The Maine Crime: Mortgage Fraud In The Great State Of Maine: PART 1 Make that 25 pages at a time

WALL STREET ANDTHE FINANCIAL CRISIS Anatomy of a Financial Collapse

United States Senate

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

Committee on Homeland Security and Governmental Affairs

______________________________________________________________

Carl Levin, Chairman

Tom Coburn, Ranking Minority Member

WALL STREET AND

THE FINANCIAL CRISIS:

Anatomy of a Financial Collapse

MAJORITY AND MINORITY STAFF REPORT

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS UNITED STATES SENATE

April 13, 2011

SENATOR CARL LEVIN

Chairman

SENATOR TOM COBURN, M.D.

Ranking Minority Member

PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

ELISE J. BEAN

Staff Director and Chief Counsel

ROBERT L. ROACH

Counsel and Chief Investigator

LAURA E. STUBER

Counsel

ZACHARY I. SCHRAM

Counsel

DANIEL J. GOSHORN

Counsel

DAVID H. KATZ

Counsel

ALLISON F. MURPHY

Counsel

ADAM C. HENDERSON

Professional Staff Member

PAULINE E. CALANDE

SEC Detailee

MICHAEL J. MARTINEAU

DOJ Detailee

CHRISTOPHER J. BARKLEY

Staff Director to the Minority

ANTHONY G. COTTO

Counsel to the Minority

KEITH B. ASHDOWN

Chief Investigator to the Minority

JUSTIN J. ROOD

Senior Investigator to the Minority

VANESSA CAREIRO

Law Clerk

BRITTANY CLEMENT

Law Clerk

DAVID DeBARROS

Law Clerk

ERIN HELLING

Law Clerk

HELENA MAN

Law Clerk

JOSHUA NIMMO

Intern

ROBERT PECKERMAN

Intern

TANVI ZAVERI

Law Clerk

MARY D. ROBERTSON

Chief Clerk

Permanent Subcommittee on Investigations

199 Russell Senate Office Building – Washington, D.C. 20510

Main Number: 202/224-9505

Web Address: www.hsgac.senate.gov [Follow Link to “Subcommittees,” to “Investigations”]

WALL STREET AND THE FINANCIAL CRISIS:

Anatomy of a Financial Collapse

TABLE OF CONTENTS

I. EXECUTIVE SUMMARY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

A. Subcommittee Investigation . . . ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

B. Overview . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

(1) High Risk Lending: Case Study of Washington Mutual Bank. . . . . . . . . . . . . . . . . . 2

(2) Regulatory Failures: Case Study of the Office of Thrift Supervision. . . . . . . . . . . . . 4

(3) Inflated Credit Ratings: Case Study of Moody’s and Standard & Poor’s. . . . . . . . . . 5

(4) Investment Bank Abuses: Case Study of Goldman Sachs and Deutsche Bank.. . . . . 7

C. Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

II. BACKGROUND. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

A. Rise of Too-Big-To-Fail U.S. Financial Institutions. . . . . . . . . . . . . . . . . . . . . . . . . . . 15

B. High Risk Mortgage Lending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

C. Credit Ratings and Structured Finance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

D. Investment Banks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

E. Market Oversight. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

F. Government Sponsored Enterprises. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

G. Administrative and Legislative Actions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

H. Financial Crisis Timeline. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

III. HIGH RISK LENDING:

CASE STUDY OF WASHINGTON MUTUAL BANK. . . . . . . . . . . . . . . . . . . . . . . . . . . 48

A. Subcommittee Investigation and Findings of Fact.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

B. Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

(1) Major Business Lines and Key Personnel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

(2) Loan Origination Channels. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

(3) Long Beach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

(4) Securitization.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

(5) Overview of WaMu’s Rise and Fall. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

C. High Risk Lending Strategy.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

(1) Strategic Direction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

(2) Approval of Strategy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

(3) Definition of High Risk Lending.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

(4) Gain on Sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

(5) Acknowledging Unsustainable Housing Price Increases.. . . . . . . . . . . . . . . . . . . . . . 65

(6) Execution of the High Risk Lending Strategy.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

D. Shoddy Lending Practices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

(1) Long Beach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

(2) WaMu Retail Lending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

(a) Inadequate Systems and Weak Oversight. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

(b) Risk Layering.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

(c) Loan Fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

(d) Steering Borrowers to High Risk Option ARMs. . . . . . . . . . . . . . . . . . . . . . . . . 104

(e) Marginalization of WaMu Risk Managers.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109

E. Polluting the Financial System. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

(1) Long Beach and WaMu Securitizations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

(2) Deficient Securitization Practices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

(3) Securitizing Delinquency-Prone Loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125

(4) WaMu Loan Sales to Fannie Mae and Freddie Mac. . . . . . . . . . . . . . . . . . . . . . . . . . 136

F. Destructive Compensation Practices.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

(1) Sales Culture. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

(2) Paying for Speed and Volume. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

(a) Long Beach Account Executives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

(b) WaMu Loan Consultants. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159

(3) WaMu Executive Compensation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

G. Preventing High Risk Lending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

(1) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

(2) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

1. Ensure "Qualified Mortgages" Are Low Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . 160

2. Require Meaningful Risk Retention. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

3. Safeguard Against High Risk Products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

4. Require Greater Reserves for Negative Amortization Loans.. . . . . . . . . . . . . . . 160

5. Safeguard Bank Investment Portfolios.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

IV. REGULATORY FAILURE:

CASE STUDY OF THE OFFICE OF THRIFT SUPERVISION. . . . . . . . . . . . . . . . . . . 161

A. Subcommittee Investigation and Findings of Fact.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

B. Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

(1) Office of Thrift Supervision. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

(2) Federal Deposit Insurance Corporation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166

(3) Examination Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

C. Washington Mutual Examination History. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169

(1) Regulatory Challenges Related to Washington Mutual.. . . . . . . . . . . . . . . . . . . . . . . 169

(2) Overview of Washington Mutual’s Ratings History and Closure.. . . . . . . . . . . . . . . 173

(3) OTS Identification of WaMu Deficiencies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

(a) Deficiencies in Lending Standards.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

(b) Deficiencies in Risk Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182

(d) Deficiencies Related to Long Beach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191

(e) Over 500 Deficiencies in 5 Years. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195

iii

(4) OTS Turf War Against the FDIC. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196

D. Regulatory Failures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208

(1) OTS’ Failed Oversight of WaMu. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

(a) Deference to Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

(b) Demoralized Examiners.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215

(d) Inflated CAMELS Ratings.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228

(e) Fee Issues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230

(2) Other Regulatory Failures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231

(a) Countrywide.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231

(b) IndyMac. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233

(c) New Century . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235

(d) Fremont. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237

E. Preventing Regulatory Failures.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239

(1) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239

(2) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

1. Complete OTS Dismantling.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

2. Strengthen Enforcement.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

3. Strengthen CAMELS Ratings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

4. Evaluate Impacts of High Risk Lending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

V. INFLATED CREDIT RATINGS:

CASE STUDY OF MOODY’S AND STANDARD & POOR’S. . . . . . . . . . . . . . . . . . . . . 243

A. Subcommittee Investigation and Findings of Fact.. . . . . . . . . . . . . . . . . . . . . . . . . . . . 245

B. Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246

(1) Credit Ratings Generally. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246

(2) The Rating Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

(3) Record Revenues.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256

C. Mass Credit Rating Downgrades.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259

(1) Increasing High Risk Loans and Unaffordable Housing. . . . . . . . . . . . . . . . . . . . . . . 259

(2) Mass Downgrades. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263

D. Ratings Deficiencies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267

(1) Awareness of Increasing Credit Risks.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268

(2) CRA Conflicts of Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272

(a) Drive for Market Share. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273

(b) Investment Bank Pressure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278

(3) Inaccurate Models. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288

(a) Inadequate Data. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288

(b) Unclear and Subjective Ratings Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294

(4) Failure to Retest After Model Changes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297

(5) Inadequate Resources. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304

(6) Mortgage Fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310

E. Preventing Inflated Credit Ratings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313

(1) Past Credit Rating Agency Oversight. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313

(2) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315

(3) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

1. Rank Credit Rating Agencies by Accuracy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

2. Help Investors Hold CRAs Accountable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

3. Strengthen CRA Operations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

4. Ensure CRAs Recognize Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

5. Strengthen Disclosure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317

6. Reduce Ratings Reliance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317

VI. INVESTMENT BANK ABUSES:

CASE STUDY OF GOLDMAN SACHS AND DEUTSCHE BANK.. . . . . . . . . . . . . . . . 318

A. Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321

(1) Investment Banks In General.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321

(2) Roles and Duties of an Investment Bank: Market Maker, Underwriter,

Placement Agent, Broker-Dealer.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322

(3) Structured Finance Products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325

B. Running the CDO Machine: Case Study of Deutsche Bank. . . . . . . . . . . . . . . . . . . . 330

(1) Subcommittee Investigation and Findings of Fact. . . . . . . . . . . . . . . . . . . . . . . . . . . 333

(2) Deutsche Bank Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334

(3) Deutsche Bank’s $5 Billion Short . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337

(a) Lippmann’s Negative Views of Mortgage Related Assets. . . . . . . . . . . . . . . . . 337

(b) Building and Cashing in the $5 Billion Short. . . . . . . . . . . . . . . . . . . . . . . . . . . 341

(4) The “CDO Machine” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346

(5) Gemstone.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350

(a) Background on Gemstone. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350

(b) Gemstone Asset Selection. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353

(d) Gemstone Sales Effort. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363

(e) Gemstone Losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371

(6) Other Deutsche Bank CDOs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372

(7) Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374

C. Failing to Manage Conflicts of Interest: Case Study of Goldman Sachs. . . . . . . . . . 376

(1) Subcommittee Investigation and Findings of Fact. . . . . . . . . . . . . . . . . . . . . . . . . . . 376

(2) Goldman Sachs Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378

(3) Overview of Goldman Sachs Case Study. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382

(a) Overview of How Goldman Shorted the Subprime Mortgage Market. . . . . . . . 382

(b) Overview of Goldman’s CDO Activities.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388

(4) How Goldman Shorted the Subprime Mortgage Market.. . . . . . . . . . . . . . . . . . . . . . 398

(a) Starting $6 Billion Net Long. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398

(b) Going Past Home: Goldman’s First Net Short. . . . . . . . . . . . . . . . . . . . . . . . . . 404

(d) Building the Big Short. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430

(e) “Get Down Now”.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440

(f) Profiting from the Big Short: Making “Serious Money”. . . . . . . . . . . . . . . . . . . 444

(g) Goldman’s Records Confirm Large Short Position. . . . . . . . . . . . . . . . . . . . . . . 445

(i) Top Sheets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446

(ii) Risk Reports.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455

(h) Profiting From the Big Short. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466

(5) How Goldman Created and Failed to Manage Conflicts of Interest in its

Securitization Activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474

(a) Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477

(i) Goldman’s Securitization Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477

(ii) Goldman’s Negative Market View. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478

(iii) Goldman’s Securitization Sell Off. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481

AA. RMBS Sell Off.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481

BB. CDO Sell Off. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492

CC. CDO Marks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503

DD. Customer Losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507

(b) Goldman’s Conflicts of Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513

(i) Conflicts of Interest Involving RMBS Securities. . . . . . . . . . . . . . . . . . . . 513

(ii) Conflicts of Interest Involving Sales of CDO Securities. . . . . . . . . . . . . . 516

AA. Hudson Mezzanine Funding 2006-1. . . . . . . . . . . . . . . . . . . . . . . . . 517

BB. Anderson Mezzanine Funding 2007-1.. . . . . . . . . . . . . . . . . . . . . . . 532

CC. Timberwolf I. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541

DD. Abacus 2007-AC1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 560

(iii) Additional CDO Conflicts of Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574

AA. Liquidation Agent in Hudson 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574

BB. Collateral Put Provider in Timberwolf. . . . . . . . . . . . . . . . . . . . . . . 588

(6) Analysis of Goldman’s Conflicts of Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602

(a) Securities Laws. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603

(b) Analysis .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609

(i) Claiming Market Maker Status.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609

(ii) Soliciting Clients and Recommending Investments. . . . . . . . . . . . . . . . . . 613

(iii) Failing to Disclose Material Adverse Information. . . . . . . . . . . . . . . . . . . 615

(iv) Making Unsuitable Investment Recommendations. . . . . . . . . . . . . . . . . . 619

(7) Goldman’s Proprietary Investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 624

D. Preventing Investment Bank Abuses.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 636

(1) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 636

(2) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 638

1. Review Structured Finance Transactions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 638

2. Narrow Proprietary Trading Exceptions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 638

3. Design Strong Conflict of Interest Prohibitions.. . . . . . . . . . . . . . . . . . . . . . . . . 639

4. Study Bank Use of Structured Finance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639

# # #

Wall Street and The Financial Crisis:

Anatomy of a Financial Collapse

April 13, 2011

In the fall of 2008, America suffered a devastating economic collapse. Once valuable

securities lost most or all of their value, debt markets froze, stock markets plunged, and storied

financial firms went under. Millions of Americans lost their jobs; millions of families lost their

homes; and good businesses shut down. These events cast the United States into an economic

recession so deep that the country has yet to fully recover.

This Report is the product of a two-year, bipartisan investigation by the U.S. Senate

Permanent Subcommittee on Investigations into the origins of the 2008 financial crisis. The

goals of this investigation were to construct a public record of the facts in order to deepen the

understanding of what happened; identify some of the root causes of the crisis; and provide a

factual foundation for the ongoing effort to fortify the country against the recurrence of a similar

crisis in the future.

Using internal documents, communications, and interviews, the Report attempts to

provide the clearest picture yet of what took place inside the walls of some of the financial

institutions and regulatory agencies that contributed to the crisis. The investigation found that

the crisis was not a natural disaster, but the result of high risk, complex financial products;

undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the

market itself to rein in the excesses of Wall Street.

While this Report does not attempt to examine every key moment, or analyze every

important cause of the crisis, it provides new, detailed, and compelling evidence of what

happened. In so doing, we hope the Report leads to solutions that prevent it from happening

again.

I. EXECUTIVE SUMMARY

A. Subcommittee Investigation

In November 2008, the Permanent Subcommittee on Investigations initiated its

investigation into some of the key causes of the financial crisis. Since then, the Subcommittee

has engaged in a wide-ranging inquiry, issuing subpoenas, conducting over 150 interviews and

depositions, and consulting with dozens of government, academic, and private sector experts.

The Subcommittee has accumulated and reviewed tens of millions of pages of documents,

including court pleadings, filings with the Securities and Exchange Commission, trustee reports,

prospectuses for public and private offerings, corporate board and committee minutes, mortgage

transactions and analyses, memoranda, marketing materials, correspondence, and email. The

Subcommittee has also reviewed documents prepared by or sent to or from banking and

securities regulators, including bank examination reports, reviews of securities firms,

enforcement actions, analyses, memoranda, correspondence, and email.

In April 2010, the Subcommittee held four hearings examining four root causes of the

financial crisis. Using case studies detailed in thousands of pages of documents released at the

hearings, the Subcommittee presented and examined evidence showing how high risk lending by

U.S. financial institutions; regulatory failures; inflated credit ratings; and high risk, poor quality

financial products designed and sold by some investment banks, contributed to the financial

crisis. This Report expands on those hearings and the case studies they featured. The case

studies are Washington Mutual Bank, the largest bank failure in U.S. history; the federal Office

of Thrift Supervision which oversaw Washington Mutual’s demise; Moody’s and Standard &

Poor’s, the country’s two largest credit rating agencies; and Goldman Sachs and Deutsche Bank,

two leaders in the design, marketing, and sale of mortgage related securities. This Report

devotes a chapter to how each of the four causative factors, as illustrated by the case studies,

fueled the 2008 financial crisis, providing findings of fact, analysis of the issues, and

recommendations for next steps.

B. Overview

(1) High Risk Lending:

Case Study of Washington Mutual Bank

The first chapter focuses on how high risk mortgage lending contributed to the financial

crisis, using as a case study Washington Mutual Bank (WaMu). At the time of its failure, WaMu

was the nation’s largest thrift and sixth largest bank, with $300 billion in assets, $188 billion in

deposits, 2,300 branches in 15 states, and over 43,000 employees. Beginning in 2004, it

embarked upon a lending strategy to pursue higher profits by emphasizing high risk loans. By

2006, WaMu’s high risk loans began incurring high rates of delinquency and default, and in

2007, its mortgage backed securities began incurring ratings downgrades and losses. Also in

2007, the bank itself began incurring losses due to a portfolio that contained poor quality and

fraudulent loans and securities. Its stock price dropped as shareholders lost confidence, and

depositors began withdrawing funds, eventually causing a liquidity crisis at the bank. On

September 25, 2008, WaMu was seized by its regulator, the Office of Thrift Supervision, placed

in receivership with the Federal Deposit Insurance Corporation (FDIC), and sold to JPMorgan

Chase for $1.9 billion. Had the sale not gone through, WaMu’s failure might have exhausted the

entire $45 billion Deposit Insurance Fund.

This case study focuses on how one bank’s search for increased growth and profit led to

the origination and securitization of hundreds of billions of dollars in high risk, poor quality

mortgages that ultimately plummeted in value, hurting investors, the bank, and the U.S. financial

system. WaMu had held itself out as a prudent lender, but in reality, the bank turned

increasingly to higher risk loans. Over a four-year period, those higher risk loans grew from

19% of WaMu’s loan originations in 2003, to 55% in 2006, while its lower risk, fixed rate loans

fell from 64% to 25% of its originations. At the same time, WaMu increased its securitization of

subprime loans sixfold, primarily through its subprime lender, Long Beach Mortgage

Corporation, increasing such loans from nearly $4.5 billion in 2003, to $29 billion in 2006.

From 2000 to 2007, WaMu and Long Beach together securitized at least $77 billion in subprime

loans.

WaMu also originated an increasing number of its flagship product, Option Adjustable

Rate Mortgages (Option ARMs), which created high risk, negatively amortizing mortgages and,

from 2003 to 2007, represented as much as half of all of WaMu’s loan originations. In 2006

alone, Washington Mutual originated more than $42.6 billion in Option ARM loans and sold or

securitized at least $115 billion to investors, including sales to the Federal National Mortgage

Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). In

addition, WaMu greatly increased its origination and securitization of high risk home equity loan

products. By 2007, home equity loans made up $63.5 billion or 27% of its home loan portfolio,

a 130% increase from 2003.

At the same time that WaMu was implementing its high risk lending strategy, WaMu and

Long Beach engaged in a host of shoddy lending practices that produced billions of dollars in

high risk, poor quality mortgages and mortgage-backed securities. Those practices included

qualifying high risk borrowers for larger loans than they could afford; steering borrowers from

conventional mortgages to higher risk loan products; accepting loan applications without

verifying the borrower’s income; using loans with low, short term “teaser” rates that could lead

to payment shock when higher interest rates took effect later on; promoting negatively

amortizing loans in which many borrowers increased rather than paid down their debt; and

authorizing loans with multiple layers of risk. In addition, WaMu and Long Beach failed to

enforce compliance with their own lending standards; allowed excessive loan error and exception

rates; exercised weak oversight over the third party mortgage brokers who supplied half or more

of their loans; and tolerated the issuance of loans with fraudulent or erroneous borrower

information. They also designed compensation incentives that rewarded loan personnel for

issuing a large volume of higher risk loans, valuing speed and volume over loan quality.

As a result, WaMu, and particularly its Long Beach subsidiary, became known by

industry insiders for its failed mortgages and poorly performing RMBS securities. Among

sophisticated investors, its securitizations were understood to be some of the worst performing in

the marketplace. Inside the bank, WaMu’s President Steve Rotella described Long Beach as

“terrible” and “a mess,” with default rates that were “ugly.” WaMu’s high risk lending operation

was also problem-plagued. WaMu management was provided with compelling evidence of

deficient lending practices in internal emails, audit reports, and reviews. Internal reviews of two

high volume WaMu loan centers, for example, described “extensive fraud” by employees who

“willfully” circumvented bank policies. A WaMu review of internal controls to stop fraudulent

loans from being sold to investors described them as “ineffective.” On at least one occasion,

senior managers knowingly sold delinquency-prone loans to investors. Aside from Long Beach,

WaMu’s President described WaMu’s prime home loan business as the “worst managed

business” he had seen in his career.

Documents obtained by the Subcommittee reveal that WaMu launched its high risk

lending strategy primarily because higher risk loans and mortgage backed securities could be

sold for higher prices on Wall Street. They garnered higher prices, because higher risk meant the

securities paid a higher coupon rate than other comparably rated securities, and investors paid a

higher price to buy them. Selling or securitizing the loans also removed them from WaMu’s

books and appeared to insulate the bank from risk.

The Subcommittee investigation indicates that unacceptable lending and securitization

practices were not restricted to Washington Mutual, but were present at a host of financial

institutions that originated, sold, and securitized billions of dollars in high risk, poor quality

home loans that inundated U.S. financial markets. Many of the resulting securities ultimately

plummeted in value, leaving banks and investors with huge losses that helped send the economy

into a downward spiral. These lenders were not the victims of the financial crisis; the high risk

loans they issued were the fuel that ignited the financial crisis.

(2) Regulatory Failures:

Case Study of the Office of Thrift Supervision

The next chapter focuses on the failure of the Office of Thrift Supervision (OTS) to stop

the unsafe and unsound practices that led to the demise of Washington Mutual, one of the

nation’s largest banks. Over a five year period from 2004 to 2008, OTS identified over 500

serious deficiencies at WaMu, yet failed to take action to force the bank to improve its lending

operations and even impeded oversight by the bank’s backup regulator, the FDIC.

Washington Mutual Bank was the largest thrift under the supervision of OTS and was

among the eight largest financial institutions insured by the FDIC. Until 2006, WaMu was a

profitable bank, but in 2007, many of its high risk home loans began experiencing increased rates

of delinquency, default, and loss. After the market for subprime mortgage backed securities

collapsed in July 2007, Washington Mutual was unable to sell or securitize its subprime loans

and its loan portfolio fell in value. In September 2007, WaMu’s stock price plummeted against

the backdrop of its losses and a worsening financial crisis. From 2007 to 2008, WaMu’s

depositors withdrew a total of over $26 billion in deposits from the bank, triggering a liquidity

crisis, followed by the bank’s closure.

OTS records show that, during the five years prior to WaMu’s collapse, OTS examiners

repeatedly identified significant problems with Washington Mutual’s lending practices, risk

management, asset quality, and appraisal practices, and requested corrective action. Year after

year, WaMu promised to correct the identified problems, but never did. OTS failed to respond

with meaningful enforcement action, such as by downgrading WaMu’s rating for safety and

soundness, requiring a public plan with deadlines for corrective actions, or imposing civil fines

for inaction. To the contrary, until shortly before the thrift’s failure in 2008, OTS continually

rated WaMu as financially sound.

The agency’s failure to restrain WaMu’s unsafe lending practices stemmed in part from

an OTS regulatory culture that viewed its thrifts as “constituents,” relied on bank management to

correct identified problems with minimal regulatory intervention, and expressed reluctance to

interfere with even unsound lending and securitization practices. OTS displayed an unusual

amount of deference to WaMu’s management, choosing to rely on the bank to police itself in its

use of safe and sound practices. The reasoning appeared to be that if OTS examiners simply

identified the problems at the bank, OTS could then rely on WaMu’s assurances that problems

would be corrected, with little need for tough enforcement actions. It was a regulatory approach

with disastrous results.

Despite identifying over 500 serious deficiencies in five years, OTS did not once, from

2004 to 2008, take a public enforcement action against Washington Mutual to correct its lending

practices, nor did it lower the bank’s rating for safety and soundness. Only in 2008, as the bank

incurred mounting losses, did OTS finally take two informal, nonpublic enforcement actions,

requiring WaMu to agree to a “Board Resolution” in March and a “Memorandum of

Understanding” in September, neither of which imposed sufficient changes to prevent the bank’s

failure. OTS officials resisted calls by the FDIC, the bank’s backup regulator, for stronger

measures and even impeded FDIC oversight efforts by at times denying FDIC examiners office

space and access to bank records. Tensions between the two agencies remained high until the

end. Two weeks before the bank was seized, the FDIC Chairman contacted WaMu directly to

inform it that the FDIC was likely to have a ratings disagreement with OTS and downgrade the

bank’s safety and soundness rating, and informed the OTS Director about that communication,

prompting him to complain about the FDIC Chairman’s “audacity.”

Hindered by a culture of deference to management, demoralized examiners, and agency

infighting, OTS officials allowed the bank’s short term profits to excuse its risky practices and

failed to evaluate the bank’s actions in the context of the U.S. financial system as a whole. Its

narrow regulatory focus prevented OTS from analyzing or acknowledging until it was too late

that WaMu’s practices could harm the broader economy.

OTS’ failure to restrain Washington Mutual’s unsafe lending practices allowed high risk

loans at the bank to proliferate, negatively impacting investors across the United States and

around the world. Similar regulatory failings by other agencies involving other lenders repeated

the problem on a broad scale. The result was a mortgage market saturated with risky loans, and

financial institutions that were supposed to hold predominantly safe investments but instead held

portfolios rife with high risk, poor quality mortgages. When those loans began defaulting in

record numbers and mortgage related securities plummeted in value, financial institutions around

the globe suffered hundreds of billions of dollars in losses, triggering an economic disaster. The

regulatory failures that set the stage for those losses were a proximate cause of the financial

crisis.

(3) Inflated Credit Ratings:

Case Study of Moody’s and Standard & Poor’s

The next chapter examines how inflated credit ratings contributed to the financial crisis

by masking the true risk of many mortgage related securities. Using case studies involving

Moody’s Investors Service, Inc. (Moody’s) and Standard & Poor’s Financial Services LLC

(S&P), the nation’s two largest credit rating agencies, the Subcommittee identified multiple

problems responsible for the inaccurate ratings, including conflicts of interest that placed

achieving market share and increased revenues ahead of ensuring accurate ratings.

Between 2004 and 2007, Moody’s and S&P issued credit ratings for tens of thousands of

U.S. residential mortgage backed securities (RMBS) and collateralized debt obligations (CDOs).

Taking in increasing revenue from Wall Street firms, Moody’s and S&P issued AAA and other

investment grade credit ratings for the vast majority of those RMBS and CDO securities,

deeming them safe investments even though many relied on high risk home loans.1 In late

2006, high risk mortgages began incurring delinquencies and defaults at an alarming rate.

Despite signs of a deteriorating mortgage market, Moody’s and S&P continued for six months to

issue investment grade ratings for numerous RMBS and CDO securities.

Then, in July 2007, as mortgage delinquencies intensified and RMBS and CDO securities

began incurring losses, both companies abruptly reversed course and began downgrading at

record numbers hundreds and then thousands of their RMBS and CDO ratings, some less than a

year old. Investors like banks, pension funds, and insurance companies, who are by rule barred

from owning low rated securities, were forced to sell off their downgraded RMBS and CDO

holdings, because they had lost their investment grade status. RMBS and CDO securities held

by financial firms lost much of their value, and new securitizations were unable to find investors.

The subprime RMBS market initially froze and then collapsed, leaving investors and financial

firms around the world holding unmarketable subprime RMBS securities plummeting in value.

A few months later, the CDO market collapsed as well.

Traditionally, investments holding AAA ratings have had a less than 1% probability of

incurring defaults. But in 2007, the vast majority of RMBS and CDO securities with AAA

ratings incurred substantial losses; some failed outright. Analysts have determined that over

90% of the AAA ratings given to subprime RMBS securities originated in 2006 and 2007 were

later downgraded by the credit rating agencies to junk status. In the case of Long Beach, 75 out

of 75 AAA rated Long Beach securities issued in 2006, were later downgraded to junk status,

defaulted, or withdrawn. Investors and financial institutions holding the AAA rated securities

lost significant value. Those widespread losses led, in turn, to a loss of investor confidence in

the value of the AAA rating, in the holdings of major U.S. financial institutions, and even in the

viability of U.S. financial markets.

Inaccurate AAA credit ratings introduced risk into the U.S. financial system and

constituted a key cause of the financial crisis. In addition, the July mass downgrades, which

were unprecedented in number and scope, precipitated the collapse of the RMBS and CDO

secondary markets, and perhaps more than any other single event triggered the beginning of the

financial crisis.

1 S&P issues ratings using the “AAA” designation; Moody’s equivalent rating is “Aaa.” For ease of reference, this

Report will refer to both ratings as “AAA.”

The Subcommittee’s investigation uncovered a host of factors responsible for the

inaccurate credit ratings issued by Moody’s and S&P. One significant cause was the inherent

conflict of interest arising from the system used to pay for credit ratings. Credit rating agencies

were paid by the Wall Street firms that sought their ratings and profited from the financial

products being rated. Under this “issuer pays” model, the rating agencies were dependent upon

those Wall Street firms to bring them business, and were vulnerable to threats that the firms

would take their business elsewhere if they did not get the ratings they wanted. The ratings

agencies weakened their standards as each competed to provide the most favorable rating to win

business and greater market share. The result was a race to the bottom.

Additional factors responsible for the inaccurate ratings include rating models that failed

to include relevant mortgage performance data, unclear and subjective criteria used to produce

ratings, a failure to apply updated rating models to existing rated transactions, and a failure to

provide adequate staffing to perform rating and surveillance services, despite record revenues.

Compounding these problems were federal regulations that required the purchase of investment

grade securities by banks and others, which created pressure on the credit rating agencies to issue

investment grade ratings. While these federal regulations were intended to help investors stay

away from unsafe securities, they had the opposite effect when the AAA ratings proved

inaccurate.

Evidence gathered by the Subcommittee shows that the credit rating agencies were aware

of problems in the mortgage market, including an unsustainable rise in housing prices, the high

risk nature of the loans being issued, lax lending standards, and rampant mortgage fraud. Instead

of using this information to temper their ratings, the firms continued to issue a high volume of

investment grade ratings for mortgage backed securities. If the credit rating agencies had issued

ratings that accurately reflected the increasing risk in the RMBS and CDO markets and

appropriately adjusted existing ratings in those markets, they might have discouraged investors

from purchasing high risk RMBS and CDO securities, and slowed the pace of securitizations.

It was not in the short term economic interest of either Moody’s or S&P, however, to

provide accurate credit ratings for high risk RMBS and CDO securities, because doing so would

have hurt their own revenues. Instead, the credit rating agencies’ profits became increasingly

reliant on the fees generated by issuing a large volume of structured finance ratings. In the end,

Moody’s and S&P provided AAA ratings to tens of thousands of high risk RMBS and CDO

securities and then, when those products began to incur losses, issued mass downgrades that

shocked the financial markets, hammered the value of the mortgage related securities, and helped

trigger the financial crisis.

(4) Investment Bank Abuses:

Case Study of Goldman Sachs and Deutsche Bank

The final chapter examines how investment banks contributed to the financial crisis,

using as case studies Goldman Sachs and Deutsche Bank, two leading participants in the U.S.

mortgage market.

Investment banks can play an important role in the U.S. economy, helping to channel the

nation’s wealth into productive activities that create jobs and increase economic growth. But in

the years leading up to the financial crisis, large investment banks designed and promoted

complex financial instruments, often referred to as structured finance products, that were at the

heart of the crisis. They included RMBS and CDO securities, credit default swaps (CDS), and

CDS contracts linked to the ABX Index. These complex, high risk financial products were

engineered, sold, and traded by the major U.S. investment banks.

From 2004 to 2008, U.S. financial institutions issued nearly $2.5 trillion in RMBS and

over $1.4 trillion in CDO securities, backed primarily by mortgage related products. Investment

banks typically charged fees of $1 to $8 million to act as the underwriter of an RMBS

securitization, and $5 to $10 million to act as the placement agent for a CDO securitization.

Those fees contributed substantial revenues to the investment banks, which established internal

structured finance groups, as well as a variety of RMBS and CDO origination and trading desks

within those groups, to handle mortgage related securitizations. Investment banks sold RMBS

and CDO securities to investors around the world, and helped develop a secondary market where

RMBS and CDO securities could be traded. The investment banks’ trading desks participated in

those secondary markets, buying and selling RMBS and CDO securities either on behalf of their

clients or in connection with their own proprietary transactions.

The financial products developed by investment banks allowed investors to profit, not

only from the success of an RMBS or CDO securitization, but also from its failure. CDS

contracts, for example, allowed counterparties to wager on the rise or fall in the value of a

specific RMBS security or on a collection of RMBS and other assets contained or referenced in a

CDO. Major investment banks developed standardized CDS contracts that could also be traded

on a secondary market. In addition, they established the ABX Index which allowed

counterparties to wager on the rise or fall in the value of a basket of subprime RMBS securities,

which could be used to reflect the status of the subprime mortgage market as a whole. The

investment banks sometimes matched up parties who wanted to take opposite sides in a

transaction and other times took one or the other side of the transaction to accommodate a client.

At still other times, investment banks used these financial instruments to make their own

proprietary wagers. In extreme cases, some investment banks set up structured finance

transactions which enabled them to profit at the expense of their clients.

Two case studies, involving Goldman Sachs and Deutsche Bank, illustrate a variety of

troubling practices that raise conflicts of interest and other concerns involving RMBS, CDO,

CDS, and ABX related financial instruments that contributed to the financial crisis.

The Goldman Sachs case study focuses on how it used net short positions to benefit from

the downturn in the mortgage market, and designed, marketed, and sold CDOs in ways that

created conflicts of interest with the firm’s clients and at times led to the bank=s profiting from

the same products that caused substantial losses for its clients.

From 2004 to 2008, Goldman was a major player in the U.S. mortgage market. In 2006

and 2007 alone, it designed and underwrote 93 RMBS and 27 mortgage related CDO

securitizations totaling about $100 billion, bought and sold RMBS and CDO securities on behalf

of its clients, and amassed its own multi-billion-dollar proprietary mortgage related holdings. In

December 2006, however, when it saw evidence that the high risk mortgages underlying many

RMBS and CDO securities were incurring accelerated rates of delinquency and default,

Goldman quietly and abruptly reversed course.

Over the next two months, it rapidly sold off or wrote down the bulk of its existing

subprime RMBS and CDO inventory, and began building a short position that would allow it to

profit from the decline of the mortgage market. Throughout 2007, Goldman twice built up and

cashed in sizeable mortgage related short positions. At its peak, Goldman’s net short position

totaled $13.9 billion. Overall in 2007, its net short position produced record profits totaling $3.7

billion for Goldman’s Structured Products Group, which when combined with other mortgage

losses, produced record net revenues of $1.2 billion for the Mortgage Department as a whole.

Throughout 2007, Goldman sold RMBS and CDO securities to its clients without

disclosing its own net short position against the subprime market or its purchase of CDS

contracts to gain from the loss in value of some of the very securities it was selling to its clients.

The case study examines in detail four CDOs that Goldman constructed and sold called

Hudson 1, Anderson, Timberwolf, and Abacus 2007-AC1. In some cases, Goldman transferred

risky assets from its own inventory into these CDOs; in others, it included poor quality assets

that were likely to lose value or not perform. In three of the CDOs, Hudson, Anderson and

Timberwolf, Goldman took a substantial portion of the short side of the CDO, essentially betting

that the assets within the CDO would fall in value or not perform. Goldman’s short position was

in direct opposition to the clients to whom it was selling the CDO securities, yet it failed to

disclose the size and nature of its short position while marketing the securities. While Goldman

sometimes included obscure language in its marketing materials about the possibility of its

taking a short position on the CDO securities it was selling, Goldman did not disclose to

potential investors when it had already determined to take or had already taken short investments

that would pay off if the particular security it was selling, or RMBS and CDO securities in

general, performed poorly. In the case of Hudson 1, for example, Goldman took 100% of the

short side of the $2 billion CDO, betting against the assets referenced in the CDO, and sold the

Hudson securities to investors without disclosing its short position. When the securities lost

value, Goldman made a $1.7 billion gain at the direct expense of the clients to whom it had sold

the securities.

In the case of Anderson, Goldman selected a large number of poorly performing assets

for the CDO, took 40% of the short position, and then marketed Anderson securities to its

clients. When a client asked how Goldman “got comfortable” with the New Century loans in the

CDO, Goldman personnel tried to dispel concerns about the loans, and did not disclose the firm’s

own negative view of them or its short position in the CDO.

In the case of Timberwolf, Goldman sold the securities to its clients even as it knew the

securities were falling in value. In some cases, Goldman knowingly sold Timberwolf securities

to clients at prices above its own book values and, within days or weeks of the sale, marked

down the value of the sold securities, causing its clients to incur quick losses and requiring some

to post higher margin or cash collateral. Timberwolf securities lost 80% of their value within

five months of being issued and today are worthless. Goldman took 36% of the short position in

the CDO and made money from that investment, but ultimately lost money when it could not sell

all of the Timberwolf securities.

In the case of Abacus, Goldman did not take the short position, but allowed a hedge fund,

Paulson & Co. Inc., that planned on shorting the CDO to play a major but hidden role in

selecting its assets. Goldman marketed Abacus securities to its clients, knowing the CDO was

designed to lose value and without disclosing the hedge fund’s asset selection role or investment

objective to potential investors. Three long investors together lost about $1 billion from their

Abacus investments, while the Paulson hedge fund profited by about the same amount. Today,

the Abacus securities are worthless.

In the Hudson and Timberwolf CDOs, Goldman also used its role as the collateral put

provider or liquidation agent to advance its financial interest to the detriment of the clients to

whom it sold the CDO securities.

The Deutsche Bank case study describes how the bank’s top global CDO trader, Greg

Lippmann, repeatedly warned and advised his Deutsche Bank colleagues and some of his clients

seeking to buy short positions about the poor quality of the RMBS securities underlying many

CDOs, described some of those securities as “crap” and “pigs,” and predicted the assets and the

CDO securities would lose value. At one point, Mr. Lippmann was asked to buy a specific CDO

security and responded that it “rarely trades,” but he “would take it and try to dupe someone”

into buying it. He also at times referred to the industry’s ongoing CDO marketing efforts as a

“CDO machine” or “ponzi scheme.” Deutsche Bank’s senior management disagreed with his

negative views, and used the bank’s own funds to make large proprietary investments in

mortgage related securities that, in 2007, had a notional or face value of $128 billion and a

market value of more than $25 billion. Despite its positive view of the housing market, the bank

allowed Mr. Lippmann to develop a large proprietary short position for the bank in the RMBS

market, which from 2005 to 2007, totaled $5 billion. The bank cashed in the short position from

2007 to 2008, generating a profit of $1.5 billion, which Mr. Lippmann claims is more money on

a single position than any other trade had ever made for Deutsche Bank in its history. Despite

that gain, due to its large long holdings, Deutsche Bank lost nearly $4.5 billion from its mortgage

related proprietary investments.

The Subcommittee also examined a $1.1 billion CDO underwritten by Deutsche Bank

known as Gemstone CDO VII Ltd. (Gemstone 7), which issued securities in March 2007. It was

one of 47 CDOs totaling $32 billion that Deutsche Bank underwrote from 2004 to 2008.

Deutsche Bank made $4.7 million in fees from Gemstone 7, while the collateral manager, a

hedge fund called HBK Capital Management, was slated to receive $3.3 million. Gemstone 7

concentrated risk by including within a single financial instrument 115 RMBS securities whose

financial success depended upon thousands of high risk, poor quality subprime loans. Many of

those RMBS securities carried BBB, BBB-, or even BB credit ratings, making them among the

highest risk RMBS securities sold to the public. Nearly a third of the RMBS securities contained

subprime loans originated by Fremont, Long Beach, and New Century, lenders well known

within the industry for issuing poor quality loans. Deutsche Bank also sold securities directly

from its own inventory to the CDO. Deutsche Bank’s CDO trading desk knew that many of

these RMBS securities were likely to lose value, but did not object to their inclusion in

Gemstone 7, even securities which Mr. Lippmann was calling “crap” or “pigs.” Despite the poor

quality of the underlying assets, Gemstone’s top three tranches received AAA ratings. Deutsche

Bank ultimately sold about $700 million in Gemstone securities, without disclosing to potential

investors that its global head trader of CDOs had extremely negative views of a third of the

assets in the CDO or that the bank’s internal valuations showed that the assets had lost over $19

million in value since their purchase. Within months of being issued, the Gemstone 7 securities

lost value; by November 2007, they began undergoing credit rating downgrades; and by July

2008, they became nearly worthless.

Both Goldman Sachs and Deutsche Bank underwrote securities using loans from

subprime lenders known for issuing high risk, poor quality mortgages, and sold risky securities

to investors across the United States and around the world. They also enabled the lenders to

acquire new funds to originate still more high risk, poor quality loans. Both sold CDO securities

without full disclosure of the negative views of some of their employees regarding the

underlying assets and, in the case of Goldman, without full disclosure that it was shorting the

very CDO securities it was marketing, raising questions about whether Goldman complied with

its obligations to issue suitable investment recommendations and disclose material adverse

interests.

The case studies also illustrate how these two investment banks continued to market new

CDOs in 2007, even as U.S. mortgage delinquencies intensified, RMBS securities lost value, the

U.S. mortgage market as a whole deteriorated, and investors lost confidence. Both kept

producing and selling high risk, poor quality structured finance products in a negative market, in

part because stopping the “CDO machine” would have meant less income for structured finance

units, smaller executive bonuses, and even the disappearance of CDO desks and personnel,

which is what finally happened. The two case studies also illustrate how certain complex

structured finance products, such as synthetic CDOs and naked credit default swaps, amplified

market risk by allowing investors with no ownership interest in the reference obligations to place

unlimited side bets on their performance. Finally, the two case studies demonstrate how

proprietary trading led to dramatic losses in the case of Deutsche Bank and undisclosed conflicts

of interest in the case of Goldman Sachs.

Investment banks were the driving force behind the structured finance products that

provided a steady stream of funding for lenders originating high risk, poor quality loans and that

magnified risk throughout the U.S. financial system. The investment banks that engineered,

sold, traded, and profited from mortgage related structured finance products were a major cause

of the financial crisis.

C. Recommendations

The four causative factors examined in this Report are interconnected. Lenders

introduced new levels of risk into the U.S. financial system by selling and securitizing complex

home loans with high risk features and poor underwriting. The credit rating agencies labeled the

resulting securities as safe investments, facilitating their purchase by institutional investors

around the world. Federal banking regulators failed to ensure safe and sound lending practices

and risk management, and stood on the sidelines as large financial institutions active in U.S.

financial markets purchased billions of dollars in mortgage related securities containing high

risk, poor quality mortgages. Investment banks magnified the risk to the system by engineering

and promoting risky mortgage related structured finance products, and enabling investors to use

naked credit default swaps and synthetic instruments to bet on the failure rather than the success

of U.S. financial instruments. Some investment banks also ignored the conflicts of interest

created by their products, placed their financial interests before those of their clients, and even

bet against the very securities they were recommending and marketing to their clients. Together

these factors produced a mortgage market saturated with high risk, poor quality mortgages and

securities that, when they began incurring losses, caused financial institutions around the world

to lose billions of dollars, produced rampant unemployment and foreclosures, and ruptured faith

in U.S. capital markets.

Nearly three years later, the U.S. economy has yet to recover from the damage caused by

the 2008 financial crisis. This Report is intended to help analysts, market participants,

policymakers, and the public gain a deeper understanding of the origins of the crisis and take the

steps needed to prevent excessive risk taking and conflicts of interest from causing similar

damage in the future. Each of the four chapters in this Report examining a key aspect of the

financial crisis begins with specific findings of fact, details the evidence gathered by the

Subcommittee, and ends with recommendations. For ease of reference, all of the

recommendations are reprinted here. For more information about each recommendation, please

see the relevant chapter.

Recommendations on High Risk Lending

1. Ensure “Qualified Mortgages” Are Low Risk. Federal regulators should use their

regulatory authority to ensure that all mortgages deemed to be “qualified residential

mortgages” have a low risk of delinquency or default.

2. Require Meaningful Risk Retention. Federal regulators should issue a strong risk

retention requirement under Section 941 by requiring the retention of not less than a

5% credit risk in each, or a representative sample of, an asset backed securitization’s

tranches, and by barring a hedging offset for a reasonable but limited period of time.

3. Safeguard Against High Risk Products. Federal banking regulators should

safeguard taxpayer dollars by requiring banks with high risk structured finance

products, including complex products with little or no reliable performance data, to

meet conservative loss reserve, liquidity, and capital requirements.

4. Require Greater Reserves for Negative Amortization Loans. Federal banking

regulators should use their regulatory authority to require banks issuing negatively

amortizing loans that allow borrowers to defer payments of interest and principal, to

maintain more conservative loss, liquidity, and capital reserves.

5. Safeguard Bank Investment Portfolios. Federal banking regulators should use the

Section 620 banking activities study to identify high risk structured finance products

and impose a reasonable limit on the amount of such high risk products that can be

included in a bank’s investment portfolio.

Recommendations on Regulatory Failures

1. Complete OTS Dismantling. The Office of the Comptroller of the Currency (OCC)

should complete the dismantling of the Office of Thrift Supervision (OTS), despite

attempts by some OTS officials to preserve the agency’s identity and influence within

the OCC.

2. Strengthen Enforcement. Federal banking regulators should conduct a review of

their major financial institutions to identify those with ongoing, serious deficiencies,

and review their enforcement approach to those institutions to eliminate any policy of

deference to bank management, inflated CAMELS ratings, or use of short term profits

to excuse high risk activities.

3. Strengthen CAMELS Ratings. Federal banking regulators should undertake a

comprehensive review of the CAMELS ratings system to produce ratings that signal

whether an institution is expected operate in a safe and sound manner over a specified

period of time, asset quality ratings that reflect embedded risks rather than short term

profits, management ratings that reflect any ongoing failure to correct identified

deficiencies, and composite ratings that discourage systemic risks.

4. Evaluate Impacts of High Risk Lending. The Financial Stability Oversight Council

should undertake a study to identify high risk lending practices at financial

institutions, and evaluate the nature and significance of the impacts that these

practices may have on U.S. financial systems as a whole.

Recommendations on Inflated Credit Ratings

1. Rank Credit Rating Agencies by Accuracy. The SEC should use its regulatory

authority to rank the Nationally Recognized Statistical Rating Organizations in terms

of performance, in particular the accuracy of their ratings.

2. Help Investors Hold CRAs Accountable. The SEC should use its regulatory

authority to facilitate the ability of investors to hold credit rating agencies accountable

in civil lawsuits for inflated credit ratings, when a credit rating agency knowingly or

recklessly fails to conduct a reasonable investigation of the rated security.

3. Strengthen CRA Operations. The SEC should use its inspection, examination, and

regulatory authority to ensure credit rating agencies institute internal controls, credit

rating methodologies, and employee conflict of interest safeguards that advance

rating accuracy.

4. Ensure CRAs Recognize Risk. The SEC should use its inspection, examination, and

regulatory authority to ensure credit rating agencies assign higher risk to financial

instruments whose performance cannot be reliably predicted due to their novelty or

complexity, or that rely on assets from parties with a record for issuing poor quality

assets.

5. Strengthen Disclosure. The SEC should exercise its authority under the new Section

78o-7(s) of Title 15 to ensure that the credit rating agencies complete the required

new ratings forms by the end of the year and that the new forms provide

comprehensible, consistent, and useful ratings information to investors, including by

testing the proposed forms with actual investors.

6. Reduce Ratings Reliance. Federal regulators should reduce the federal government’s

reliance on privately issued credit ratings.

Recommendations on Investment Bank Abuses

1. Review Structured Finance Transactions. Federal regulators should review the

RMBS, CDO, CDS, and ABX activities described in this Report to identify any

violations of law and to examine ways to strengthen existing regulatory prohibitions

against abusive practices involving structured finance products.

2. Narrow Proprietary Trading Exceptions. To ensure a meaningful ban on

proprietary trading under Section 619, any exceptions to that ban, such as for marketmaking

or risk-mitigating hedging activities, should be strictly limited in the

implementing regulations to activities that serve clients or reduce risk.

3. Design Strong Conflict of Interest Prohibitions. Regulators implementing the

conflict of interest prohibitions in Sections 619 and 621 should consider the types of

conflicts of interest in the Goldman Sachs case study, as identified in Chapter VI(C)(6)

of this Report.

4. Study Bank Use of Structured Finance. Regulators conducting the banking

activities study under Section 620 should consider the role of federally insured banks

in designing, marketing, and investing in structured finance products with risks that

cannot be reliably measured and naked credit default swaps or synthetic financial

instruments.

II. BACKGROUND

Understanding the recent financial crisis requires examining how U.S. financial markets

have changed in fundamental ways over the past 15 years. The following provides a brief

historical overview of some of those changes; explains some of the new financial products and

trading strategies in the mortgage area; and provides background on credit ratings, investment

banks, government sponsored enterprises, and financial regulators. It also provides a brief

timeline of key events in the financial crisis. Two recurrent themes are the increasing amount of

risk and conflicts of interest in U.S. financial markets.

A. Rise of Too-Big-To-Fail U.S. Financial Institutions

Until relatively recently, federal and state laws limited federally-chartered banks from

branching across state lines.2 Instead, as late as the 1990s, U.S. banking consisted primarily of

thousands of modest-sized banks tied to local communities. Since 1990, the United States has

witnessed the number of regional and local banks and thrifts shrink from just over 15,000 to

approximately 8,000 by 2009,3 while at the same time nearly 13,000 regional and local credit

unions have been reduced to 7,500.4 This broad-based approach meant that when a bank

suffered losses, the United States could quickly close its doors, protect its depositors, and avoid

significant damage to the U.S. banking system or economy. Decentralized banking also

promoted competition, diffused credit in the marketplace, and prevented undue concentrations of

financial power.

In the mid 1990s, the United States initiated substantial changes to the banking industry,

some of which relaxed the rules under which banks operated, while others imposed new

regulations, and still others encouraged increased risk-taking. In 1994, for the first time,

Congress explicitly authorized interstate banking, which allowed federally-chartered banks to

open branches nationwide more easily than before.5 In 1999, Congress repealed the Glass-

Steagall Act of 1933, which had generally required banks, investment banks, securities firms,

and insurance companies to operate separately,6 and instead allowed them to openly merge

operations.7

2 See McFadden Act of 1927, P.L. 69-639 (prohibiting national banks from owning branches in multiple states);

Bank Holding Company Act of 1956, P.L. 84-511 (prohibiting banking company companies from owning branches

in multiple states). See also “Going Interstate: A New Dawn for U.S. Banking,” The Regional Economist, a

publication of the Federal Reserve Bank of St. Louis (7/1994).

The same law also eliminated the Glass-Steagall prohibition on banks engaging in

3 See U.S. Census Bureau, “Statistical Abstract of the United States 2011,” at 735,

http://www.census.gov/compendia/statab/2011/tables/11s1175.pdf.

4 1/3/2011 chart, “Insurance Fund Ten-Year Trends,” supplied by the National Credit Union Administration

(showing that, as of 12/31/1993, the United States had 12,317 federal and state credit unions).

Data provided by the National Credit Union Administration, 1/3/11.

5 Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, P.L. 103-328 (repealing statutory

prohibitions on interstate banking).

6 Glass-Steagall Act of 1933, also known as the Banking Act, P.L. 73-66.

7 Gramm-Leach-Bliley Act of 1999, also known as the Financial Services Modernization Act, P.L. 106-102. Some

banks had already begun to engage in securities and insurance activities, with the most prominent example at the

time being Citicorp’s 1998 merger with the Travelers insurance group.

proprietary trading8 and exempted investment bank holding companies from direct federal

regulation.9 In 2000, Congress enacted the Commodity Futures Modernization Act which barred

federal regulation of swaps and the trillion-dollar swap markets, and which allowed U.S. banks,

broker-dealers, and other financial institutions to develop, market, and trade these unregulated

financial products, including credit default swaps, foreign currency swaps, interest rate swaps,

energy swaps, total return swaps, and more.10

In 2002, the Treasury Department, along with other federal bank regulatory agencies,

altered the way capital reserves were calculated for banks, and encouraged the retention of

securitized mortgages with investment grade credit ratings by allowing banks to hold less capital

in reserve for them than if the individual mortgages were held directly on the banks’ books.11 In

2004, the SEC relaxed the capital requirements for large broker-dealers, allowing them to grow

even larger, often with borrowed funds.12 In 2005, when the SEC attempted to assert more

control over the growing hedge fund industry, by requiring certain hedge funds to register with

the agency, a federal Court of Appeals issued a 2006 opinion that invalidated the SEC

regulation.13

These and other steps paved the way, over the course of little more than the last decade,

for a relatively small number of U.S. banks and broker-dealers to become giant financial

conglomerates involved in collecting deposits; financing loans; trading equities, swaps and

commodities; and issuing, underwriting, and marketing billions of dollars in stock, debt

instruments, insurance policies, and derivatives. As these financial institutions grew in size and

complexity, and began playing an increasingly important role in the U.S. economy, policymakers

began to ask whether the failure of one of these financial institutions could damage not only the

U.S. financial system, but the U.S. economy as a whole. In a little over ten years, the creation of

too-big-to-fail financial institutions had become a reality in the United States.14

8 Glass-Steagall Act, Section 16.

9 Gramm-Leach-Bliley Act of 1999, also known as the Financial Services Modernization Act, P.L. 106-102. See

also prepared statement of SEC Chairman Christopher Cox, “Role of Federal Regulators: Lessons from the Credit

Crisis for the Future of Regulation,” October 23, 2008 House Committee on Oversight and Government Reform

Hearing, (“It was a fateful mistake in the Gramm-Leach-Bliley Act that neither the SEC nor any regulator was given

the statutory authority to regulate investment bank holding companies other than on a voluntary basis.”).

10 The 2000 Commodity Futures Modernization Act (CFMA) was enacted as a title of the Consolidated

Appropriations Act of 2001, P.L. 106-554.

11 See 66 Fed. Reg. 59614 (Nov. 29, 2011), http://www.federalregister.gov/articles/2001/11/29/01-29179/risk-basedcapital-

guidelines-capital-adequacy-guidelines-capital-maintenance-capital-treatment-of.

12 See “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised

Entities,” RIN 3235-AI96, 17 CFR Parts 200 and 240 (8/20/2004) (“amended the net capital rule under the

Securities Exchange Act of 1934 to establish a voluntary alternative method of computing net capital for certain

broker-dealers”). The Consolidated Supervised Entities (CSE) program, which provided SEC oversight of

investment bank holding companies that joined the CSE program on a voluntarily basis, was established by the SEC

The Maine Crime: Mortgage Fraud In The Great State Of Maine

Sunday, September 4, 2011

PART 1 Make that 25 pages at a time

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