the GSEs and use the profits to increase their lending.
Over time, however, Fannie Mae and Freddie Mac began to purchase larger quantities of
higher risk loans, providing a secondary market for those loans and encouraging their
proliferation. Between 2005 and 2007, Fannie Mae alone purchased billions of dollars in high
risk home loans, including Option ARM, Alt A, and loans with subprime characteristics. For
example, data from Fannie Mae shows that, in mid 2008, 62% of the Option ARM loans on its
books had been purchased between 2005 and 2007.94 Likewise, 84% of its interest-only loans
were purchased in that time frame, as were 57% of those with FICO scores less than 620; 62% of
its loans with loan-to-value ratios greater than 90; and 73% of its Alt A loans.95 While these
loans constituted only a small percentage of Fannie Mae’s purchases at the time, they came to
account for some its most significant losses. By the middle of 2009, Fannie Mae reported an
unpaid principal balance of $878 billion for its loans with subprime characteristics, nearly a third
of its total portfolio of $2.7 trillion.96
According to economist Arnold Kling, Fannie Mae and Freddie Mac purchased these
loans after “lowering their own credit standards in order to maintain a presence in the market and
to meet their affordable housing goals.”97
Throughout their history, Fannie Mae and Freddie Mac were able to bundle the
mortgages they purchased into securities that were popular with investors, because many
believed the securities carried the implicit support of the federal government. The Congressional
Budget Office found the following:
“Because of their [Fannie Mae and Freddie Mac] size and interconnectedness with other
financial institutions, they posed substantial systemic risk—the risk that their failure
could impose very high costs on the financial system and the economy. The GSEs’
market power also allowed them to use their profits partly to benefit their other
stakeholders rather than exclusively to benefit mortgage borrowers. The implicit
guarantee created an incentive for the GSEs to take excessive risks: Stakeholders would
benefit when gambles paid off, but taxpayers would absorb the losses when they did not.
... One way that Fannie Mae and Freddie Mac increased risk was by expanding the
volume of mortgages and MBSs held in their portfolios, which exposed them to the risk
94 Fannie Mae, 2008 Q2 10-Q Investor Summary, August 8, 2008,
96 Fannie Mae, 2009 Second Quarter Credit Supplement, August 6, 2009,
97 “Not What They Had In Mind: A History of Policies that Produced the Financial Crisis of 2008,” September
2009, Mercatus Center, http://mercatus.org/sites/default/files/publication/NotWhatTheyHadInMind(1).pdf.
of losses from changes in interest or prepayment rates. Over the past decade, the two
GSEs also increased their exposure to default losses by investing in lower-quality
mortgages, such as subprime and Alt-A loans.”98
The risks embedded in their mortgage portfolios finally overwhelmed the GSEs in
September 2008, and both Fannie Mae and Freddie Mac were taken into conservatorship by the
federal government. Since that time, the Treasury Department has spent nearly $150 billion to
support the two GSEs, a total which projections show could rise to as high as $363 billion.99
Ginnie Mae. Additional housing policies that allowed borrowers with less than adequate
credit to obtain traditional mortgages included programs at the Federal Housing Administration
(FHA) and the Department of Veterans Affairs (VA). Both agencies provided loan guarantees to
lenders that originated loans for borrowers that qualified under the agencies’ rules. Many of the
loans guaranteed by the FHA and VA, some of which required down payments as low as 3%,
were bundled and sold as mortgage backed securities through the Government National
Mortgage Association (Ginnie Mae), an additional government sponsored enterprise. Like
Fannie Mae and Freddie Mac, Ginnie Mae guaranteed that it would make up for any securitized
loan that defaulted, producing another type of mortgage backed security that was popular with
investors, many of whom believed that the security carried an implicit federal guarantee.
In the years leading up to the financial crisis, FHA guaranteed millions of home loans
worth hundreds of billions of dollars.100 According to FHA data, as of 2011, nearly 20% of all
FHA loans originated in 2008 were seriously delinquent, meaning borrowers had missed three or
more payments, while loans originated in 2007 had a serious delinquency rate of over 22%. The
2007 and 2008 loans, which currently make up about 15% of FHA’s active loan portfolio,
remain the worst performing in that portfolio. In 2009 and 2010, FHA tightened its underwriting
guidelines, and the loans it guaranteed performed substantially better. By early 2011, the serious
delinquency rate for all FHA borrowers was about 8.8%, down from over 9.4% the prior year.
G. Administrative and Legislative Actions
In response to the financial crisis, Congress and the Executive Branch have taken a
number of actions. Three that have brought significant changes are the Troubled Asset Relief
Program, Federal Reserve assistance programs, and the Dodd-Frank Wall Street and Consumer
Troubled Asset Relief Program (TARP). On October 3, 2008, Congress passed and
President Bush signed into law the Emergency Economic Stabilization Act of 2008, P.L. 110-
98 Congressional Budget Office, “Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage
Market,” December 2010, at x, http://www.cbo.gov/ftpdocs/120xx/doc12032/12-23-FannieFreddie.pdf.
99 Federal Housing Finance Agency, News Release, “FHFA Releases Projections Showing Range of Potential
Draws for Fannie Mae and Freddie Mac,” October 21, 2010, http://fhfa.gov/webfiles/19409/Projections_102110.pdf.
100 The statistics cited in this paragraph are taken from the U.S. Department of Housing and Urban Development,
“FHA Single-Family Mutual Mortgage Insurance Fund Programs, Quarterly Report to Congress, FY 2011 Q1,”
March 17, 2011, at 4 and 19, http://www.hud.gov/offices/hsg/rmra/oe/rpts/rtc/fhartc_q1_2011.pdf.
343. This law, which passed both Houses with bipartisan majorities, established the Troubled
Asset Relief Program (TARP) and authorized the expenditure of up to $700 billion to stop
financial institutions from collapsing and further damaging the U.S. economy. Administered by
the Department of the Treasury, with support from the Federal Reserve, TARP funds have been
used to inject capital into or purchase or insure assets at hundreds of large and small banks.
The largest recipients of TARP funds were AIG, Ally Financial (formerly GMAC
Financial Services), Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan
Stanley, PNC Financial Services, U.S. Bancorp, and Wells Fargo, as well as Chrysler, and
General Motors. Most have repaid all or a substantial portion of the TARP funds they received.
Although initially expected to cost U.S. taxpayers more than $350 billion, the
Congressional Budget Office estimated in November 2010, that the final cost of the TARP
program will be approximately $25 billion.101
Federal Reserve Emergency Support Programs. In addition, as the financial crisis
began to unfold, the Federal Reserve aggressively expanded its balance sheet from about $900
billion at the beginning of 2008, to more than $2.4 trillion in December 2010, to provide support
to the U.S. financial system and economy. Using more than a dozen programs, through more
than 21,000 individual transactions, the Federal Reserve provided trillions of dollars in assistance
to U.S. and foreign financial institutions in an effort to promote liquidity and prevent a financial
collapse.102 In some instances, the Federal Reserve created new programs, such as its Agency
Mortgage Backed Securities Purchase Program which purchased more than $1.25 trillion in
mortgages backed by Fannie Mae, Freddie Mac, and Ginnie Mae.103
Dodd-Frank Act. On July 21, 2010, Congress passed and President Obama signed into
law the Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203. This law,
which passed both Houses with bipartisan majorities, expanded the authority of regulatory
agencies to try to prevent future financial crises. Among other provisions, the law:
In other instances, it
modified and significantly expanded existing programs, such as by lowering the quality of
collateral it accepted for access to and increasing lending by the discount window.
– established a Financial Stability Oversight Council, made up of federal financial
regulators and others, to identify and respond to emerging financial risks;
– established a Consumer Financial Protection Bureau to strengthen protections of
American consumers from abusive financial products and practices;
– restricted proprietary trading and investments in hedge funds by banks and other large
101 11/2010 “Report on the Troubled Asset Relief Program,” prepared by the Congressional Budget Office,
102 “Usage of Federal Reserve Credit and Liquidity Facilities,” Federal Reserve Board, available at
103 “Agency Mortgage-Backed Securities Purchase Program,” Federal Reserve Board, available at
– prohibited sponsors of asset backed securities from engaging in transactions that would
involve or result in a material conflict of interest with investors in those securities;
– established procedures to require nonbank firms whose failure would threaten U.S.
financial stability to divest some holdings or undergo an orderly liquidation;
– strengthened regulation of credit rating agencies;
– strengthened mortgage regulation, including by clamping down on high cost mortgages,
requiring securitizers to retain limited liability for securities reliant on high risk
mortgages, banning stated income loans, and restricting negative amortization loans;
– required better federal regulation of mortgage brokers;
– directed regulators to require greater capital and liquidity reserves;
– required regulation of derivatives and derivative dealers;
– required registration of certain hedge funds and private equity funds;
– authorized regulators to impose standards of conduct that are the same as those
applicable to investment advisers on broker-dealers who provide personalized
investment advice to retail customers; and
– abolished the Office of Thrift Supervision.
H. Financial Crisis Timeline
This Report reviews events from the period 2004 to 2008, in an effort to identify and
explain four significant causes of the financial crisis. A variety of events could be identified as
the start of the crisis. Candidates include the record number of home loan defaults that began in
December 2006; the FDIC’s March 2007 cease and desist order against Fremont Investment &
Loan which exposed the existence of unsafe and unsound subprime lending practices; or the
collapse of the Bear Stearns hedge funds in June 2007. Still another candidate is the two-week
period in September 2008, when half a dozen major U.S. financial institutions failed, were
forcibly sold, or were bailed out by U.S. taxpayers seeking to prevent a collapse of the U.S.
This Report concludes, however, that the most immediate trigger to the financial crisis
was the July 2007 decision by Moody’s and S&P to downgrade hundreds of RMBS and CDO
securities. The firms took this action because, in the words of one S&P senior analyst, theinvestment grade ratings could not “hold.” By acknowledging that RMBS and CDO securities